$tarrBuck Report July 30, 2006: Should You Buy Long Term Care Insurance?

July 30, 2006

$tarrBuck Report July 30, 2006: Should You Buy Long Term Care Insurance?

No one wants to go into a nursing home for old age assistance. Much better to live in your own home and die in your own bed. Most 65 year olds will never enter a nursing home in the rest of their lives. But disabilities of age lead many elderly to nursing home care, typically after age 80.

How likely is a nursing home stay?
A 65 year-old man has a 27% chance of entering a nursing home at some future time. Once he’s entered, the average stay is 16 months; an eighth of men entering a nursing home spend more than three years there.
Women live longer than men, and men are often disabled with a still-healthy wife to care for them at home. A 65 year-old woman has a 44% chance of entering a nursing home at some future time and her average stay, once entered, is two years. An eighth of women in a nursing home will spend over five years.

How much will a nursing home cost?
The cost of nursing home care depends where you are and the quality of the home. The national average cost is $143 per day. In the coastal metropolitan areas of the US (NYC, DC, Boston, LA, SF), expect $150 to $200 per day. That’s $50,000 to $75,000 a year, more than most people can afford. Especially for a prolonged stay.

Who pays if you don’t? Medicaid!
Over a third of nursing home care is paid for by Medicaid (not Medicare) the joint Federal-state insurance for the medically indigent. There are very firm spend-down requirements for Medicaid eligibility. First your money pays for your care; when your money is nearly exhausted, Medicaid kicks in.

What does long term care insurance do for you?
Private long term care insurance provides all or part of the cost of nursing home (and in some cases at-home) long term care. There is usually a waiting period (an insurance deductible) of days or months during which you’ll pay for your own care. Then your insurance kicks in. It may have a limited term of benefits — several years, as much as you are likely to need — or last your whole remaining life.
Only a small fraction (around 4%) of long-term care expenses in the US are paid for by (non-Medicaid) insurance. The limited number of people with insurance and the limits of coverage make sure of that.
If Medicaid is going to pick up the tab eventually, why should you insure at all? For most people of average income and wealth that’s precisely the right question. Long term care insurance is expensive and substitutes for government-provided Medicaid. Most people will not find it a good use of their money to insure long term care.
For people of substantial income and wealth — wealth that may be called upon to finance long term care — long term care insurance fulfills three principal needs:
> It provides the assurance that convenient financing of prolonged care is available so that you and your family do not have to worry about accessing and liquidating assets to cover the cost. Insurance can protect your money and avoid disagreements in the family.
> It assures the value of your estate for your spouse and your heirs.
> It assures your nursing home, when you apply for admission, that their bills will be paid in full, not at the reduced Medicaid rate. All nursing homes are required to have some Medicaid-eligible beds. But there is always a shortage. Your insurance assures you and your family that your choice of accommodation will not be limited by financing.

What about inflation?
A long term care policy specifies a maximum daily benefit — typically keyed to the average prevailing cost of care at the time you insure. But those costs are likely to go up by the time you’re ready for benefits. If you’re buying a policy, getting the inflation coverage makes sense. It’s generally set at a fixed annual percentage, not indexed to the actual inflation rate. Still, better than nothing.

When should you buy long term care insurance?
Your insurance company wants to insure you while you’re young and healthy. That leaves them years, decades, to collect insurance premiums before they’re likely to have to pay out benefits. If you’re old or sick, you may not be insurable. So insure while you’re young and healthy. Preferably in your 50’s. The average age at purchase is 65.

What about saving up for long term care?
There’s no free lunch. On average, long term care insurance will cost you significantly more than the benefits you are likely to receive. If you insure in your 50’s with a long waiting period, the annual premiums are likely to run about ten days worth of benefits. If you live for thirty years before checking into a nursing home, you’ve already paid in almost a year’s worth of benefits, far more than you’re likely to receive.
If you’re lucky and healthy, you can self-insure: don’t buy the insurance; save and invest the money that would have gone for long-term care insurance premiums. On average, you’ll come out ahead. But there’s a risk you won’t be average. If you’re disabled when you’re young or live longer than you expect to in a nursing home you may exhaust your self-insurance savings. All your wealth is on the line then for long term care, and after that you need to rely on Medicaid.

