Invest or Insure?
Once you run the numbers, it turns out the choice between self-funding or buying insurance to cover a potential long term care event isn’t a choice at all.
By David O’Leary
(11 min read)
Back in 2007, Warren Buffett made a million-dollar bet — benefiting charity, of course.
It was a way to determine which is a better investment vehicle over a ten-year period: Is it an “active” one, in which hedge fund managers are constantly working to seize new opportunities in pursuit of higher-than-average returns? Or is it the opposite — a “passive” index fund, in which the strategy is to do nearly nothing in order to get average returns?
Buffett backed the index fund. And long before those ten years were up, it was clear he would win¹ — and that his charity, Girls Incorporated of Omaha, would win big.
Buffett won the bet because he understood the following: if you select a group of investors — even a group of experienced, knowledgeable hedge fund managers — and average their results, they will most likely track the average return of the market as a whole. Hedge funds just cost more.
Fans of index funds love this story because it justifies their investment strategy. But as an insurance executive, I love it for a different reason.
It illustrates a seemingly simple idea: the average person, by definition, does about average. As much as we like to think of ourselves as unique individuals, the nice check Girls Incorporated of Omaha received is proof that “being average” can be a very good thing.
Average isn’t the enemy. It’s reality. And there is virtue in embracing that reality.
This is especially relevant when it comes to financial matters like investing and insurance — that is, when it comes to putting limited resources to work while also protecting them from risk.
In the passive view of investing, we should embrace being average — and use index funds to achieve average returns in a low-cost way. That’s what Buffet’s bet was designed to demonstrate.
In my view of insurance, we should embrace being average — and use long term care insurance as a way to mitigate costs that most people will face as they grow older. So I thought I’d make a bet of my own — to demonstrate the value of long term care insurance by pitting it against Buffet’s chosen index fund.
It might seem like a suicide to bet, but I’m certain that, after hearing me out, even Mr. Buffett would see the value created.
Racing Buffett’s Horse Against Genworth’s Horse
Here’s the scenario. Imagine it’s January 1, 2000. We’re going to put money on two “horses” that will “race” for many years straight, and we’ll bet $1,110 on each horse. If that seems like an arbitrary number, hang on. There’s a reason for it.
With the first $1,110, we purchase shares of an S&P 500 index fund — the same index Buffett chose for his bet. With the other $1,110, we purchase long term care insurance — in 2000, the annual premium of a particular Genworth’s Privileged Choice long term care insurance policy was exactly $1,110*. Each year, we pay the insurance premium and invest an equal amount in the index fund. When the insurance premium goes up, we increase our investment to match.
Now, fast forward to 2018. Which dollar amount will be bigger: the total value of our investment portfolio or the total amount available to us if we claim all of the benefits of our insurance policy?
I won’t leave you hanging. The available insurance benefit can pay out more. A lot more. In fact, it can pay out nearly three times as much: roughly $63,000 vs. $175,000.
Before I walk through exactly how the numbers played out, I want to give a little context. Because the reason for that huge difference gets to the core of why people purchase insurance in the first place — and why it makes sense for many more to do so.
Mitigating Risk: Using Insurance vs. Using Your Own Funds
From accidents to fires to injuries, life is full of risks. Auto, home, health, and other common types of insurance exist to help mitigate the costs associated with those risks.
The same is true of long term care insurance. It’s there for you as you age, to help you plan for and handle certain unpredictable costs that arise as you get older, by reimbursing you for what you spend on long term care.
And what is long term care? To get technical, long term care is care that you need if you can no longer perform everyday tasks by yourself such as eating, bathing, getting dressed, and moving around.² Many people rely on long term care services and supports while recovering from a stroke, fighting cancer, managing diabetes or dementia, or dealing with an injury — or simply just getting older and losing strength, flexibility, and mobility.
Not everyone will experience these conditions, but many will, because we all age. I don’t need to rely on averages to convince you of that! At the same time, it’s natural to wonder what our chances might be, on average, as well as what the costs might be.
According to the Department of Health and Human Services,³ nearly 70 percent of Americans who reach age 65 will need some kind of long term care at some point as they grow older. It’s not just some people who will experience a long term care event. It’s most people.
