Afternoon at a long-term care facility

Retirement might be easier if spending needs stayed nearly constant from year-to-year, but they don’t. Long-term care, motor homes, family members in need, and other special plans require lumps of cash at particular times.

Lumps of spending shrink a portfolio and jeopardize its sustainability. They also may alter the risk characteristics of retirees’ lives. Both of these prospects can be analyzed with the  four-questions in a prior blog post. Condensed into a statement, they give the following guide: “Spending plans that are near in time, certain at that time, and specific and large in amount should not be exposed to much investment risk. But plans that are more distant, flexible in time and/or amount, and relatively small, can be exposed to risk.”

Long-Term Care

Long-term care (LTC) is a good subject to illustrate planning for lumpy spending. The need for LTC usually arises close to the end of life, maybe 15 or more years after retirement.

Readers might envision a specific setting to help see the dynamics of planning for LTC. Consider a couple who have a $1 million portfolio allocated 65% stocks and 35% bonds. They withdraw $40,000 each year. They both receive Social Security as well. 

Suppose the husband has noticeably declining health, and they want to prepare to place him in a nursing home. They estimate needing about $300,000 of today’s portfolio for his stay, and they believe he will need a nursing home in about six years. Both are currently 78 years old. They do not have long-term care insurance.

Readers might think $300,000 is too low, but a 2012 study by Northwestern Mutual estimated the nationwide, average cost of a nursing home was about $91,000 per year, and the average length of stay was 2-3 years. A comparable assisted living cost was $38,000 per year.

Thinking Through the Spending Problem

The couple’s goal is to adjust their portfolio to insure for LTC . They will consider the risk characteristics of their portfolio in three steps Then they will consider the size of their regular withdrawals. 

In the following analysis, each of three factors indicates separately a bond allocation; the three bond percentages are then averaged. The analysis is also summarized in a nearby table.

• First, is the need for LTC near in time? If it were within a year, the bond/cash component would be 1, or 100%. For more years away, we might divide the possible bond percentage range, which is 65% here (100% -35%), by a 20-year planning horizon. The long-term bond allocation for our retirees is 35%, and we might increase the bond allocation for each year less than 20 by 3.25% per year (65%/20%). Since they estimate needing a nursing home in about six years, this element points to a bond/cash allocation of about 80%.
• Second, is the time certain? The answer is “no.” The precise path of the husband’s decline and the family’s reaction can’t be predicted. If the time were certain, we might say the corresponding bond allocation would be 100%. If it could be postponed 10 or 15 years, we might leave the bond allocation at 35%, which is the level for the general portfolio. Here, for this element, we can assign a bond allocation halfway between 35% and 100%, or about 70%.
• Third, will LTC require a specific, known amount of money, or can it be funded at flexible levels? If the amount is specific and known, it gets a bond allocation of 1 or 100%, thinking there would be no desire for risking a lesser amount. If the amount is very uncertain, it would receive a bond allocation close to 35%, like the remaining portfolio. In this case, let’s suppose our retirees have checked prices at nursing homes, and they have determined the amount of money they want to be certain. (Alternatively, they might consider one-two years of assisted living to substitute for the first year or so in a nursing home. Assuming assisted living offered suitable care, it would lower the total cost.)

If our couple gives equal weight to the three factors, then the resulting bond/cash allocation is 82.5%, or 83%, which stands in stark contrast to their bond/cash allocation for the rest of the portfolio (35%). The bottom of the table shows how this new plan for LTC affects the entire portfolio: the overall allocation for the entire $1 million becomes almost 51% stocks and about 49% bonds.

The couple will want to revise the allocation annually, letting the bond/cash allocation approach 100% as LTC gets closer.

Annual Withdrawals

The last relevant issue is whether the amount in question is a large part of the portfolio and if so, how to adjust the annual withdrawals. The couple may stay with $40,000, or they might reduce the withdrawal to 4% of the non-LTC part ($700,000), which is $28,000.

If the couple is fearful of rapidly rising LTC costs, they can insure against that by withdrawing less for year-to-year living. If they maintain their $40,000 withdrawal, they will effectively be reducing the probability of portfolio growth to fund rising LTC costs.

Individual circumstance vary, and one couple may reduce withdrawals to $28,000, another may stay at $40,000, and a third may withdraw an amount in between. 

Conclusions

Most writing about portfolio management treats the topic of annual withdrawals. But retirement is like other periods in life where lumpy spending plans intrude into an otherwise even flow. Retirees need to think through these lumps and integrate them into their financial lives.

This post describes one way of analyzing the lumps by thinking of four dimensions to each special spending need. The process leads to two possible effects on retired life: less risky asset allocations and reduced annual withdrawals. 

There are other ways to analyze such special projects, but if they are consistent with most portfolio analyses, they will lead to similar effects. Special, lumpy spending needs, whatever they are, should prompt most retirees to reduce portfolio risk and perhaps annual withdrawals.