Worried About Long-Term Care Expenses? Let’s Do Something About It.

If there’s a worry that keeps retirees from maximizing their spending during their lifetimes—whether spending on themselves or making lifetime gifts to loved ones and charity—it’s the fear of needing a big sum of money for long-term care at the end of their lives.

Even a glancing remark on long-term care in one of my presentations seems to send the room into a state of uproar. People are eager to share stories about why they decided not to purchase long-term-care insurance (usually because a loved one had a terrible claims experience), and those who did purchase policies complain about soaring premiums. But there are also cautionary tales about people who decided to forgo insurance for long-term care: how a parent was forced to loot her portfolio at the end of her life or how adult children burned themselves out delivering unpaid care. Everyone’s got a story, and they’re rarely good.

Beyond my anecdotes, the data bear out that paying for long-term care weighs heavily on older adults’ minds. An AARP survey of older adults found widespread confusion about whether the government pays for long-term care (it doesn’t) as well as concern about how to pay for care. In the survey, 59% of respondents said they were concerned about running out of money to pay for long-term care. In a similar vein, in a 2021 survey conducted by the Society of Actuaries, paying for long-term care was number two on the list of top retirement worries for preretirees, just behind inflation.

Given that just 7 million people are covered by long-term-care insurance in the United States today, and there are more than 75 million over age 60, according to the 2020 U.S. Census, that’s a lot of people who are probably either worrying a little or a lot about what long-term-care expenses might mean for their retirement plans. For those self-funders, I like the idea of creating a dedicated long-term-care bucket that is separate from the spendable portfolio. Earmarking a portion of assets for long-term care can provide valuable peace of mind and also gives them permission to spend (or gift) at a reasonable rate from the remaining portfolio. If the retiree doesn’t end up using the long-term-care bucket, it can pass to heirs and/or charity.

A Fourth Bucket?

I’ve often written about the Bucket strategy for retirement portfolio planning, where the retiree sets up three buckets based on anticipated retirement-portfolio withdrawals. The first bucket covers one to two years’ worth of living expenses and consists mainly of ultrasafe assets like money market funds or bank accounts. The second bucket provides another five to eight years’ worth of cash flow needs and gets parked in high-quality bonds. The remainder of the portfolio goes into Bucket 3, which consists primarily of a globally diversified equity portfolio. The virtue of this setup is that the retiree can pull spending from cash if nothing else in the portfolio is cooperating (see: 2022). If equities experience a sustained downturn, the cash and bonds should provide a cushion.

But a fourth bucket can fit into this framework, too, for people who want to maintain a cushion in case they need to cover long-term-care expenses. That sounds straightforward, but practical questions remain, such as how much to sink into the long-term-care bucket, what types of investments to put into it, and where to hold it. Let’s take them one by one.

How Much

Statistics on long-term care can help inform the size of your long-term-care bucket. You’ll need to focus on two key items: the anticipated cost of whatever type of care you’d prefer to receive (in-home care or care in an institutional setting, for example) and the expected duration of that care.

Northwestern Mutual’s 2022 Cost of Care study and calculator can help you benchmark the cost of care based on desired care type and your geography. For example, a Florida resident could expect to pay about $360 a day, or $131,400 a year, for a private room in a skilled nursing facility. You could put an even finer point on the exercise by inquiring about the cost of care at preferred facilities in your own community or by checking with a local agency that provides in-home caregivers. (Remember that if your plan is for in-home care, you’ll have other concurrent expenses for food and housing.)

Regarding the duration of care, the typical long-term care need—2.2 years for men and 3.7 years for women—is a starting point. But financial advisor and doctor Carolyn McClanahan cautions that those are averages and notes that healthy people are likely to have a longer care need; for very healthy clients, she benchmarks five years’ worth of long-term-care expenses.

The good news is that nonportfolio income—Social Security, for most of us—continues to bring a stream of income throughout our lives, including when we’re in a long-term-care setting. That reduces the size of the long-term-care fund.

To use a simple example, let’s say a single male in Florida wants to build a long-term-care fund. He could use $260,000 as his ballpark care outlay (two years’ worth of care at $130,000 per year). But if he’s receiving $40,000 a year from Social Security, he could reduce the size of his long-term-care bucket accordingly, to $180,000. This isn’t an exact science, obviously, since no one knows whether they’ll need care or how long it might last. But it’s a start.

Obviously, pulling $180,000 from his spendable portfolio to serve as his long-term-care bucket is a “peace of mind allocation.” But there are implications for spending. Say he has $1 million and is using the 4% guideline for spending. Pre-long-term-care bucket, his portfolio withdrawal amounts to $40,000 annually; after the long-term-care bucket is removed from his spendable portfolio, it’s $35,200. In other words, there’s no free lunch.

How to Invest It

Most people who need long-term care need it toward the end of their lives: The average nursing home resident is 81 years old. Thus, you can use your age and your proximity to that average long-term-care age to help guide how you invest the money. If you’re 65 and just embarking on retirement, it makes sense to asset allocate with a long time horizon in mind, holding a balanced portfolio or one that tilts even more heavily to stocks. After all, you have a 15-plus-year time horizon, and long-term-care costs could inflate significantly between then and now. You need some growth.

If you’re in your mid-70s or older, that argues for maintaining a more conservative asset allocation for your long-term-care fund, especially now that higher yields are available in cash instruments and high-quality bonds. No matter what, be sure to build a portfolio that plays good defense against inflation, because some parts of the long-term-care market—especially home-provided care—have seen a rapid escalation in costs. The Centers for Medicaid and Medicare Services estimate that the cost of home-based care will increase at a rate of 7% annually through 2029, for example.

Where to Invest It

The “where” of your long-term-care bucket is the easiest question. I tend to favor a traditional tax-deferred account for a few key reasons. The first is simply that that’s where most people who are getting close to or who are in retirement today hold the bulk of their assets.

A traditional IRA also makes sense from a tax perspective. Withdrawals from a traditional IRA or other traditional tax-deferred account are indeed taxable, to the extent that they consist of pretax contributions and investment earnings (in other words, the bulk of most tax-deferred accounts). But individuals incurring heavy long-term-care costs often easily exceed the threshold for deductibility of healthcare expenses. (In 2023, healthcare expenses that exceed 7.5% of adjusted gross income are deductible.) That means that the deduction can offset the taxes due on the IRA withdrawal.

It’s also worth noting that most long-term-care costs are incurred later in life, when required minimum distributions (which apply to traditional tax-deferred accounts for people who are over age 73) apply. In other words, the money has to come out of the account and be taxed at this life stage anyway, and the medical expense deduction helps to ease the tax burden.

You needn’t maintain a separate account for your long-term-care fund, but it is important to let your loved ones know that the long-term-care bucket exists and where to find it.

Backup Plans

If you don’t want to go all-in on a long-term-care bucket—and no doubt that the annual cost-of-care figures that I previously cited are off-putting—that’s fine. Even a smaller sum can help allay worries, especially if you think through what might be there as a backup: home equity (via a reverse mortgage, for example) or residual amounts in your “spendable” portfolio. (Some withdrawal strategies do a better job of leaving leftovers than others, as discussed in our latest withdrawal-rate research.)

And of course Medicaid is the largest payer of long-term-care costs in the U.S. by a good distance. Because long-term care is so often related to dementia, those with tighter financial plans might think about using their long-term-care fund to cover the early years of long-term care, when cognitive abilities are apt to be higher, and turn to Medicaid-provided care later on if needed. That plan isn’t ideal, but at least it’s a plan.