Tuesday, January 12, 2016

How Future Expected Long-Term Care Expenses Affect Your Current Retirement Spending Budget--Part 2

No sooner had I finished my January 9th post on long-term care (LTC) expenses when I received an email from Derek Castle indicating (as nicely as possible) that he thought I was perhaps being too conservative in determining the impact on a retiree's current spending budget resulting from establishing a separate reserve for future LTC expenses.  While Mr. Castle did not disagree with the assumptions I recommended  for  estimating  future LTC costs and the resulting reserve for such costs, he argued (and I agree) that it is likely that other expenses will be reduced if and when a retiree enters a LTC facility.  This post will discuss a possible approach for determining a retiree's current spending budget to reflect the reduction in certain expenses when a retiree expects to enter a LTC facility in the future and has established a separate reserve to fund future LTC costs.  To do this, I will revise the budget for Richard Retiree, whose 2016 budget was discussed in my post of December 26, 2015.

In our December 26 post, Richard Retiree assumed that he would live another 27 years and die at age 95.  He also developed a reserve for future LTC costs by assuming that he would spend three years in an assisted living facility and one year in a nursing home and that those costs would be covered by the equity in his home.  In addition to these expenses, Richard developed his budget for 2016 assuming that all types of expenses (other than his unexpected expenses) would be incurred until his assumed death in 27 years at age 95.  However, as Mr. Castle pointed out, it is likely that some of the expenses that Richard plans to incur prior to entering LTC will be reduced after he enters LTC (which he expects to be in 23 years).  So how should we adjust Richard's previously determined budget for this apparent overlap period?

We can argue about which expenses might be reduced when Richard enters into LTC, and we can also argue about how much those expenses might be reduced.  Fortunately, I am going to let Richard and his financial advisor make this decision.  Richard decides that even though he plans to spend a total of four years in LTC facilities, he will not see a reduction in his essential health-related expenses when he enters the facility and while his essential non-health related and non-essential  expenses may be reduced, he expects that they will not be totally eliminated (at least not until perhaps his final year).  He decides that instead of assuming a 23-year period for incurring these expenses (i.e., the number of years before he plans to enter the LTC facility) or a 27-year period (as he did for the December 26 post), he will split the difference and assume that the reduction in his essential non-health related expenses and non-essential expenses will be equivalent to assuming that they cease completely 25 years from now. 

The basic principle underlying  the Actuarial Approach is that to be considered in actuarial balance, a retiree's assets (current assets plus the present value of future expected benefit payments or payments from other sources of income) must be equal to the retiree's liabilities (the present value of future expected expenses/amounts left to heirs).   The chart below shows Richard's revised Actuarial Balance Sheet.  Some explanation of the numbers in this chart follows:

(click to enlarge)


Richard's accumulated savings of $1,095,193 (which includes $180,000 of home equity assets) is allocated to the following reserve accounts as follows:

  • Reserve for future unexpected expenses:  $102,000 
  • Reserve for future LTC expenses: $180,000
  • Reserve for future Essential Health Expenses: $135,000
  • Reserve for Essential Non-Health Expenses (for next 25 years): $361,330
  • Reserve for death benefit expenses (assumed to be payable in 27 years):  $3,047
  • Reserve for Non-Essential Expenses:  $313,816
The present value of Richard's Social Security benefit of $432,037 is the present value at a 4.5% discount rate of a stream of annual payments (assumed to be payable at the beginning of each year) starting at $20,340 and increasing by2.5% per annum for the next 26 years.

The present value of Richard's immediate life annuity payments of $242,199 is the present value at a 4.5% discount rate of a stream of annual payments of $15,000 per year for 27 years (also assumed to be payable at the beginning of each year).

The reserve for future LTC expenses of $180,000 is developed by assuming that Richard's home equity is $180,000 and will increase by 4.5% per year, or alternatively that it is more than $180,000 but will increase by less than 4.5% per year but will still cover Richard's expected LTC costs. 

The reserve for Essential Non-health Expenses was derived by using the "Excluding Social Security V 3.1 spreadsheet and solving for the accumulated savings that, together with 25 years of expected Social Security and annuity payments would provide for expected essential non-health expenses of $50,000 per year increasing at 2.5% per annum.


The present value of essential non-health related expenses of $1,000,943 is equal to the present value of a stream of payments of $50,000 per year increasing by 2.5% per annum for 25 years. 

The present value of the remaining expenses (except for non-essential  expenses) are equal to the asset reserve allocated to that item above. 

The present value of the non-essential expenses of $348,439 is equal to the reserve for non-essential expenses of $313,816 shown in the assets above plus the present value of the final two years worth of Social Security and annuity payments not used to support essential non-health expenses. 

Revised Results

By assuming a 25-year funding period rather than a 27, the present value of Richard's essential non-health expenses (plus death benefit expenses) have been reduced by about $61,100 (there is some rounding involved).  In addition to increasing his non-essential spending assets by about $61,100, Richard will be spreading his non-essential expenses over a 25 year period rather than a 27-year period, so his non-essential spending budget for 2016 will increase from $17,793 to $22,486, and his total spending budget will increase from $72,793 to $77,486, as follows:

  • Essential Health Budget:  $5,000 
  • Essential Non-Health Budget: $50,000
  • Non-Essential Budget:  $22,486
  • Total 2016 Spending Budget:  $77,486
For retirees who want to reflect the cost of LTC in their budget, but who do not want to get into this much detail in their calculations, the bottom line spending budget result for Richard is equivalent to using the original methodology (with a 27-year budget period for all expenses) but reflecting only about 58% of the expected present value of LTC cost.  Amazingly, this was pretty close to the estimate made by Mr. Castle, whom I thank again for raising this issue with me.

Always happy to learn from others.  Keep those good suggestions for improvements in the Actuarial Approach for spending budgets coming!