Self-Funding Long-Term Care
Those who do not make plans to fund the long-term care they may need as they get older often end up having to pay for their care our of their own pockets because they have no alternative. Other people consciously plan to use their own income, savings, and assets to pay for care. This section looks at self-funding, discussing the problems with this approach and exploring some of the financial vehicles that can be used to fund care.
Those planning to pay for their own long-term care should consider these questions:
• Will your assets be enough to cover your long-term care needs?
• Even if your accumulated assets are sufficient, do you really want to spend them on long-term care? Wouldn't you prefer to preserve them and pass them on to your spouse or other heirs?
As we saw in the preceding discussion, long-term care services are costly, and paying for them requires a large amount of money. Suppose, for example, that someone who is 45 years old today decides to create a fund to pay for her future long-term care needs. The average length of stay in a nursing home is roughly 2.5 years; if an average cost of $171 per day is assumed, the total amount at today's prices would be about $155,000. And if the person needs that amount of nursing home care in 40 years, when she is 85, she will need $1,098,499 (assuming costs continue to increase by 5 percent annually). To accumulate that amount by then, she will have to save about $315 a month and invest it at an 8 percent rate of return; at a 5 percent rate of return she would have to save $720 a month. And this does not even take into account any home care or assisted living the person might need.
Most people will find putting aside that much money every month extremely difficult, and doing so is not very cost-effective. And there is another problem -- if a person adopts this savings plan but needs long-term care while she is still relatively young, the funds accumulated by that time may fall short of her expenses. Clearly, for most people, relying on savings and assets to pay for long-term care is not a feasible option.
A few people do have sufficient financial assets to pay long-term care costs. However, even they should ask whether they want to gamble on possibly having to pay an uncapped liability (that is, a loss that has no fixed limit). If the gamble is lost, they may have to spend very large amounts of money on care, money that otherwise could have been used to enhance their quality of life or provide for their heirs.
However, for those who are paying for their own care, either because they made no other provisions in advance or because they deliberately chose to self-fund, there are a number of funding sources aside from savings accounts, stocks and bonds, and other common assets. These include home equity, annuities, life insurance policies, and health savings accounts (HSAs).
The most important financial asset many older people have is home equity, the value of the home they own after any mortgage amount owed or other liability has been subtracted. The amount of home equity can be substantial, especially if the home was purchased many years before and the mortgage has been mostly entirely paid off. In such cases, home equity can be an important source of funds to cover long-term care costs.
In the past, there were only two main ways of turning home equity into funds that could be used to pay for long-term careselling the home or taking out a home equity loan. Each of these alternatives has serious drawbacks. Selling means leaving a longtime residence, and a home equity loan requires regular payments at a time when a person needs more income, not another expense. Fortunately, there are now several new methods of drawing on home equity. Here we will discuss the most popular reverse mortgages.
A reverse mortgage is a type of home equity loan available to those 62 and older. We can best understand how it works by comparing it to regular mortgages and conventional home equity loans.
• In a regular mortgage, a bank or other lending institution lends a person the money he needs to buy a home, and the person pays the lender back by means of monthly payments. The home is security for the loan.
• In a conventional home equity loan, a bank lends money to someone who already owns a home outright or has substantial equity in one, with the home or the equity serving as security for the loan. As with a mortgage, in a conventional home equity loan the borrower must make regular payments to the lender.
• In a reverse mortgage, as in a conventional home equity loan, a bank lends money to a homeowner with the home serving as security. However, in a reverse mortgage, the homeowner does not have to make regular payments to the lender. Instead, the loan must be paid off only when the homeowner dies, sells the home, or moves out of the home.
Thus a reverse mortgage can be advantageous for an elderly person -- she can obtain funds from her home equity without having to worry about being able to make loan payments, as she would with a conventional home equity loan, and without having to leave her home.
There are different types of reverse mortgages, and whether a person qualifies for one depends on the type he is applying for. But generally speaking, a homeowner must be at least 62 years old, and the home must be his principal residence.
The lender's payment to the homeowner can be made in a lump sum, in monthly payments, through a line of credit to be drawn on as needed, or a combination of these. The fact that in most cases the lender makes regular or periodic payments to the homeowner (instead of the homeowner making regular payments to the lender as in a regular mortgage) is why this arrangement is called a reverse mortgage.
The amount a lender advances a homeowner depends on several factors, including the value of the home, the homeowner's age, the interest rate charged, the type of reverse mortgage, the payout method chosen by the homeowner, and, for federally insured reverse mortgages, local lending limits established by the Federal Housing Administration (FHA).
