4 Best Practices When Self-Insuring for Long-Term Care

"I plan to self-insure."

That statement, or some variation of it, was a frequent refrain from many posters in the Comments field below my recent articles on long-term care. My first article provided an overview of the limitations of relying on Medicare and Medicaid to cover long-term care costs, and a follow-up amalgamated some basic statistics about long-term care to help readers make well-grounded decisions about handling these costs. Self-insurance simply means sidestepping the insurance company, setting enough money aside to cover any long-term care costs that might arise.

You often hear that individuals with $2 million or more in assets can self-insure for long-term care because they can likely cover nursing- or in-home-care costs by dipping into their own nest eggs. I'd assert that $2 million isn't what it once was, however, particularly given rapidly rising long-term care costs, longevity rates, and increasing rates of dementia and Alzheimer's disease among the elderly.

Rising insurance costs have deterred other would-be purchasers of long-term care policies: As interest rates have trended down, premiums on long-term policies have stepped up, in some cases dramatically. Pre-existing health conditions have put long-term care coverage off limits for others, and some readers noted that they'd been spooked by stories of (or personal experience with) insurers jacking up premiums or refusing to pay benefits. Still other commenters--and this contingent was alive and well in the threads--have decided to play the odds, arguing that the chances of them incurring catastrophic long-term care costs are not high enough to warrant forking over thousands of dollars in premiums.

Yet saying you'll insure for long-term care is one thing; actually doing it is another. If you've decided to cover long-term care costs out of pocket, how much should you reasonably set aside to cover such expenses, and in what vehicles should you invest the money?

If you're in the "self-insure for long-term care" group, consider the following.

Best Practice 1: Make sure you're saving enough.
The key step to take if self-insuring is on your radar is to give some thought to how much you might actually need to cover long-term care costs and then craft a plan to amass that sum. This article includes some statistics about long-term care costs that can help you set your targets: In 2012, the median annual rate for a private room in a nursing home was $81,000, and the average length of stay was 2.44 years. You'll also need to factor in inflation: Median nursing home costs increased at a 4.5% annualized rate between 2008 and 2012, and that high rate of inflation could well persist as seniors live longer and stoke demand for long-term care services. This calculator allows you to tweak those variables to arrive at a reasonable savings target: If you're younger than 50, especially, that long-term care inflation rate, compounded over many years, is pretty daunting. For couples, self-insuring is an even greater financial challenge. In a worst-case scenario in which both spouses need long-term care during their lifetimes, the costs could be double the aforementioned estimates.

Best Practice 2: Factor in ongoing living expenses.
Some readers in favor of self-insuring have pointed out, quite logically, that long-term care costs might not be as financially ruinous as you often hear. If you're in a long-term care setting, the thinking goes, you won't need to buy your own food or maintain a household or car. But that assumption rests on a few conditions, which your own situation might or might not meet. First off, it assumes that you'll obtain long-term care outside of your home. In reality, however, many seniors prefer to receive care in their own homes, so their housing and food-related costs would be unlikely to change significantly. Second, other living expenses will only automatically cease for single people who enter long-term care settings or for those who have outlived their spouses. But it's not at all uncommon for one spouse to need long-term care while the other remains healthy. In such situations, the couple's financial resources will need to cover the costs of maintaining the household for the healthy spouse while simultaneously paying for long-term care.

Best Practice 3: Create a distinct 'bucket' for long-term care expenses.
The fact that long-term care costs might well be in addition to--rather than instead of--regular living expenses argues for not only budgeting for them separately, but also for segregating them from your other retirement assets. In fact, some readers have noted that they've set up a separate "bucket" for long-term expenses, and that stands out as a best practice for those self-insuring for long-term care. If it turns out that they don't need the assets for long-term care needs during their lifetimes, that money would pass to their heirs.

Those with a separate long-term care bucket would separate those assets from their other retirement accounts when testing the sustainability of their planned in-retirement withdrawal rate, for example. Bucketing also allows investors to give that portion of their portfolio its own asset allocation because those assets would be among the last to be depleted during their lifetimes. For fiftysomethings, a fairly aggressive asset mix makes sense, given that the average age upon entering a nursing home is 79 and that outearning the long-term care inflation rate is a key goal. Those who are in their 70s, meanwhile, will want their long-term care assets to skew heavily toward bonds and cash because they could need to tap those assets within the next five to 10 years. Married couples with dramatic differences in their ages, meanwhile, might consider creating two long-term care buckets with distinct time horizons.

Best Practice 4: Consider the possibility of a 'fat tail' event.
For baseline planning purposes, it's reasonable to use the averages when estimating the duration of long-term care needs, when you're likely to need long-term care, and the annual cost. (You'll need to inflation-adjust the costs, of course.) Although that's a good starting point, it's also worthwhile to factor in the possibility of a so-called fat-tail event, the chance that your own situation will deviate widely from the averages. While the average person entering a nursing home is 79, needs nursing-home care for 2.4 years, and paid $81,000 for that care in 2011, there's a risk that you could need long-term care for many more years than those averages would suggest. For example, 10% of those entering nursing homes stay there for five or more years.

Certain types of long-term care policies help hedge against catastrophic long-term care costs, but those who have decided to self-insure for long-term care needs will need to be a bit more creative. For example, if you have substantial home equity in your home, a reverse mortgage could serve as the next line of defense once you depleted the assets you had earmarked for long-term care. So-called longevity insurance is another idea for hedging against fat-tail long-term care expenses. This kind of insurance, which is a fixed deferred annuity that begins paying you a stream of income at a given future date, such as when you reach your life expectancy, has the advantage of being flexible; you could use those assets for long-term care costs or, if you're healthy, to cover your living expenses. Yet fixed deferred annuities are an imperfect hedge against long-term care costs because you can't turn on the income when you need it. If you end up needing care at 69 and payouts from your fixed deferred annuity weren't set to begin until you turned 80, the product would be of little use to you.

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