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Please Mind the Gap!

For my first professional career, I worked as a stock market analyst in Hong Kong and, later, Shanghai. For those of you who have never been there, Hong Kong is very crowded—at least on the island—and traffic easily rivals that of Los Angeles. The most efficient way to travel within Hong Kong is by the Mass Transit Railway (MTR). To maintain the safety and orientation of millions of riders, the MTR announces in Cantonese, Mandarin and English information, including which train is arriving to the station, which station the train is approaching, which line connections can be made at a particular station, on which side the doors will open, and the slightly cryptic warning to “Please mind the gap”. Originally, that was the entire warning. Now, for clarity, the mechanical voice elaborates “Please mind the gap between the train and the platform.” Apparently, enough people have fallen or have had a foot stuck for this to be a real concern. For any of you that might be travel or train geeks, or are just curious, you can listen to the announcements here.

A one-sentence summation of special needs financial planning might be “Please mind the gap.” In this case, “the gap” is the difference between the amount of any government-funding streams that will be available to your son or daughter with a disability and what it will actually cost him/her to live in a decent home with qualified support staff and the kind of clothes, furniture, electronics as well as relational, recreational, fitness, travel and spiritual opportunities that make life worth living. It’s that gap that your special needs plan will need to fully fund, including whatever you pay out of pocket while you are still alive, and whatever you leave to a special needs trust when you depart. Moreover, it’s a gap that your special needs plan will need to fully fund over a very long time. And that, dear readers, is where the devil gets into the details.

The first thing to understand is the power—both for good and ill—of compounding. Undocumented urban legend has Albert Einstein declaring that compounding is the most powerful force in the universe. As questionable as that attribution is, the statement itself is only something of an exaggeration. When it comes to any kind of financial forecasting, the rate of compounding applied to each variable has an enormous impact on the result. This is because a small growth rate, applied consistently over a long period of time to even a small base number, is going to result in a very large number at the end of the time period. The second thing is to understand is what elements of the plan’s input you are compounding at what rate.

At its most basic level, a special needs plan has two inputs. The first input is the annual amount the person with a disability will require to cover all expenses. The second input is the amount of public funding the person is going to receive through Social Security, Medicaid and Medicare coverage of healthcare costs and Medicaid Waiver funding for personal support services. In my two decades of experience, public funding is never sufficient to cover all costs. So, there is an initial gap. Subsequently, the first input, the overall cost, is going to increase annually due to general inflation. The second input, the public funding, is also going to increase annually at whatever rate the government decides. There is no guarantee that the rates of increase of each input will be the same, and it is prudent to consider that public funding may not keep pace with rising costs. As a result, you are looking at a gap that continues to widen over the life of the plan. In addition to the growth rate applied to the cost side and the growth rate applied to the income side, there is also a growth rate that must be applied to any money that is set aside to fund the gap and invested until it is needed.

To get a sense of both the size of the investment needed to fund a growing gap over a long period of time and the effect on the size of that investment of even a small change in any one of those growth rates, let’s run a simple example. Let us consider a parent, who is 67, and looking to plan for an adult child who is 37 and who will be living a typical, average lifespan to age 87. The parent wants to know how much money s/he will need today to cover the adult child’s supplemental needs for life. In the first year of the plan, the total cost for the child to live in a decently supported living situation is $75,000. In the first year of the plan, the amount of government funding that the child will receive from various sources is $70,000. The initial gap is $5,000. Now, let us assume the cost will grow at an inflation rate of 2.5%, but the government funding will only grow at a slightly lower rate of 2%. As a result, the $5,000 gap will grow to a $10,000 gap by year 10 when the parent is 77 and the adult child is 47 and nearly to $18,000 by the year 20, when the parent is 87 and the adult child is 57. If the parent wants to have a sufficient amount set aside by the time s/he is 67 and retiring, and plans to invest the set-aside funds to generate a nominal annual rate of return of 5%, then the lump sum required to fund this entire scenario would be slightly more than $315,000, which is a pretty large number relative to the initial modest gap of $5,000.

Each respective rate of increase can have a significant impact on the calculations. For example, if we assume that the costs and income streams still grow at the respective rates of 2.5% and 2%, but the invested assets only return 4%, then the lump-sum-funding requirement increases to more than $400,000. Or, if we increase the expected inflation rate for the cost side to 3% but assume that the government funding stream still grows at 2% and the assets can still be invested at 5%, then the funding required would be more than $530,000. In a kind of “worst case” scenario, if the costs were to grow at 3%, the government funding at only 2% and the investments at only 4%, the lump sum required would be nearly $700,000. You get the picture.

To my untrained eye, the gap between the train and the platform is pretty uniform across all Hong Kong MTR stations. Given the constant repetition of the warning and the fact that the platform edge is highlighted in bright yellow, it’s not difficult to “mind the gap” with little thought. By contrast, minding the gap between the amount your adult child will require to live well and the available government funding is much more delicate—and a lot bigger deal. No one has a crystal ball view of what inflation or Social Security/Medicaid/Medicare COLAs or investment returns will be over the next 50 years. But a trained financial professional can help you run sensitivity scenarios and help you determine the minimum amount of money you will need to feel secure that the gap is covered for the duration of your child’s anticipated life span.

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