The lender's payment to the homeowner is not subject to income tax, because it is not income but rather a loan that will eventually be repaid. Interest on a reverse mortgage is not tax deductible until it is actually paid -- that is, at the end of the loan period when the debt is paid off.
A homeowner taking out a reverse mortgage retains title to her home and is responsible for maintaining the home and paying real estate taxes. If the homeowner dies, the lender does not take title to the home, but the homeowner's heirs must payoff the loan. Usually the debt is repaid by selling the home or refinancing the property with a traditional mortgage.
For most types of reverse mortgages, the homeowner can use the money received for any purpose, including long-term care. However, reverse mortgages do have some limitations and disadvantages as a long-term care funding source. If the borrower leaves her home permanently, the mortgage must be paid off, and if she remains in an assisted living residence or nursing home for 12 months or more, she is considered to have permanently left the home; consequently, while a reverse mortgage can fund home care and short stays in a facility, it is not a solution for extended nursing home care. Also, a person taking out a reverse mortgage will substantially reduce her home equity, leaving her with less to rely on as a financial reserve and to pass on to her heirs. Finally, given the high cost of long-term care, the funds obtained from a r4everse mortgage may not be adequate to cover costs.
An annuity is a type of investment. The investor (called the annuitant) pays money to an insurance company or financial institution, and in return the insurer makes regular payments to the annuitant over a period of time. Depending on the type of annuity, this period may be for as long as the annuitant lives or for a limited, predetermined time. The amount of the payments made to the annuitant may be fixed and unchanging, or it may vary according to the performance of the investments the annuitant's money is placed in.
The payments from an annuity can be used to pay some of the cost of long-term care services. Alternatively, an annuity can be used in combination with long-term care insurance. The annuity income pays for the premiums of an LTCI policy, and the policy covers the costs of care. And some people use funds from a reverse mortgage to buy an annuity and then use the annuity income to pay for long-term care or LTCI premiums.
For example, a person could purchase a single-premium fixed life annuity. In this type of annuity, the annuitant makes a onetime payment (the single premium) to an insurer, and in return the insurer pays the annuitant a fixed amount of money every year for as long as he lives. A person age 60 might be able to purchase an annuity that would pay $5,000 annually for life for about $85,000, $40,000 less than the amount needed to generate that much through an interest-bearing investment. At age 65, a $5,000 annuity could be purchased for about $67,000. (The older the purchaser, the fewer years the financial institution will likely have to pay the annuity, so the less it charges.) And the annuity payments would be partially tax-free. Of course, $5,000 a year would not usually be anywhere near enough to cover the cost of long-term care, but it could be used to pay LTCI premiums.
In order to offer a simple example, we have described above a pure life annuity. However, most people choose an annuity that guarantees that at least the amount of money paid in will be paid out -- in other words, if the annuitant dies before he has received payments totaling the amount he paid for the annuity, payments will be made to his beneficiaries until that amount is reached. Of course, such an annuity costs more or makes lower payments than a pure life annuity.
A fixed annuity such as the one described above is guaranteed to pay the agreed -- upon amount, nothing less. There are also variable annuities, in which the payment amount varies with the performance of the investments the annuity funds are placed in. With such an annuity, there is no guarantee that the payment amount wail be sufficient to cover long-term care expenses or LTCI premiums, so it may not be a suitable approach for someone seeking to provide for these cost.
Unless a very large amount is invested in an annuity, the payments will cover only a portion of long-term care expenses. It should also be noted that annuities have costs and charges that can make them in some ways less attractive investment vehicles than mutual funds or individual stocks and bonds.
A life insurance policy provides protection against the financial consequences of the death of one or more individuals. That is, if a covered person (an insured) dies while the policy is in force, the insurer makes a payment (known as a death benefit) to the beneficiary or beneficiaries designated by the insured. People purchase life insurance for various reasons: to ensure the financial security of a spouse, children, and other family members; to preserve an estate for heirs by providing money to pay estate taxes and settle outstanding debts; or to create an inheritance for a loved one or a charity.
Life insurance was not developed to meet long-term care needs. But a person can obtain money from her life insurance policy in various ways and use that money to pay long-term care expenses. However, as we will see, this approach has serious disadvantages and should generally be used only as a last resort by those who have no other options.
Accelerated Death Benefits
Accelerated death benefits (also known as living benefits) are payments of a portion or all of the death benefit before the death of the insured. For an insurer to pay accelerated death benefits, an event specified in the policy (a benefit trigger) must occur. In early versions of these benefits, the insurer paid only if the insured suffered from a terminal illness, and that is still a common triggering event. However, many policies now allow for payment under other circumstances, and benefit triggers typically include one or more of the following: diagnosis of a terminal illness or physical condition, as a result of which death is likely to occur within a specified number of months; diagnosis of one of several specified critical illnesses; permanent confinement to a nursing home; the need for extended long-term care (in a facility, at home, or in the community) because of an inability to perform a specified number of ADLs; and a cognitive impairment.