Should you buy long term care insurance?
If you’re very rich and plan to stay that way, you’re self-insured. Don’t bother.
If you have average income and wealth, Medicaid has you covered. There are probably better uses for your money. You probably shouldn’t bother.
If you’re moderately wealthy, you and your family are at risk. Look into long term care insurance. It may be expensive; but it may be cheap for peace of mind.

(c) Copyright R. M. Starr 2006

$tarrBuck Report for July 23, 2006: What Did Chairman Bernanke Say?

July 23, 2006

$tarrBuck Report for July 23, 2006: What Did Chairman Bernanke Say?

by R. M. Starr

Last Wednesday Dr. Ben Bernanke, Chairman of the Federal Reserve Board of Governors, gave his semi-annual Humphrey-Hawkins testimony to Congress. Must have been good news! While he was speaking the Dow gained over 200 points! Of course, the stock market lost most of Wednesday’s gains during the rest of the week, but it was a really fun day. What did Chairman Bernanke say? What does it mean for you?

Wall Street was pleased because the Street interpreted Bernanke’s remarks as meaning that the Fed is very nearly done raising interest rates. That reduces the competition for stocks from the fixed-income market. How come? Aren’t there still signs of increasing inflation? Isn’t gasoline still becoming more expensive?

Bernanke noted several things:
> The Fed concentrates both on economic growth and inflation.
> The measure of inflation the Fed concentrates on is core inflation. They purposely try not to respond to food and energy prices because those prices do not really significantly reflect US monetary policy or domestic US economic activity. The Fed’s principal concern regarding oil prices is whether energy price increases will spread to more general price inflation — possibly through catch-up wage increases.
> The Fed needs to be forward-looking. Policy actions take about a year to work through the economy. The housing market just started responding to 2004’s interest rate increases in late 2005. The economy will still be adjusting to 2006’s interest rate increases in 2007.
> US economic growth is expected to slow down in the second half of 2006. Slowing economic activity tends to slow price increases (with a time lag) so an anti-inflation monetary policy is already in place.
> The Fed is concerned both with actual inflation and inflationary expectations. Expectations can enter price and wage decisions. So far, inflationary expectations are under control.

Bottom line. Bernanke didn’t promise to stop raising interest rates, but he gave a really broad hint. A slowing economy with low inflation expectations still absorbing the two past years’ of interest rate increases doesn’t need any additional monetary restraint. The last Federal Funds rate target increase (in June) or the next (in August) will probably be the final increase for the foreseeable future.

That’s good news if you hold long bonds, owe an adjustable rate mortgage, or if you own preferred or common stocks. It’s not so good if you’re a saver in CD’s, a savings account, or Treasury bills; you might have wanted a few more rate increases to juice your return.

Wall Street enjoyed the news for at least one day.

(c) Copyright R. M. Starr 2006

$tarrBuck Report, July 16, 2006: Tax Shelter in Your Investment Plan

July 16, 2006

$tarrBuck Report, July 16, 2006: Tax Shelter in Your Investment Plan
by
R. M. Starr

Working Americans have a variety of tax shelter opportunities. Most major employers offer 401(k) plans, often including an employer contribuition. Additional variants — depending on your employment and tax situation include (traditional) IRA’s, Keogh’s, 403(b)’s, 457(b)’s, …. These earned-income tax shelters are powerful means of investing, providing increased profits and rapid capital accumulation. When you invest in your tax shelter you pay no current income tax on salary money you invest or on investment earnings in the account. You pay income tax later when you withdraw your money.
Why use tax shelter?: The tax shelter delivers more because the tax shelter pays its taxes later, much later. Meanwhile, money that would have been spent in taxes is earning profits that are reinvested. Tax sheltered money starts bigger and grows faster than taxable saving. Even after paying taxes there’s a lot more left!
Tax-deferred plans combine two investment powerhouses: tax shelter and compound returns. Your savings come from before-tax income. Money that would have been paid in taxes works for you instead, and the returns are reinvested untaxed. Taxes are paid only when the money is withdrawn, usually on retirement, years or decades after it is deposited. In the meanwhile, it has time to grow. Tax shelter lets it grow faster than in a taxable investment. “Compounding” means earning further profits on returns reinvested. Compounding is the financial miracle, allowing money to double and redouble in a few years. For example, at 10% annual growth, your money doubles in seven years and quadruples in fourteen.

