There’s No Magic Number for Self-Funding Long-Term Care

A version of this article appeared Oct. 22, 2018.

What's your retirement "number"? Distilling retirement readiness into a single dollar amount certainly has its appeal. Many people anchor on the idea of amassing $1 million, $3 million, or $5 million because it sounds like it should be plenty; they don't crunch the numbers on how much they'll actually need.

In a similar vein, I find that investors seek out a specific asset threshold to help determine whether they could self-fund long-term-care costs rather than buying long-term-care insurance. In my early days of focusing on retirement planning, $1.5 million was often asserted to be a “safe” asset threshold for paying long-term-care costs out of pocket. More recently—no doubt in light of the fact that we’ve seen long-term-care costs trend up more rapidly than the general inflation rate—that figure has crept up to $2.5 million.

On the one hand, it's laudable that people are thinking about the logistics of paying for long-term care rather than just giving it the periodic anxious thought. And it's only natural that more and more people would be strategizing about ways to avoid long-term-care insurance. Premiums have been increasing on existing policyholders, and more and more insurers have gotten out of the business of selling pure long-term-care insurance.

At the same time, looking to total portfolio assets to determine whether one should self-fund long-term care or purchase insurance seems like the wrong way to go about it. Instead, I think it makes more sense to size up the long-term-care need on its own: the likelihood that you'll need long-term care, how much it's apt to cost and for how long, whether you'd receive that care at home or free up your home as an asset to pay for it, and so forth. Armed with an understanding of those costs, you can then look at whether your portfolio, factoring in both the long-term-care costs and all other expenses, is up to the job.

Refining the Discussion Before I go any further, I’ll discuss why I think the question of “How big a portfolio do I need to self-insure for long-term care?” isn’t the right question.

First, a nitpicky point about terminology: I prefer the term “self-fund” to describe paying long-term-care costs out of pocket to “self-insure.” As a reader once pointed out to me (and I’ve never forgotten), people using actual insurance products benefit from risk pooling—the fact that some people will make claims and may pay less than they put into the policy, while others will purchase a policy but never make claims at all. That risk-pooling feature makes insurance cheaper than planning to cover each and every exigency with our own funds. It’s also why the term “self-insuring” is something of a misnomer: You can’t really be insured if you’re the only one in the risk pool.

More substantively, total asset thresholds aren’t that useful whether determining whether you’ll be able to pay for long-term care from your own coffers or whether you’ll need to find another alternative. The key reason is the same reason why portfolio assets alone can’t tell you if you have enough for the whole of your retirement. Without factoring in your spending rate, your time horizon, and your asset allocation, there’s no way to make even an educated guess about whether that amount is enough.

Take, for example, two people with the same $2 million portfolios. One is a 62-year-old who plans to spend $96,000 per year from her balanced portfolio; the other is a 68-year-old who’s planning to spend $50,000 a year from her similarly allocated portfolio. The former investor probably won’t have enough—even if she has $2 million, her spending rate of nearly 5% initially, combined with a time horizon that could be 30 years or longer, is too rich. The 68-year-old with the 2.5% spending rate, on the other hand, should be just fine; in fact, she might even consider giving herself a raise, especially in periods of strong market performance.

Using absolute asset level to determine whether to purchase long-term care is an even more vague and unhelpful exercise. Without any knowledge of how much you plan to spend from that portfolio for all of your other in-retirement expenses, you can't possibly know whether that portfolio will be holding enough extra assets at the end of your life to cover long-term-care costs.

A Better Way To gauge asset adequacy for long-term-care costs, the first step should be to make a reasonable estimate of what those expenses might be. Then, armed with a view of those expenses, you can assess whether the amount that's left over in your portfolio after you've covered your other expenses is sufficient to fund them. Here are the key steps to take.

Step 1: Gauge the likelihood of needing care. I wouldn't spend a lot of time on this one. The fact that about half of us will need some type of long-term care in our lifetimes and half won't suggests that we all ought to factor long-term-care planning into our retirement planning. After all, if I told you that there was a roughly 50/50 chance that your house would burn to the ground during the time that you owned it, is there a possibility you would do nothing about it? That's not to suggest that everyone needs to purchase insurance, but rather you consider the full range of options for covering your care if you develop a need.

Step 2: Ballpark the cost of care. The next is to put some hard numbers around what that care would actually cost.

This article includes some statistics about long-term-care costs that can help you set your targets: In 2020, the median annual rate for a private room in a nursing home was just over $100,000. Note that there were enormous variations in the cost of care based on geographic location: Genworth's annual Cost of Care survey enables you to focus on the community where you'd likely receive care. The data vary about average duration of care, but most of the statistics converge in the 2.5-year range.

You'll also need to factor in inflation when ballparking potential long-term-care costs: Median nursing home costs (private room) increased at a 3.6% annualized rate between 2019 and 2020, and that high rate of inflation could well persist as seniors live longer and stoke demand for long-term-care services. If you're younger than 50, especially, that long-term-care inflation rate, compounded over many years, is pretty daunting. For couples, self-funding 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.

Step 3. Customize based on your own situation and preferences. Before assuming that you need a $250,000 long-term-care fund if you're going to pay for long-term care out of your own coffers (or $500,000 if you're part of a married couple), spend some time customizing those figures. Geography is important, as discussed above, as is the type of care you'd prefer to receive.

The aforementioned costs are for a nursing home, whereas people would prefer to receive care in their homes. (In fact, the number of people in nursing homes is on the decline.) Hiring in-home care also seems to be cheaper than receiving care in a facility. However, it's important to remember that most other household expenses, such as housing and food-related costs, would continue with in-home care, whereas they would be bundled in with the cost of care received in a facility.

If you're part of a married couple, bear in mind that 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.

Step 4: Think through a backup plan. Here's the elephant in the room: 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 and 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.

Does that mean you should pad your long-term-care fund even more, to allow for the possibility of a catastrophic long-term-care need? Possibly, but that's only going to be an option for very wealthy people. For most people wishing to self-fund, I think it makes sense to set aside a baseline long-term-care fund based on the averages and then rely on other sources to cover any additional long-term-care costs.

For example, homeowners might be able to use home-sale proceeds to fund such a catastrophic long-term-care need, though that might not be feasible for married couples with one "well" spouse who still needs a place to live. In that case, 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.

Step 5: See if your retirement plan can support a long-term-care fund. Armed with a reasonable estimate of how large your long-term-care fund should be, you can then go back to your total in-retirement portfolio. Are your assets sufficient to cover your ongoing living expenses, based on a reasonable withdrawal rate strategy, plus the additional long-term-care costs? If the answer is “yes, comfortably,” you probably have enough to self-fund long-term care. If your plan is tight, purchasing some type of insurance—even if it seems costly—is the right way to go. For people whose in-retirement budgets are so tight that setting aside a long-term-care fund or purchasing insurance isn’t an option, public resources (Medicaid-provided care) would be the default. In fact, Medicaid currently covers the majority of long-term-care expenses in the United States today.

Step 6: Segregate long-term-care assets from spendable assets. Finally, if you plan to self-fund long-term care, it's important to take the next step of segregating that fund 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.

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 50-somethings, 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 and asset allocations.