And according to the Cost of Care Survey Genworth performs each year, costs continue to rise⁴ and can also vary greatly depending on where you live. For a three-year long term care need, the median cost for a private nursing home room in Birmingham, Alabama, is almost $225,000; in Hartford, Connecticut, it’s approaching $500,000. (Check costs in your area using Genworth’s Cost of Care web app.)⁵
In other words, long term care can be very expensive. Families face a huge financial risk, and mitigating that risk should be part of everyone’s financial planning.
Generally speaking, there are four ways to handle the costs of long term care:
- Government assistance: Because long term care is not health care, Medicare — the health program for the elderly — covers it only for a limited time after a hospital stay and care must be received in an approved facility. While Medicaid can contribute toward long term care, it requires people to use their income to pay for care and spend down most of their assets to qualify. Moreover, Medicaid is not designed to bear the nation’s long term care burden. As the Baby Boomer generation ages, America faces an increasingly serious — and thus far disturbingly silent — crisis.⁶
- Unpaid care from friends or family members: As Genworth has found through the Beyond Dollars Study, providing long term care for a loved one can be both a source of pride and extremely demanding. Unpaid caregivers give up free time, spend their own income and savings, sacrifice their other relationships, and even sacrifice their own health and well-being in order to provide care.
- Long term care insurance: After you purchase a long term care insurance policy, the insurer will pay policy benefits to you for what you spend on covered long term care. This is one of the horses in our race.
- Self-fund: Choosing this option means building up enough assets to cover the potential cost of a long term care need, as well as other retirement expenses. There are, of course, many ways to save or invest — a savings account, government bonds, fine art, you name it. But because funds that follow indices like the S&P 500 are a benchmark for the stock market and an increasingly popular way to park money, they make an ideal tool for comparison. The S&P 500 is the other horse in our race.
Compared to the alternatives, self-funding can seem like an enticing option. It might seem easier to simply purchase an index fund and forget about the rest. It might even seem safer to invest in index funds. In order to self-fund you will need to have a few key attributes — the discipline to invest over decades and the stomach to weather market downturns. You will also need to plan to have enough assets to cover a potentially very expensive long term care need, on top of whatever else you planned to do with your retirement assets.
When it comes down to it, there is one key difference between self-funding and purchasing insurance. Self-funding means taking on the risk yourself. Insurance means spreading the risk among many people.
By using insurance to spread the risk, we significantly amplify the power of what our dollars can do to pay for your long term care needs.
How Insurance Outpaces Self-Funding
This chart shows, year by year, how the race played out between the Genworth insurance policy and the S&P 500 index fund — specifically, the S&P 500 Total Return, which includes the reinvestment of dividends. For more details about the policy and the fund, see the endnotes.*
Source: CBOE.com and Genworth*
First, a summary of what you’re seeing:
- We used a real-world example policy, Privileged Choice, typical of the products Genworth offered across the country in 2000. The annual premium of this particular policy went up four times between 2000 and 2018 through in-force rate increases.
- The date indicates the age of the person in this example at the time when they both paid the premium and made the investment. We start in 2000, at age 62, and track toward age 80 — the age at which the average policyholder is likely to begin to start using their long term care insurance.
- The insurance benefit pool is the total amount available to reimburse the policyholder for what they spend on covered long term care services. Here’s how it’s calculated: Policies have both a daily benefit amount and a benefit period. In this case, policyholders can claim up to $100 per day until the benefit pool is used up. This policy also has inflation protection, which is why the daily benefit amount — and the benefit pool — increase over time.
- The investment portfolio value is the total market value of the shares of the index fund owned. The value of the index fund started at $1,455.22 per share and over time rose to $2,695.81 per share. In 2018, as the chart indicates, 12.07 shares totaled $63,451.
- The far right column shows the power of insurance leverage. Let’s dig in to what that means.
The Power of Insurance Leverage
If the word “leverage” makes you think of something convoluted, like debt-to-equity ratios, forget that. What we’re talking about here is very simple. This kind of leverage is about how much more you can get back in return for what you put in.
