Opportunity Cost and your Long Term Care Decision

If you are out shopping for long term care (commonly abbreviated as LTCI or LTC), I'm going to encourage you to take a look at a way of providing long term care benefits that is probably new to you. On the other hand, if you are in the crowd that thinks they will never need long term care, I would also suggest you evaluate this line of thinking.

Dick and Jane are both age 65, recently retired and models of good health. They have ignored the long term care subject until recently. They just put Jane's mother, who is 88, into a nursing home. Talk about sticker shock! She is in a nice place, but Dick and Jane are not 100% certain that her assets will allow her to stay there for the rest of her life.

Consequently, they have been out looking at long term care for themselves. They figure they can afford to insure a portion of what it might cost them if they ever need some form of LTCI, so they are looking at a benefit of $3,000 a month. The premium is around $4,200 a year.

Here's a new concept that Dick and Jane must become accustomed to now that they are retired. They both had good jobs during their working years. If they ever wanted to buy anything, it was just a question of looking at their income to see if they could swing the purchase. Pretty straightforward.

Now that they are retired, most of their expenditures are going to come from investment returns on the assets they have accumulated, not income from working. So they need to understand the difference between premium cost and opportunity cost. Here's what I mean…

If they elect to buy this $4,200 a year long term care policy, the money has to come from somewhere. Chances are it's coming from the interest earned on perhaps a CD or an annuity. But there is an opportunity cost associated with paying the premiums from earnings on any asset.

Let's say they are going to pay this $4,200 from the interest on a CD they own which is earning 5.4% interest. Since interest is taxable, and assuming they are in a 15% tax bracket, they would have to have $91,300 in that CD to produce $4,200 after tax to pay the premium.

They can't spend the $91,300. It can't grow. Basically, they have "committed" $91,300 of their assets to pay the premium on their LTC policy. That's the one "job" of this $91,300. The premium may only be $4,200 a year, but the opportunity cost is $91,300.

Let's take a look at another of their alternatives. It's called asset based long term care. How it works will unfold as I provide the example and contrast below.

One approach to asset based long term care involves re-positioning $91,300 of Dick and Jane's CD to a combination long term care/life insurance policy plan with an insurance company. Here's what moving this money does for them…

The money on deposit with the insurance company grows at interest, but it is tax-deferred interest so the insurance company will not send them 1099s every year for an amount they have to pay tax on like the bank is required to do. In 10 years, assuming current rates, the $91,300 will grow to $127,000; in 20 years $161,000. The CD, remember, does not grow, as its job is to spin off interest to pay the annual $4,200 premium on the traditional LTCI plan.

If either Dick or Jane needs any form of long term care, the insurance company plan will pay them $3,900 a month for 50 months--$900 a month more than the traditional plan.

But here's the real kicker.

If Dick and Jane never need long term care, then the camp that doesn't buy it would have been right. If Dick and Jane bought the traditional long term care plan, in 10 years they would have paid out $42,000 in premiums and about $7,400 in taxes on their CD interest in order to net out the required premium. That's a total of $49,700. The $91,300 portion of their CD would still be $91,300.

However, if Dick and Jane never need long term care, chose the asset based long term care plan and both die, for example in 10 years, the outcome is different. They have paid no annual premiums and the life insurance company will pay about $198,000 tax free to their kids.

Which sounds like a better plan?