Let’s begin with a crash course in inflation. Way back in 1953, a gallon of gas cost 20-cents, a new car $1,650, and a new home $9,550. If you were a teacher, you’d pay for it all on your modest salary of $4,200/year. 59-years later, you don’t need me to research today’s prices: as a shopper and checkbook-balancer you know exactly what everything costs, right down to a $4.00 gallon of gas, and which station in your neighborhood is the cheapest.
Just like that $10,000 home which today costs $273,000, the services which your LTC policy covers are no different. They rise over time. The hard part is making an educated guess how much.
Since your policy covers not only Nursing and Assisted-Living Facilities, but also Home Care and Independent Providers, the cost of labor can drive up underlying claim costs, as can the price of real estate, taxes, debt service, hiring and training, regulation compliance, and old-fashioned supply & demand. An LTC insurance policy whose benefits do not keep pace over time comes dangerously close to being worthless. A $100/day plan which at one time seemed ample could in the future cover only a small fraction of $800/day future care costs.
WHICH INFLATION RIDER IS BEST?
That’s easy. The best inflation protection would be one in which you don’t overpay for an excessively-high rate you don’t need, nor underpay for a low rate which doesn’t keep up over time. It would move flexibly with the cost of care itself.
Failing this, we can rely on a general rule of thumb: the younger you are as a purchaser, the greater your need for compounding, and the higher the rate of compounding you’ll need. Applicants who are older will tend to receive less benefit from the exponential growth of compounding (and needn’t overpay). Such buyers may find straight-line simple inflation growth sufficient, or even the Guaranteed Purchase Option strategy I will outline below.
A word of caution: producers of old knew that most claims began in the early 80’s, and figured as much when choosing an inflation option. Today’s buyer may well live into her 90’s with ease, or even 100’s, so inflation protection needs to account for an additional 10 to 20 years or more of growth.
THE MOVING TARGET
The inflation protection option which moves in tandem with the actual cost of goods and services is called “CPI-Compound“, owing to the fact that your benefits are pegged to changes in the “Consumer Price Index“, and “Compound” because each year’s increase is compounded on Last Year’s Benefit. (By contrast, when you purchase any “Simple” inflation option, each increase is based on your First Year Benefit.) The CPI is considered such a benchmark of the growth of US goods and services that Social Security checks and many US Pension Funds are also pegged to it. In terms of hard numbers, its historic 50-year average is roughly 4.1% at the time of this writing.
One of the unheralded advantages of CPI-based inflation protection is that the carrier’s profit margin is assured. This is a good thing! The policyholder can relax knowing her premium rates will remain more stable in the future, and even if inflation rises to double-digits her benefits will easily grow in tandem.
CARRIERS FEEL THE SQUEEZE
While the CPI is a floating rate, consider the fate of “fixed” inflation rates in an age where the Federal Reserve has just made the unprecedented announcement that it will keep Interest Rates near 0% for the next 2 years. For carriers who are obligated to grow policy benefits at 5% Compounded while earning next-to-nothing on their Investment Portfolios, the results have been catastrophic, resulting in rate increases to make-up the difference, or carriers abandoning the industry entirely.
THE 5% STANDARD
If 5% Compound is so damaging, how did it become the standard? Of those policyholders who elected an inflation option in 2010, over 45% chose 5% Compound. (In decreasing popularity were 3% Compound, then 5% Simple, with other choices barely registering.)
We can point to several factors which might explain the dominance of 5% Compound. First is the requirement since 1997 (due to tthe Health Insurance Portability & Accountability Act, or HIPAA) that every carrier offer it at the point-of-sale, with a concurrent requirement from consumers that they affirmatively “opt-out”. Second is the advent of so-called “Partnership Policies” (launched nationwide beginning in 2005) which by definition require that a buyer aged 60 or younger purchase Compound inflation (whether 5%, 3% or some other minimum up to each State to decide).[i]
Just as Alexander Fleming is credited with accidentally discovering penicillin, it would appear that 5% Compound owes its discovery to no more illustrious an occasion than chance.
“It just sounded right,” was the description of one gentleman who claimed to personally know the actuary who developed it. “It was arbitrarily picked,” said another industry insider, when recounting what he heard from his colleagues at the NAIC. A brand-new benefit in the 1980′s, 5% Compound was soon seized upon by consumer groups insisting it become standardized and mandated. During the ensuing negotiations, both 7% Compound was raised and rejected, as was a CPI-based rider which would’ve increased both benefits and premiums; in the end, the “mandated offer” of 5% Compound was settled upon which survives to this day.
WHAT’S THE REAL RATE OF INFLATION?
You’ve read the argument above for a floating rate linked to the Consumer Price Index. Another approach consists in looking at each year’s Cost of Care Surveys put out by third-parties and evaluating the real rise in the underlying cost of healthcare. Results from 3 such sources follow, showing compounded annual growth rates:
- Yr-over-Yr, ALF (One-Bed, Single Occ.) 1.19%
- Yr-over-Yr, NH (Semi-Private Room) 3.63%…….