Insurers must compensate for the loss they incur by paying the death benefit early instead of keeping the money and earning investment income on it until the insured dies. An insurer usually requires a slightly higher premium, or it may reduce the benefit amount or treat the advance payment as a loan and charge interest.
The amount that an insured may obtain as an accelerated death benefit varies according to the policy. Many policies will pay up to a certain limit, defined either as a dollar figure or a percentage of the death benefit (usually at least 50 percent). Other policies will pay the full death benefit. A long-term care accelerated death benefit is often paid in monthly installments, with each payment equaling a percentage of the death benefit (usually between 2 and 5 percent). Money received as accelerated benefits by terminally or chronically ill individuals is not subject to income taxation.
An obvious drawback to using the accelerated death benefit of a life insurance policy to cover long-term care costs is that it defeats the primary purpose of life insurance. The money advanced is subtracted from the death benefit of the policy and will not be available to pay estate taxes or a mortgage balance, or to provide income to the insured's family.
Another problem is that accelerated death benefits are not usually adequate to pay for long-term care for an extended time. The average person's life insurance policy has a death benefit of less than $100,000, and arr accelerated benefit may be as little as half that amount. This will not cover COSts for the several years that a person might need care.
In a viatical settlement, an insured (referred to as the viator) sells his life insurance policy to a viatical company. Specifically, the viatical company pays the viator a lump sum, the amount of which is somewhat less than the policy's death benefit, and in exchange the viatical company becomes the owner and beneficiary of the viator's policy and receives the death benefit after the viator dies. The viatical company also takes over the payment of premiums on the policy.
This transaction has advantages for both parties. The viator gets money while he is still alive, which he can use for any purpose. The viatical company normally realizes a gain because the lump sum it pays the viator is less than the death benefit it receives after the viator dies.
However, a viatical settlement is not an option for most people with life insurance. It is generally available only to those with a terminal illness and a very limited life expectancy -- sometimes five years or less but more typically two to three years or less. This is because only if the death benefit is likely to be paid in the near future is it in a viatical company's interest to buy a policy. (Nonetheless, in some cases those with chronic illnesses are able to obtain viatical settlements.)
Under the Health Insurance Portability and Accountability Act of 1996 (HIPAA), the money a viator receives from a viatical settlement is tax-free, provided she has a life expectancy of two years or less, and provided the viatical company is licensed in the states in which it does business. The determination of life expectancy is made by a licensed healthcare practitioner (a physician or nurse), not the Internal Revenue Service. And if the viator does in fact lives beyond two years, the IRS will not seek back taxes. A viatical payment made to a chronically ill person may also be tax-free, provided certain conditions are met.
Like accelerated death benefits, a viatical settlement defeats the purpose of life insurance, since when the insured dies no death benefit is available for taxes, mortgage payments, or survivors. However, for a dying person in need of long-term care services and without other means of paying for them, a viatical settlement may be an appropriate funding source.
In many states today life settlements as well as viatical settlements are available. The two are similar in that both involve the sale of a life insurance policy to a third party. But for a life settlement there is no requirement that the insured be terminally or chronically ill (although he must be elderly -- generally only applicants over 70 are accepted).
As in a viatical settlement, in a life settlement an individual sells her policy to a company for a percentage of the death benefit. The company becomes the owner of the policy, pays the premiums, and receives the death benefit when the individual dies. The amount received is much lower than for a viatical] settlement because the life expectancy of the insured is usually much longer. The money can be used for any purpose, including paying for long-term care services or LTCI premiums.
Life settlements have their drawbacks. Unlike viatical payments, proceeds from a life settlement in excess of the total amount paid in premiums over the life of the policy may be taxable. And as with a viatical] settlement, the insured's beneficiaries will receive no death benefit. But if the death benefit is not really needed (as might be the case if a person's spouse has died and her children are self-supporting), or if the premiums have become unaffordable, obtaining a life settlement may be a reasonable course of action.
Policy Loans, Withdrawals, and Surrenders
There are two types of life insurance. Term life insurance is in force for a limited, specified period (the term of the policy), and it pays a death benefit only if the insured dies during that period. For example, most employer-sponsored group life insurance is term insurance, and an employee's coverage generally continues only as long as he works for the sponsoring employer. Permanent life insurance, on the other hand, is designed to be in force for the entire lifetime of the insured. (It generally remains in force until the insured's death unless he lets it lapse by failing to pay premiums.)
