While I was Christmas shopping the other day, I was reminded of Christmas a few years ago when my youngest child, Matthew, was 11 or 12 years old. He insisted that all he wanted for Christmas was money.
Even after Matthew had been warned a million times that he would not have many presents to open since he wanted cash, he insisted that he wanted money. Conversely, his older brother had a big, extensive list of things that he wanted us to buy for him. Yes, most of you know where this is going!
Well, sure enough, Christmas came and Seth had a lot more packages to open than Matthew. Even though we did attempt to wrap a bunch of smaller trinkets for Matthew, the present opening “ceremony” apparently was underwhelming to Matthew. As a dramatic pre-teenager, he said “This is the worst Christmas evahh!!!”
That Christmas, Matthew learned what the economic phrase of “opportunity cost” is.
Opportunity cost is the notion that when we choose to allocate our money, resources or time to one particular item, we are missing out on the “opportunity” that exists with other items. He missed the opportunity to open a bunch of presents like his brother did. But hey, my wife and I can only wrap so many socks, deodorant and toothpaste! Whether we explicitly know it or not, our intuition is to allocate our time, resources and money to where the opportunity costs” are minimized, all else being equal.
A financial example of opportunity cost might be choosing to pay off a $500,000 mortgage with a 3% interest rate, thereby missing the opportunity to earn a 5% return by investing that $500,000 elsewhere. In this example, the Dave Ramseys of the World would say that we should pay off the mortgage to remove that 3% interest “cost.” Conversely, I say that paying off that mortgage early is the wrong move because by doing so we will have an “opportunity cost” of that additional 2% (5% minus 3%) that we otherwise could get as interest above what we are paying for the mortgage. By doing A, we miss out on doing B.
The premise of opportunity cost especially exists when we are talking about long-term care insurance, where the traditional LTCi policies were once the only game in town. A traditional LTCi policy is like health insurance; you generally pay an ongoing premium, there is no cash value, the premiums can increase, and the only way to get value out of the policy is if you have a long-term care event.
I actually like traditional LTCi, as it will usually get the client the most LTC benefit per dollar of premium that is paid. So then why is it that the total industrywide premium going into traditional LTCi policies is now dwarfed by premiums going into hybrid LTC annuity and LTC life products? For a few reasons, but I would argue the top reason being “with traditional LTCi, if I don’t use it, I lose it.” In other words, with traditional LTCi, there is generally only one opportunity to get anything out of the policy, and that is if the policyholder has a long-term care event!
This brings me to the LTC annuity conversation. This is one of the largest opportunities I see for financial professionals today. These products strike a beautiful balance between having long-term care leverage and not losing out on other opportunities such as cash value growth, flexibility or a death benefit.
The LTC annuity pitch
Note: These products are usually on a fixed annuity chassis. One of my favorite LTC companies has an LTC annuity on an indexed chassis, but let’s stick with an example using a fixed rate.
Deborah is a 70-year-old widow. She has enough retirement assets to cover her living expenses. She has $400,000 that she will likely never touch unless she has a long-term care event. The money is sitting in a savings account earning only 3% interest.
You suggest she put $200,000 into an LTC annuity that currently has an interest rate of 6%. Here is what the product can do for her:
- Does the $200,000 grow? Yes! This is an annuity where the accumulation value will increase by 6%, minus an LTC charge that we will discuss in the next paragraph. Note that the 6% can adjust each year, at least in the annuity used in this example.
- What about the LTC charge? In this example with a 70-year-old woman, the LTC charge equates to around 2% of the accumulation value. So if we are getting a 6% interest rate, that is a “net” of 4%. Better than the savings account her money is currently in.
- What if she wants to cash it out? Like any annuity, if she later decides she wants to cash it out, she can do so, and it will likely be worth a lot more than what she put in. Just remember the surrender charge period is nine years.
- What if she dies? This is not a use it or lose it proposition. As with most annuities, if she dies, the accumulation value goes to the beneficiaries.
- The best for last – what if she needs care? If she cannot do two of the six activities of daily living, her LTC benefits will be activated. What is the LTC benefit? In most states, the LTC benefit is quite simply three times the accumulation value.
To simplify, in that first year, when she moved $200,000 into the annuity, her LTC benefit is $600,000! And that LTC benefit grows while her accumulation value in the annuity grows.
Important: The insurance company does not allow her to cash all the $600,000 out at once if she needs care. Insurers have “benefit periods.” For example, the annuity in this example has a 72-month benefit period. What that means is, the maximum amount of LTC benefit that she can access per month is $8,333 ($600,000 divided by 72 months). She can do this for 72 months, until the entire $600,000 will be depleted.
*Note: Technically, the $8,333 will likely grow as well because the accumulation value and LTC value will be increasing.
To recap, Deborah moved the $200,000 from the left pocket (savings account) to the right pocket (LTC annuity). That $200,000 is what she would have spent on the cost of care anyway, so why not leverage it up three times?
What if she never needs care? Well, that $200,000 now earns a higher net interest rate than where it was before, and she can ultimately cash it out. Furthermore, when she dies, the beneficiary gets the amount that it has grown to, without surrender charges. What opportunities exist in her savings account that do not exist in this annuity? I cannot think of very many.
Why agents like LTC annuities
Annuity agents in particular love selling these LTC annuities. Obviously, that is partially because these are “annuities,” but the reasoning goes deeper than that.
- These LTC annuities are for lump sum premiums, not recurring premiums like traditional LTCi has generally been. Annuity agents are used to collecting large premiums.
- Relatively little underwriting. These LTC annuities generally come with a couple of handfuls of “knockout questions,” so the agent has a good feel upfront of whether the client will be approved. The insurance carrier will often pull the client’s reports (Medical Information Bureau, prescription drugs, motor vehicle report) on their end but there are generally no medical records ordered.
- It is an easy conversation to have, even if the annuity agent doesn’t know the LTC language.
The ideal client
- A client 60 years old or older who generally has enough retirement assets to live off. That extra $100,000-$300,000 that they have sitting in a bank account would be great for funding an LTC annuity.
- A client who has at least a few hundred thousand dollars. That is, enough assets for them to be concerned about Medicaid spenddown.
- Clients who may not be healthy enough for traditional LTCi or LTC/life hybrid insurance. Again, LTC annuity underwriting is generally more lenient.
- A client who has a nonqualified annuity or life insurance policy with a lot of gain in it that has not yet been taxed! Tax law allows you to 1035 exchange that annuity or life policy over to this LTC annuity. If the LTC annuity is used for long-term care, that gain will not be taxed.
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