Financing Long-Term Care Expenses

Financing Long-Term Care Expenses

A closer look at the options

The “permanence” of the $5.25 million inflation-indexed applicable exclusion amount in the American Taxpayer Relief Act of 2012 (ATRA) gives estate-planning and investment professionals the opportunity to re-examine how they advise clients. For many, tax-driven planning will take a back seat—supplanted, perhaps, by non-quantitative considerations. But, there are some situations in which rigorous quantitative analysis is more important than ever.

Prior to ATRA, many wealthy clients focused on transferring excess wealth—money they hopefully won’t need to support their lifestyle—in a manner they expect will minimize estate taxes. But in this post-ATRA world, aggressive lifetime wealth transfer initiatives could cause families to lose a substantial step-up in income tax basis at death on assets that wouldn’t have been subject to estate tax in any event, due to the ever-increasing exclusion amount.1   

Moreover, when deciding to transfer wealth, it’s difficult to draw a sharp line between money needed for lifestyle (core) spending and excess (surplus) capital. A pool of funds deemed adequate to support only anticipated lifestyle expenses may fall well short of the mark if an adult child fails to launch or an aging parent needs to be brought back into the household due to health issues. Should clients establish an additional reserve fund to cover these expenses? How much should be reserved? And, should those funds be retained on a client’s balance sheet (and thus receive a step-up in basis at death to the extent not expended) or held off balance sheet in an irrevocable trust (thereby avoiding estate tax, but probably losing the step-up in basis)? 



A financial reserve can be established for almost any purpose—including support of collateral relatives, anticipated repairs and improvements to a residence, tax liabilities associated with the sale of a business and educational expenses for descendants, to name just a few. But for many families, the funding of future long-term care (LTC) costs is an issue of particular concern. Although modern medicine allows people to live longer, many elderly Americans—even those who aren’t technically sick—struggle to perform basic activities of daily living (ADLs), such as feeding, bathing and dressing themselves.  

Family members often help a loved one perform ADLs, but is it realistic to expect them to do so on a full-time basis? What kind of toll will this take on the care providers—not just in terms of out-of-pocket expenses and lost earnings, but also the emotional costs and impacts on their own health and well-being? If professional care providers will handle some, or all, of those functions, how much will those services cost the family? And, for how long will those costs be incurred?


The Insurance Alternative

Most financial set-asides—reserves for purposes like education or residential improvements—must be borrowed and ultimately repaid, or self-financed. But, in the case of LTC costs, there are alternatives to borrowing and self-financing that may make the financial analysis a bit more complicated. One possibility would be to self-insure. A second would be to acquire stand-alone LTC insurance. And, a third would be to acquire a hybrid product that’s both a life insurance policy and an LTC rider in one wrapper. Other financing mechanisms are possible,2 but let’s focus on these three and examine each in turn.



Self-insuring LTC costs isn’t possible for every family. But, for those who can afford it, a significant benefit is that funds not expended on LTC may remain available as a legacy to surviving family members, as opposed to being spent on insurance premiums. Post-ATRA, there’s a substantial probability in many families that the senior generation’s inflation-indexed applicable exclusion will be sufficient to shield unexpended funds remaining in a LTC reserve from estate taxes—a potentially huge benefit.3 But, how much should one reserve for LTC expenses? How likely is it that LTC services will be needed? What form will that care take—assisted living, nursing home or in-home care? When will those services be needed and for how long? How should investments in the reserve fund be allocated? What if the investment performance of the fund is worse than anticipated? These are difficult questions that require careful planning and financial analysis, taking into particular account the desires of the family.


Stand-Alone LTC Policies

For those families that can’t self-insure—and even for those that can—a stand-alone LTC insurance policy may be an attractive option. Under most policies, the payment of benefits is triggered by an insured’s cognitive impairment or inability to perform, without substantial assistance, at least two ADLs.4 

These policies take two basic forms. Indemnity policies simply pay a specified daily amount on a triggering event, regardless of how much the family actually pays out for LTC. In contrast, reimbursement policies cover the actual costs incurred. In either case, stand-alone LTC insurance is “classic” insurance—policyholders who don’t use some or all of the policy benefits pay for those who do. Thus, in financial terms, policyholders who collect substantial benefits usually reap a windfall, and those who don’t often incur a substantial opportunity cost due to premiums paid and investment returns that those dollars would have yielded. This interesting risk/reward trade-off will be explored in one of the two case studies that follow.


Hybrid Policies

The third approach—a hybrid life insurance policy with an LTC rider—helps soften some of the sharper edges of the first two approaches. In a hybrid policy, benefits not expended on LTC during the insured’s lifetime are available to beneficiaries as a death benefit. Moreover, a hybrid policy may guarantee the benefit amount, so long as the specific annual premiums are paid on time; in contrast, stand-alone LTC premium levels generally aren’t guaranteed.5 On the other hand, stand-alone policies tend to offer more features—like inflation-indexed benefits—than hybrid products do. 


