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By: Wade D. Pfau, Ph.D., CFA, and Michael Finke, Ph.D., CFP®

All retirees must plan today for the possibility that they will experience significant long-term care health expenditures. Large unplanned expenses, such as those relating to long-term care, have the potential to wreak havoc on a retirement income plan.

Executive summary

The unknown cost of health care is among the most significant risks to any retirement plan. All retirees face the possibility of a debilitating illness that will require advanced and costly care over a long period of time. This risk is a source of anxiety for retirees, yet most are unwilling to accept the variable costs and potential loss of premiums paid under conventional health-based long-term care insurance products. And few have taken steps to understand the complete range of long-term care insurance product features and options available to them.

A different generation of protection, such as life insurance and long-term care or annuities and long-term care, create a hybrid product consideration.

A hybrid product protects against long-term care expenditures while also providing a guaranteed death benefit, which guards against the possibility of lost premiums. This new class of hybrid products is central to our analysis, in which we simulate multiple long-term care scenarios to demonstrate the impact of a hybrid product, a traditional health-based long-term care policy and a self-funding approach. In scenarios where no long-term care event is experienced, premiums paid using a traditional health-based policy are simply lost, while a hybrid policy provides a death benefit. In scenarios where a long-term care event is experienced, insurance helps dramatically reduce the net costs to a household.

Long-term care insurance provides value when health expenses are high. At the 90th percentile of long-term care costs, an unprotected retiree — one who is self-funding protection against a long-term care event — will be exposed to risk of over $1 million in assets.

In contrast, a retiree holding a long-term care insurance policy will be exposed to roughly one-third the risk of out-of-pocket expenses and premiums. With long-term care insurance — like all insurance products — a retiree trades a premium expense for protection against a loss. In this case, the loss due to high health expenses can have a devastating impact on legacy values and income security.

Outcomes for a conventional long-term care policy and a hybrid policy are similar under the 90th percentile costs, assuming that premiums on a conventional policy do not increase. Despite these similar outcomes, survey evidence suggests that individuals are much more attracted to a product that provides protection against significant health expense as well as a death benefit, and provides both without the negative features of variable premium costs and the potential for lost premium dollars.