One of the things that can discourage people from buying long-term-care insurance is the idea of paying a lot of money for a policy that with any luck they’ll never have to use.

Of course, almost all insurance is like that. But long-term-care insurance is particularly expensive and frequently, its purchase comes at a time when people are facing retirement and looking for ways to cut back.

Hybrid policies

One way to avoid spending a lot of money directly on a long-term-care policy while still getting its benefits is to buy an insurance policy with a long-term-care rider.

These hybrid policies work variously, but the type that has gotten the most attention is a long-term-care annuity. Beginning in 2010, the IRS will let those who hold one of these deferred annuities use the money to pay for long-term care free of federal taxes. Annuities allow money to grow tax-free, but the tax man has to be paid when the money is removed. These long-term-care annuities free holders from this obligation.

Several insurers, including Mutual of Omaha, Genworth, Bankers Life and OneAmerica, now offer hybrid deferred annuities.

Most hybrid deferred annuities operate this way:

Purchasers put money — $50,000 is about the minimum — into an annuity. These also can be funded with another annuity or a whole or universal life insurance policy that the owner no longer needs through what the IRS calls a 1035 exchange.

Purchasers then choose the amount of long-term care coverage they want, usually 200 percent or 300 percent of the face value of the annuity, and they decide if they want inflation coverage. They also have to decide how long they want the coverage to last, usually two to six years. Inflation coverage will affect the maximum duration of the plan.

Genworth uses this clear-cut example:

A 60-year-old purchases a $50,000 long-term care annuity with 5 percent inflation protection compounded annually with a 200 percent coverage maximum and a six-year benefit period. So, his initial long-term-care coverage maximum is $100,000 — double the premium he paid. (If he had refused inflation protection, then he could have chosen three times the premium, or $150,000.)

If he makes no withdrawals over 20 years at a 3.5 percent compound interest rate, minus administrative fees, he would have — under the 5 percent inflation-protected scenario –$265,330 available in long-term-care insurance. Or a monthly maximum of $3,685.

If this person never needs long-term care, then the annuity can be redeemed for its accumulated value when it matures at 20 years — or it can be left to accumulate further interest and the long-term care policy will remain enforce.

When this person dies, his heirs will inherit the greater of the accumulated annuity value, if there have been no withdrawals, or the single premium he paid initially less the amount of long-term care paid.

The pros of hybrid policies

  • The underwriting is usually less stringent than for a conventional long-term care policy. Genworth, for example, asks applicants whether they have or have had some serious illnesses like cancer, but the company doesn’t require a physical, and less serious ailments don’t affect insurability at all. People as old as 80 may be able to buy these policies, even with a $50,000 initial investment.
  • Most policies have few restrictions on how you use the money. Once you meet the qualifications, usually the inability to manage two of the six activities of daily living (eating, bathing, dressing, toileting, transferring and maintaining continence, or cognitive impairment), how you spend your money is up to you. You can pay a neighbor or a family member to help out or use the tax-free payments to augment other money that you have available.
  • If you are in a high tax bracket even post retirement, getting the money federal tax-free could make a big difference in the amount you have to spend.
  • The annuity and your long-term-care insurance are fully funded. Once the plan is in place, you don’t have to pay anymore. Unlike with long-term-care insurance, you won’t lose your coverage by forgetting to make payments.

The cons of hybrid policies

Independent agent Adam Hyers, owner of Hyers & Associates in Columbus, Ohio, who sells both these and conventional long-term-care policies, offers these precautions:

  • You have to have at least $50,000 lying around that you are willing to tie up indefinitely. “You should ask yourself do I have enough money readily available for an emergency,” Hyers says. The money in the annuity is particularly inaccessible during the first five or 10 years because if you try to get your money out of an annuity before it matures, the surrender fees could be as much as 10 percent. Even after the policy is mature, if you take any money out, it will reduce the value of the long-term care insurance by that figure multiplied by the rate of compounding. 
  • If you buy the annuity when you are 60, it will be fully mature when you are 80. If you then choose to leave the annuity in effect so you continue to have long-term-care insurance when you need it the most, the interest rate will decline — probably precipitously.
  • The return on hybrid annuities is often meager — significantly less than the return on more conventional annuities. Before you buy one, consider whether it makes more sense to buy an annuity with a higher return and spend the extra interest on a conventional long-term-care policy.
  • These policies generally don’t qualify for partnership plans that protect you from having to spend all your money before you qualify for Medicaid. If you have a lingering illness, having partnership insurance that protects some of your assets could be important.

The health care reform bill calls for setting up a government-run long-term-care insurance program, which will be offered primarily through employers. Details are expected to be available in 2011, with participants required to pay in for five years before being eligible for benefits of about $50 per day. Some people may decide this government plan is enough, while others with more assets may want to protect them by purchasing a private long-term-care insurance policy.

Tennessee-based financial consultant Hank Parrott advises looking at these hybrid policies as an estate-planning tool first and foremost. “The money will accumulate and you can leave it to your kids. The long-term care is just an added benefit,” he says.

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