Two Hypotheticals

To illustrate some of the trade-offs of these three approaches, let’s examine two hypothetical case studies.

Case study: Stand-alone policy or self-insurance?

First, consider the case of Olive and Stan D’Alone, each age 50. They have a substantial portfolio of investment assets that should be more than adequate to secure their core spending needs for their joint lives, but each has a parent who’s suffering from dementia. After seeing how paying LTC costs on behalf of their parents has affected their own portfolio,6 they’re thinking about what they themselves might need in the future. Should they buy a stand-alone LTC policy to cover the costs of that care? They’re considering a policy that requires an annual premium of $9,800 and would reimburse each spouse up to $400 per day (indexed for inflation at 5 percent per year) of care costs for up to three full years. They would like to know whether they should acquire this policy or self-insure; they’re not interested in the hybrid approach.

Bernstein’s proprietary Wealth Forecasting SystemSM (WFS) ran a simulation that compared paying stand-alone LTC premiums to investing those same dollars in a taxable 60 percent stock/40 percent bond portfolio. The WFS generates 10,000 plausible paths that the capital markets could take and then tests each investment strategy across those 10,000 paths. The WFS models only broad market indices, not proprietary investment services from Bernstein or any other investment manager. In this analysis, we invested $9,800 per year in a capital markets portfolio, rather than in the LTC policy. Which approach is likely to work better?

The answer depends largely on when, and whether, Olive or Stan draws upon the LTC benefit. For the purposes of this example, let’s assume that only one spouse (say Stan) needs LTC services during his lifetime7 and that he draws the maximum benefit—$400 per day, adjusted for inflation at 5 percent per year, for three consecutive years—prior to his death.  

“Risky Business,” this page, highlights one risk of self-insuring: Even if Stan doesn’t need the benefits until he’s 90 years old, the self-insurance pool he created would run out of money in about 1.5 years, on average, leaving the core lifestyle portfolio to pick up any excess costs. “Weighing the Options,” this page, shows that the probability of the stand-alone LTC policy providing greater financial benefits than self-insurance is very high—over an 80 percent likelihood, even if the first benefit payment is postponed for 40 years. If both Olive and Stan were to need LTC care, this likelihood would be even higher.

But, one potential downside of relying solely on stand-alone LTC insurance is highlighted in “Opportunity Costs,” p. 25. In this instance, let’s assume that Olive and Stan beat the odds and never need LTC during their joint lifetimes, which this example assumes to be 40 years. In such a case, there’s no policy cash value or death benefit on which to fall back.8 As a result, all of the premium dollars expended and all of the potential investment growth of those dollars over 40 years will have been lost. Based upon Bernstein’s projections, the opportunity cost to the portfolio would be $1.5 million in the median case—somewhat less in poor market conditions, substantially more in strong markets. Note that this cost is borne by the descendants—a lost legacy that may have been covered by the inflation-adjusted applicable exclusion had the D’Alones self-insured.

This case study illustrates an important aspect of stand-alone LTC insurance. When relied on exclusively, it’s a high risk, high reward strategy. For those families who can afford it, the better strategy may be to use stand-alone insurance to cover a portion of the anticipated costs and self-insurance to cover the rest. This blended approach may be necessary in any event—if, for example, LTC is required for more than three years per insured or the type of care rendered costs more than $400 per day, adjusted for inflation. The fact that the premiums required for this type of policy aren’t guaranteed—and may be (and in recent years, have been)9 increased by carriers with the approval of state insurance regulators—only heightens the risk of relying exclusively on stand-alone insurance. 

Families weighing these considerations will need comprehensive advice. Bernstein recommends a coordinated approach, using qualified insurance, financial, legal and tax advisors.

Case study: Hybrid policy or self-insurance?

Now consider a second case study, this time involving a divorced male, Hy Bridd, age 50, who’s concerned that if he needs LTC, there may not be a spouse or loved one available to assist. Self-insurance is an option, but he’s rejected stand-alone LTC insurance as too expensive. He’s intrigued, however, by an alternative strategy—acquiring a universal life insurance policy that includes an LTC rider. The $310,090 death benefit under this policy is guaranteed to age 120 if the “no-lapse” annual premium of $3,078 is paid on time each year.10 And, if he needs LTC during his lifetime, the death benefit can be “accelerated,” without penalty, to provide a monthly indemnity of just over $6,200—roughly $200 per day—to cover the costs of that care for up to 50 months. That monthly benefit isn’t indexed for inflation, but unlike stand-alone insurance, the annual premium will never increase. The life insurance death benefit will be reduced, dollar for dollar, by the amount of lifetime LTC benefits paid. How does this arrangement compare to self-insuring, assuming a 60 percent stock/40 percent bond mix in the reserve portfolio?