An Example
The example of B. B. Boehmer illustrates the point. He’ll get considerably more from his tax shelter than he could from unsheltered investing:
Saving and investing without tax shelter
B. B. is in the 35% income tax bracket (combined Federal and state). On each additional dollar of income, he pays income taxes of 35¢. One way for B. B. to invest is fully taxable. B. B. pays taxes on his salary, invests from after-tax income, pays taxes on the investment profits, reinvests the remainder, and so forth …. He decides to save $300 per month.
B. B. faces a choice of investment alternatives. Saving $300 per month from age 45 until age 65, B. B. decides to invest in the stock market with an average annual return of 10% (6.5% after taxes). His expected accumulation calculates out to $139,770. He can then withdraw monthly spending of $1057 (after-tax) for twenty years. He’ll draw the balance down to zero by age 85. Earning 6.5% annually, he’s more than tripled his money — each month he can withdraw more than three times what he saved twenty years earlier. Every year, B. B. pays income taxes on this investment income, sharing his investment success with the Federal and state governments, making no use of tax shelter.

Tax sheltered saving and investing
Now let’s look at a tax-sheltered alternative. Since B. B. is now saving in a tax deferred way, he can put more money into the tax shelter than he did into taxable savings; he invests the money he would have paid in taxes into the tax shelter. He had been planning to save $300 per month in after-tax income. That’s $461.50 a month in before-tax income. He saves $461.50 a month for twenty years and invests in the stock market at the expected return of 10% per year. The tax savings show up each year: instead of growing at 6.5% after-tax, his money grows faster, at 10%. The taxes will be paid later, after the money has had a chance to grow.
After twenty years of saving this way B. B. expects to accumulate
$ 317,215 (before-tax), more than twice as much as taxable saving. Now it’s time for the payout. He spends the money over twenty years to age 85, running the balance down to zero. The tax deferred tax shelter will support monthly payouts of $ 3106 before-tax, equivalent to $ 2019 after-tax. That’s more than six times as much as B. B. saved monthly. It’s almost twice as much as taxable saving would have provided.

The chart below shows a payout projection including a comparison with the (less volatile) 5% and 7.5% yield alternatives. Even at 5%, the tax shelter provides a significantly higher return. The monthly payout after-tax with stock market investing in B. B. ’s example is almost twice as much from the tax shelter as from unsheltered saving. Why? B. B. contributed equivalent amounts to the two plans; both plans paid their taxes at the same rates. The tax shelter delivers more because the tax shelter pays its taxes later, much later. Meanwhile, money that would have been spent in taxes is earning profits that are reinvested. tax shelter moneys start bigger and grow faster. Even after paying their taxes, there’s a lot more left!

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RETIREMENT INCOME PROJECTION: B. B. BOEHMER

Age: 45 ; Retirement age: 65; Marginal income tax rate: 35%.

Taxable Savings Program

Saves $ 300 per month in after-tax income
Yield before-tax:            10%             7.5%             5%
Yield after-tax:             6.5%             4.9%             3.25%
Accumulated savings
at age 65:                   $ 139,770    $ 117, 480    $ 99, 230
After-tax monthly income
to age 85:                     $ 1057         $ 755             $ 556

Tax-Deferred Savings Program
Saves $ 300 per month in after-tax income PLUS deferred taxes of $161.50 = $ 461.50
Tax deferred yield:             10%           7.5%               5%
Accumulated savings
(before-tax) at age 65:      $ 317,215 $239,820         $ 183,120
Monthly income from
savings to age 85
Before-tax:                     $ 3106         $ 1898             $ 1189
After-tax:                         $ 2019         $ 1234             $ 773
———————————–

Bottom line: Use your tax shelter! Max out your contributions. Tax shelter lets your investment returns grow and grow.