While both term and permanent life insurance policies have death benefits, a permanent policy (but not a term policy) also normally accumulates a cash value. This is an amount of money, based on the amount of premiums paid and the investment growth of those premiums, that the insured can access in certain ways. The cash value of a policy normally grows during the life of the policy as the insured pays more premiums and those premiums yield more investment earnings. An insured can access her cash value by means of a policy loan, a policy withdrawal, or a policy surrender.
In a policy loan an insured borrows a portion of the cash value from the insurer. The insured is not required to repay the loan during her lifetime; instead, when the insured dies, the loan amount plus interest is subtracted from the death benefit paid to beneficiaries.
Under a universal life insurance policy, a policy withdrawal is possible. In a universal life insurance policy, the premium amount is flexible -- a target amount is set, but the insured may pay more or less than this amount. The more he pays, the faster the cash value of the policy grows. (This differs from a whole life insurance policy, in which a fixed premium amount is set at purchase.) For some universal policies, the death benefit consists of not only the face amount but also the cash value of the policy, so for these policies the actual payment at death depends in part on how much cash value the insured has accumulated.
In a policy withdrawal, the insured simply withdraws money from the cash value of the policy, just as she would from a bank account. A policy withdrawal is not a loan, so repayment is not required and there is no interest to pay. The amount is limited by the cash value of the policy -- if the entire cash value is withdrawn, this constitutes policy surrender (see below). Of course, the cash value of the policy is reduced by the amount withdrawn. Consequently, for policies that pay beneficiaries the cash value as well as the face amount, the total amount paid will be reduced.
Finally, in a policy surrender, the insured terminates her life insurance policy and receives the cash value of the policy minus any surrender charges (called the cash surrender value). Surrender enables a person to obtain the largest possible amount of a policy's cash value; however, the amount is generally much less than the death benefit that beneficiaries would have received.
As with accessing the death benefit of a policy, accessing the cash value tends to defeat the purpose of life insurance by reducing or eliminating the benefit available to heirs, and the funds produced are not usually sufficient to pay for long-term care for very long.
Health Savings Accounts (HSAs)
Health Savings Accounts (HSAs) were created by the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (commonly known as the Medicare Modernization Act, or MMA). An HSA is a tax-advantaged arrangement designed to help people pay for their healthcare, and it can also be used to fund long-term care.
An employer can sponsor an HSA for an employee, or an individual can establish one for himself. The employee or individual makes contributions to his HSA (up to an annual limit), and these contributions are tax-free. An employer may also contribute to an employee's HSA, and these contributions are also excluded from the employee's taxable income. Funds in an HSA are carried over from year to year and accumulate, and investment earnings and gains are tax-free. A person can withdraw money from his HSA at any time for any purpose, and if a withdrawal is used to pay healthcare expenses (including long-term care) not covered by insurance, it is tax-free. Thus an HSA enables an individual to pay long-term care costs with tax-free money, resulting in considerable savings.
To be eligible to contribute to an HSA or have contributions made on his behalf, an individual must be covered by a high deductible health plan (HDHP). For a health plan to qualify as an HDHP it must have an annual deductible of at least $1,110 for individual coverage and $2,200 for family coverage, and annual cost-sharing payments (deductibles, coinsurance, and co payments) may not exceed $5,500 (individual) or $11,000 (family) (2007 figures, adjusted annually). Also, the individual may not be covered by any other broad-based health plan or Medicare. An LTCI policy is not considered a broad based health plan for HSA purposes. A Medicare beneficiary may not make contributions to an HSA, but he can withdraw money from an HSA he contributed to before enrolling in Medicare.
The maximum annual contribution to an HSA is $2,850 for an individual or $5,650 for a family (2007). However, an exception applies to individuals age 55 and older, who may contribute a "catch-up" amount in addition to the annual maximum. In 2007, they can contribute an extra $800, and this amount will increase to $900 in 2008 and $1,000 in 2009. This exception allows those approaching retirement to build up a substantial HSA balance for use during their retirement years.
Funds accumulated in an HSA can be used tax-free to pay long-term care expenses not covered by insurance or otherwise reimbursed. HSA funds can also be used to pay LTCI premiums, and within certain limits this money is also tax-free. However, given the annual limits on contributions and the short time
HSAs have been in existence, it will be many years before anyone will have accumulated sufficient funds in an HSA to cover a substantial amount of long-term care costs. In the meantime, HSAs can be seen as a tax-advantaged source of supplementary funding.