Based on Bernstein’s assessment, as shown in “Hedging Your Bets,” this page, the hybrid policy is likely to be superior to self-insurance if benefits are triggered within the next 29 years or so—when Hy will be approaching 80 years old—assuming that he qualifies for the maximum policy benefit for a full 50 months. Self-insurance is likely to be the better strategy if his payout stream begins thereafter. But, as shown in “Risks and Rewards,” p. 26, if he doesn’t need the lifetime benefit over the next 40 years, the opportunity cost to Hy’s estate is modest compared to the value he could accumulate if he were to self-insure in a 60 percent stock/40 percent bond portfolio.

In many ways, a hybrid life insurance policy with an LTC rider is a classic hedging strategy—providing an outsized benefit if the insured needs care relatively soon, with a modest opportunity cost if he needs LTC late in life or doesn’t need it at all. Some clients will like the risk/reward trade-off of this hybrid approach better than the all-or-nothing outcome of stand-alone LTC insurance.


Our Responsibility 

Quantifying these outcomes requires careful analysis of objective data tailored to a family’s particular requirements and concerns and a view of the future that takes unexpected and even unlikely events into account. This article merely scratches the surface; much more needs to be said and written about these issues. Estate planners have a particular obligation to consider these questions, take them into account when planning and drafting for their clients and share their viewpoint with the community at large. Only by working on these issues case-by-case can we, as a group, discover and share effective solutions. 



1. The federal applicable exclusion amount currently is $5.25 million. Based on recent Bernstein projections of inflation in our wealth forecasting model, we believe that the exclusion will be nearly $9 million in 20 years in the median case, with a 10 percent chance that the exclusion will be nearly $15 million at that time. The exclusion may be thought of as a “free step-up in basis” for assets held in the gross estate at death—no federal estate tax, but with an accompanying step-up in basis for most asset classes other than income in respect of a decedent. See generally Section 1014 of the Internal Revenue Code of 1986, as amended.

2. For example, a life insurance policyholder may surrender an in-force policy for its cash surrender value or sell it on the secondary market (in a “life settlement”) to help finance future long-term care (LTC) expenses. State governments are increasingly speaking out in favor of this practice as a way to offset future public expenditures for LTC. See Kelly Greene, “States Ease Use of Life Policies for Elder Care,” The Wall Street Journal, June 17, 2013, at p. C1.

3. See supra, note 1. As a result of the $5.25 million inflation-indexed exclusion now available under the American Taxpayer Relief Act of 2012 (ATRA), many investors will be able to retain a substantial LTC reserve without incurring federal estate tax at death. State death tax and basis step-up issues also should be considered as part of any comprehensive planning analysis.

4. See IRC Section 7702B(c)(2).

5. Many life insurance policies offer a “secondary no-lapse guarantee” if premiums are paid in the amounts and at the times specified in the policy. In contrast, stand-alone LTC insurance premiums aren’t guaranteed. In recent years, insurance carriers have successfully petitioned state regulators to increase premiums on in-force LTC policies, without a corresponding increase in benefits. See American Bar Association, The Advisor’s Guide to Long-Term Care (R. David Watros and Erik T. Reynolds, eds. 2013) at p. 91 (such increases must be imposed upon an entire class of policyholders, without discriminating against older or less healthy insureds). 

6. Fortunately, such payments, ordinarily, should qualify for the unlimited federal gift tax annual exclusion for healthcare payments on behalf of another. See IRC Section 2503(e).

7. Industry estimates suggest that one-half of all individuals and more than two-thirds of those over age 65 will need LTC at some point. See, for example, Watros and Reynolds, supra note 5, at pp. 23, 41. Sources aren’t as clear as to how long such care will be required or the extent to which benefits under existing LTC policies are being fully utilized. It’s also unclear whether past health care trends will continue.  For example, a recent study suggests that dementia rates may be declining for certain demgraphics. See Gina Kolata, “Dementia Rate is found to Drop Sharply With Better Health and Education.” The New York Times, July 17, 2013 at A8.

8. See IRC Section 7702B(b)(1)(D).

9. See Watros and Reynolds, supra note 5, at p. 141, note 14 (citing insurance advisor dissatisfaction with John Hancock’s 2010 premium rate increase); see also Tara Siegel Bernard, “Fine Print and Red Tape in Long-Term Care Policies,” The New York Times, June 8, 2013, at p. B1 (citing difficulties and delays families are facing when attempting to enforce LTC insurance claims). Although stand-alone LTC policies are useful products that can provide potentially powerful benefits, they aren’t a panacea.

10. See supra note 5. Under this particular hybrid policy, premiums are waived while the insured is receiving LTC benefits, and policy charges are waived once the policy’s cash value has been exhausted.