(c) Copyright R. M. Starr 2006

$tarrBuck Report July 9, 2006 How Much Do You Need to Save for Your Retirement?

July 9, 2006

$tarrBuck Report July 9, 2006

by R. M. Starr

How Much Do You Need to Save for Your Retirement?

It happened to Paul McCartney! It could happen to you! Not stardom — facing retirement. How much should you be saving now to support yourself decades from now? For most Americans, the answer is “more than you’re saving now.” But of course that’s not a useful answer. We need a number. How much should we be putting aside monthly or annually?

This isn’t an easy math problem for a few reasons. There’s uncertainty on all sides: how long will you live? what will your investment returns be? when will you retire? how much will Social Security pay? what will inflation do? Even when we’ve used our best guesses to solve these issues there’s the arithmetic. It involves compound interest. That’s always a bit tricky. Then there are taxes — they can sap the growth of the most robust investment plan.

The starting point is four numbers: How much have you got now in funds that can be used for retirement (not vacation savings or the kids’ college funds)? How much income will you need from your own savings? How long until retirement? How long should your retirement funds last?

To deal with inflation, the way to figure is in ‘real’ inflation-adjusted dollars and investment yields. To figure out how much income you’ll need from your own savings, start with a target spending level, then subtract the other sources of retirement income: Social Security (yes, it will be there, just not so generous), defined benefit pension plans. The difference between your target spending level and your other sources of retirement income is what your wealth and saving need to provide.

An example. Joan Frank is a single professional woman age 45. She’d like to retire in twenty years at age 65. Joan comes from a long-lived family; her plans need to go to age 90, twenty-five years from retirement. She could be hit by truck tomorrow, or on her 66th birthday, but the retirement plan had better go to 90. Joan has been contributing regularly to 401(k) plans so she has $100,000 accumulated there, but there’s no defined benefit retirement plan so she’s on her own. Her Social Security statement says to expect $25,000 a year in Social Security benefits (until the trust fund runs dry). Joan has a mortgage on her condo but she figures it will be paid off by retirement and the condo will be worth (in today’s dollars) $400,000. But that’s not money you can readily tap into. Joan figures $60,000 a year is a reasonable retirement spending target, assuming the condo is paid off. After Social Security that leaves $35,000 a year she needs to come up with from her own resources.

How much can she expect from the money already in her 401(k)? We need to make a guess now. What is the average annual real (net of inflation) return she can expect? A moderately conservative figure (averaged over the twenty years to retirement) is 5% annually real. That reflects a mix of stocks and bonds and a margin of safety. Joan figures the compound return to $100,000 at 5% annual growth over 20 years. She expects the fund to grow to $265,000 (real) in twenty years. To see how Joan figured this total out go to http://www.moneychimp.com/calculator/compound_interest_calculator.htm. Then over the next 25 years it can provide annual withdrawals of $ 18,000, running the balance down to zero over Joan’s twenty-five year retirement. For this calculation go to http://www.moneychimp.com/calculator/annuity_calculator.htm.

Joan is halfway there. She wants $35,000 spending a year and she’s found $18,000. She needs to save in addition enough over the next twenty years to provide $17,000 a year additional spending. Once she’s retired she’ll be running down her savings, but that’s part of the plan. How much does she need to save each year to age 65? The arithmetic is a bit messy, but $7000 saving a year should do it. Joan puts $600 a month into an IRA or 401(k). Those tax-sheltered plans allow the money to grow without being slowed down by taxes. Joan figures that compound interest means that those contributions (totaling about $140,000) will grow to about $230,000 in twenty years, enough to sustain her spending plan of $17,000 a year.

Is there a risk here? Yes, all the uncertainties we started with are still there. Financial markets could disappoint; Joan could be exceptionally long-lived. But now Joan has a plan. There’s room for adjustment as time goes on. Joan should recalculate in five years. She may need to increase her annual saving. Or she may be able to reduce it. At age 55 she may need to plan to postpone retirement for a year or two. If she’s managed to save more than she initially planned, she may be able to accelerate retirement. She may want to use a more conservative investment portfolio after retirement — that will reduce average returns and mean she wants to reduce spending a bit.