With an investment, one person takes on the risk, and the leverage is limited. With insurance, you get more leverage precisely because more people are sharing the risk.
Picture two see-saws: the investment lever is shorter, and the insurance lever is longer. When one person pushes down on the investment lever, the other side rises in turn. When a group of people push down on the much larger insurance lever, the other side rises much higher.
Leverage is precisely what makes insurance so darn valuable to individuals, as well as to society.
It’s not designed to replace investing for retirement. It’s designed to protect your retirement investments. In essence, the chart shows the relatively small cost of providing a much larger amount of retirement asset protection.
We can take this idea further by adding another layer of data to the example above, and by putting the tried-and-true strategy of “insure — and invest the rest” to the test.
In the chart below, the two columns under “Purchase Insurance…” have the same data as the chart above. And on the left side of that, we see the larger annual investment required — $3,793.82 per year — to build a portfolio the same size as the insurance benefit pool.
On the right-hand side of “Purchase Insurance…” we see what would happen if you used that same $3,793.82 a little differently, by putting some toward insurance and the rest toward the S&P 500.
Source: CBOE.com and Genworth*
The difference is clear:
- By self-funding, we built a portfolio worth $175,704 (with the caveat that, unlike insurance, Uncle Sam will take a cut out of the portfolio value through capital gains taxes).
- Alternatively, with the “insure and invest the rest” strategy, we used the same amount of money to build an insurance benefit pool of $175,704 as well as a portfolio worth $112,253.
It goes to show why many people buy insurance. They believe their retirement assets are better spent on things they enjoy or passed down to the next generation, rather than long term care.
In instances when the cost of long term care would have been enough to deplete someone’s entire retirement portfolio, insurance helps prevent them from needing to find an alternative—like asking family members to give up their free time to provide care, or spending down assets to qualify for government assistance.
Leverage makes insurance worth the price. And that’s still true, even if the price increases over time.
Insurance for the Long Term
Earlier this year, John C. Bogle — who created the first S&P 500 index fund — passed away.⁷ He started the fund in 1975, with $11 million⁸ under management. It grew as indexing grew popular and today, has $400 billion⁹ under management. John Bogle was playing a long game.
In his many books, Bogle talked about why investors should be rational, ignore short-term ups and downs of the market, and “stay the course.” He even made that phrase the title of his memoir,¹⁰ which he finished with these words: “‘stay the course’ is also a splendid rule for fighting our way through the inevitable ups and downs of the short spans of our existence on this Earth, and for enjoying a productive and honorable life well lived.”
Those who value insurance leverage can appreciate the value of staying the course over the long term. The numbers make it clear that it’s the rational thing to do.
But what the numbers don’t measure is sense of security. They don’t measure the feeling of knowing you’ve thought through and prepared for the financial and emotional challenges that most families will experience as they age.
The value of insurance is the knowledge that it’s there for you, no matter what happens. You win if you need it. And you win if you don’t. It’s pretty much the definition of a win-win.
President and Chief Executive Officer, Genworth, U.S. Life Insurance
Next Steps: Plan for Long Term Care
*Long term care insurance policy details: PCS II with $100 daily benefit, $73,000 benefit pool at issue, 5% compound inflation protection, and $1,110 annual premium at issue. Issued to a 62-year-old, in 2000 Single Standard Rate Class, in Texas. Rate increase history: 11% in August 2008, 18% in June 2011, 47% in July 2013, 56% in September 2016. The policyholder makes no long term care claims for the duration of the “race.”
*Index details: We chose the S&P 500 Total Return (SPTR). Unlike the traditional index (SPX), SPTR includes the reinvestment of dividends. Shares of SPTR are purchased at the closing price of the first trading day of each year, according to publicly available historical pricing data accessible on CBOE.com.
- Genworth Cost of Care Survey 2018, conducted by Care Scout ®, June 2018
- Genworth Cost of Care Survey 2018, conducted by Care Scout ®, June 2018
- Bogle, J. C. (2018). Stay the Course: The Story of Vanguard and the Index Revolution [Google Books] (illustrated).