- 5-yr, Licensed Home Health Aides 1.09%
- 5-yr, Licensed Homemaker Services 1.15%
- 9-yr, NH and ALF 3.50%
- 9-yr, Home Health Aides 1.30%
- 14-yr, Home Health Care 1.86%
- 16-yr, NH 4.05%
For the reasons above, 5% Compound has fallen out of favor, replaced by the more-affordable 3% Compound. The observant producer will note, too, how nursing facility rates have tracked considerably higher than home care services over both the short-term and long-term. But before making your recommendation, ask yourself, “Where will my clients be receiving care in the future?” Industry stats show that ½ to ¾ of newly-opened claims are for Home Care: make sure your recommendations align with the services your clients expect to use.
WHAT DO THE RIDERS COST?
Using identical ages and benefits, I generated the following annual premiums for each of the following popular inflation protection riders below. Keep in mind that even this list is not exhaustive: there are inflation options that cease once your benefit has doubled, tripled, or you’ve attained a given age (such as 85). There’s even a CPI-compound option that grows only until you’ve reached age 75. The next time someone tells you LTCi is unaffordable, remember: there are options for every budget!
- 2% compound: $1,983
- 3% compound: $2,394
- 5% simple: $2,638
- 4% compound / CPI: $3,073
- 5% compound: $3,993
- GPO: $8,330[ii]
To help you get a sense of what your $200/day benefit will look like in 30-yrs, I’ve embedded this chart to illustrate the comparison for you.
WHY IS THAT GPO NUMBER SO EXPENSIVE?
It stands for “Guaranteed Purchase Option” and is also sometimes seen as “Future Purchase Option” (FPO). Guaranteed Purchase is like inflation protection in that—for a fee—you buy the right to exercise future increases to your policy benefit without having to provide evidence of insurability. Unfortunately, because such increases are bought at “attained age”, the cost of exercising each option can become prohibitively expensive.
The result is that GPO is paradoxically either the least expensive—or the most expensive—inflation option available. If you never exercise any of your future purchases, your benefit will be stagnant, and you’ll have paid only slightly more than someone with no inflation protection at all. If you were to exercise all of your future purchases—each one successively more expensive than the last as you age—your benefit will grow, and your premium will rise in tandem with each purchase. (This is seen as a distinct disadvantage compared to the other inflation options, where your premium is designed to remain level throughout your lifetime.)
Now you understand why my GPO quote above appears so pricey: I’ve shown the impact of accepting all the offers over a 30-yr illustration window, then done the math to produce one “average annual premium”.
But here’s the catch. I wouldn’t encourage any of my clients to actually exercise all of their offers.
To understand how to sell—and buy—GPO, I’ve embedded a second Inflation Graph here, which answers the question, “If I only had $2,000 to spend, how much could I purchase using different Inflation Riders?” Incredibly, for the same price if you compare 4% and 5% Compound, you could start at $130/day instead of $100/day and enjoy the use of a higher daily benefit for nearly 30-years. That’s powerful.
Which brings us back to GPO. We know going in that the rates at the oldest ages will be extreme: it’s not our intention to exercise them. Since affordability is still the biggest barrier to entry for any Non-Buyer, the single most important action anyone can take is to get their foot in the door of “some coverage“. Therefore, we can take as much of our savings from purchasing inexpensive GPO and plug it into a higher initial Daily (or Monthly) Benefit. Having done so, we can enjoy the use of that higher coverage for the next 25-yrs. (As an example, the savings from buying GPO compared to 3% Compound should allow you to purchase twice as much Benefit up-front.)
I hope this article has helped to shed light on the variety of inflation riders available today, while providing some guidance towards which is best for your situation. Ultimately, the best inflation protection is the one you buy and keep. In the 1990′s, only 44% of policies sold included inflation protection, and it’s to our industry’s credit that today’s rate has grown to a solid 77%. But that still leaves nearly 1/4th of policyholders whose benefits are stagnant and not increasing over time. Imagine if your salary was stuck in 1953 and you still made $4,200 today. It wouldn’t take you very far, would it? Don’t condemn your policyholders to an LTCi plan frozen-in-time, when so many inflation options await. As we always say when it comes to LTC Insurance, something is better than nothing.
[i] In a typical “Partnership” policy, each dollar received in benefits from the private LTC insurance company is considered “exempt” (ie ignored) when applying for the public Medicaid program, and again during the Medicaid estate recovery process. This “Partnership” between public and private institutions encourages consumers to delay the use of public assistance; to ensure these policies provide meaningful protection, proper inflation protection is required.
[ii] Although $8,330 is an average annual premium over a full 30-yr period (and a statistical construct), in real terms the GPO premium begins as low as $1,468/yr and rises as high as $28,122/yr by the end of the timeframe.