The plan should work out. But there are fallbacks if needed after retirement. Reverse mortgaging the condo, buying an annuity later.

Planning, saving, taking advantage of tax shelter and the power of compound interest are the cornerstones of retirement saving. Having a target, making a plan and sticking to it let you look to the future with confidence.

(c) Copyright R. M. Starr 2006

$tarrBuck Report, July 2, 2006: Interest Rates and Home Prices

July 2, 2006

$tarrBuck Report July 2, 2006

by R. M. Starr

Interest Rates and Home Prices

Mortgage interest payments are the price we pay for home ownership. It’s a cost even if you own your home free and clear: the money that’s tied up in your home could be out earning interest. There are two main ways to think of the interest cost: nominal and real. Nominal cost is how many dollars we need to pay each year. Real interest cost is the interest payment after subtracting out the rate of inflation.

If you’ve borrowed $200,000 at 5% interest it’s costing you $10,000 a year in interest. That’s the nominal cost. But if inflation is running at 3% a year, the purchasing power value of your debt goes down by $6000 in the same time. It’s really costing you only $4000 a year, 2% real.

If that $200,000 is the value of your house and your house is increasing in value by 15% annually then the net cost isn’t $10,000 — you’re actually making $20,000 in profit on the year. The investment in your home is appreciating by more than the interest cost. That’s why home ownership has seemed like such a good deal for many years.

So once you’ve got your mortgage loan and can afford the payments, what really matters is two quantities: the real interest rate and the rate of gain in the value of the house. What you’re paying after the depreciation in the value of your debt or after the gains you’ve made on the house. But nominal interest rates matter too. They determine your cash flow situation: can you afford the payments right now? can you qualify for the loan in the first place?

Over the last five years we’ve seen a roller coaster ride in short-term nominal interest rates, and they’ve taken the housing market with them. The US central bank, the Federal Reserve System, embarked on a vigorous program of interest rate cuts in 2001 to cure a recession and forestall deflation (a general decline in the price level focusing on “core” prices, not including food and energy). That policy has been successful. It created a growing economy and a residential real estate boom.

It’s short-term rates (for borrowing under a year) that determine the interest rate on adjustable rate mortgages (ARMs). ARMs amortize over many years, but since the interest rate resets regularly, their interest rates move with short term rates. As ARM rates moved down from over 6% in 2001 to a trough of 3.4% in 2004 and most of the way back up in 2006, the mortgage market and the housing market have moved with them.

Borrowers who could not qualify for a loan in 2001 found that they easily qualified in 2004. An ARM that required a monthly payment of $1000 in 2001 needed only $600 in mid-2004. That change expanded the pool of buyers and the purchase price they could afford as current monthly payments went down. So housing prices went higher throughout the period. And rising prices feed on themselves: everyone wants to get on the bandwagon for the ride.

The rates on fixed rate 30-year loans have been pretty steady over 2001-2006. They’re about the same now as they were in mid-2001. So the conservative buyers who locked in fixed rates have little problem meeting their monthly payments.

But ARM rates bottomed out in 2004 and they’ve been going back up. Many potential buyers now who could easily finance their house purchases at 2004’s ARM rates cannot finance a similar purchase at 2006 rates. That cuts into the demand for houses by potential buyers. That’s why the housing market is currently slowing. And as it slows, the bandwagon effect works in the opposite direction. No one really wants to get on a ride that’s going nowhere.

So where is the housing market going from here? The opposite direction of where interest rates are going.
Forecast: There will probably be no crash in house prices until the next recession, but it will be a slow market for years. As ARMs taken out in the first part of this decade reset their interest rates in coming years, there will be some pressure on the owners to sell, creating a drag for years.

Advice to buyers: Fall of this year is likely to be a buyers’ market. A slow selling season in the Summer of 2006 should create bargains in the Fall.

Advice to sellers: Patience and decisiveness. It’s a buyers’ market. The sweet prices and deals that a seller could expect in 2004 won’t be around for many years to come. Expect to wait for a buyer, and sell when you can.

(c) Copyright R. M. Starr 2006