Future inflation is even more unknown than future stock returns. At least with the stock market, companies are publicly priced and traded in real time so you can know what the markets did today. With inflation, you only definitively know it has happened a month after the price hikes have happened, and even then, some inflation may be under reported or regional.

For upcoming expenses in the near term, the mild effect of inflation can be viewed as a rounding error. However, when considering long-term expenses, ignoring inflation can ruin a retirement plan.

Recently, this powerful effect of inflation caught one reader’s eye in regards to our article “How to Self-Insure for Long-Term Care Health Expenses (2022).” They write (lightly edited):

I read your piece and approach in Forbes regarding self-insuring LTC. It makes sense except for one point: you talk about using the Genworth cost of care calculator to help estimate the 3.1 years cost of care and to save towards that. But those numbers are based on current costs. I am 60 years old, possibly 25 years away from that age 85 when I might need them. Inflation for health care in California was recently about 5%/year. According to one calculator, a semi-private room which might now cost $111k/year will cost $265k/year by 2048. I don’t have those kinds of funds on top of other needed retirement funds. So would LTC insurance make sense in my case?

The article “How to Self-Insure for Long-Term Care Health Expenses (2022)” was one of the most significant articles we wrote last year, pushing the boundary of financial planning knowledge. The methodology is trying to be as fair as possible to the long-term care issue, neither impoverishing people from extreme thrift nor lack of savings.

Our reader is right to pay heed to inflation, but ironically, the best way to plan for inflation is to discount everything and remove inflation from the math. In our analysis, we factor inflation out of both the growth of healthcare costs and the growth of your portfolio. We explain this in the original piece, when we describe the “3% return over inflation.”

In reality, both healthcare costs and your portfolio increase by inflation. However, your portfolio should produce returns which are greater than inflation. The excess return over inflation is called a real return, as opposed to the nominal return (real return compounded with inflation). In our analysis, we use a conservative 3% real return. A 3% real return means that healthcare costs grow at some sort of inflation and your portfolio grows by 3% (or more) over that inflation.

For the past 23 years, healthcare costs have risen 115.1% while CPI has risen 78.2% , for an annualized return of 3.37% for healthcare and 2.53% for CPI. A 3% real return under those historical conditions can be imagined as a nominal return of 6.47% (1.03*1.0337-1).

Historical analysis, suggests that under moderate inflationary conditions, the real return of stocks is 12.4% and the real return of bonds is 4.4%. Our assumed 3% real return is smaller than both of these and very conservative.

By using a real return, we are able to ignore all the inflation that healthcare costs experience over the time period.

Expressed as a simple algebra formula, this would be:

healthcare costs * inflation growth = portfolio balance * inflation growth * real return

The above formula has the problem of making us project both future inflation and future investment returns. However, by dividing both sides by inflation growth, we get a simpler math problem that requires fewer assumptions:

healthcare costs = portfolio balance * real return

This simple algebra movement allows us to discount the returns by inflation while arriving at the same planning result.

This strategy of factoring inflation out of the analysis has several benefits.

First, there is one less unknown variable we need to project and estimate, giving us one less place to make a mistake. Inflation assumptions and return assumptions are important in long range analysis. We typically strive to pick the estimate that will create the most conservative plan. In saving projections, that means assuming a minimal real return. In tax planning projections, that means assuming a large rate of inflation and thus more unfair taxation on that inflation. By assuming returns which make conservative plans, we are building padding into the projections and increasing the success rate.

Second, people typically underestimate the effect of both inflation and a compounded portfolio return, so knowing the nominal dollar amounts can be discouraging. Behavioral finance would suggest that people will have better success saving for goals expressed in today’s dollars.

Third, the analysis can be naturally updated each year to reflect the effects of recent actual inflation. Each year, the latest numbers which reflect actual inflation and returns can be used to course correct for outlier years in either.

Fourth, this particular analysis also provides additional padding added because if you were to need long-term care at age 85 (or earlier), it is unlikely that you will live until the planning age of 100. That would mean that some of your retirement funds would also be available for long-term care needs. Meanwhile, if your long-term care needs occur later, then your assets have longer to grow giving you potentially more money in order to self-insure healthcare costs.

So to the question: Would LTC insurance make sense because of inflation of healthcare costs? That reason alone is insufficient to justify long-term care insurance. By discounting portfolio returns to only real returns, we have already considered inflation in the planning targets.

Photo by Edu Lauton on Unsplash. Image has been cropped.