MY DAD understood long ago that the purpose of planning for retirement is not just to accumulate assets but to ultimately, as Forbes states, turn those into income.
Thankfully dad had this in mind years ago.
In planning for retirement, dad put together a portfolio that not only included some liquid assets, real estate, and retirement accounts, but also permanent life insurance that was equal in value to his retirement accounts. As the video explains, he was then able to leverage his life insurance to create significant lifetime income from his retirement assets.
What about the 4% withdrawal rate?
In prior generations many people retired with pension plans that paid them a guaranteed lifetime income once they retired.
But the majority of current retirees have 401k’s and IRA’s so they have to make their own retirement income decisions. They want to withdraw as much money as possible to provide a comfortable lifestyle, but they have to always be conscious of not outliving their money.
And the risk of running out of money in retirement is higher than ever because we are living longer. If a 70-year old couple retires today, there is a 50% chance that one of them will still be alive at age 92. Because of this increased longevity, most planners and economists are recommending that we plan for a 30-year retirement.
For years economists have tried to determine the safe withdrawal rate for retirees, or the amount that can be safely withdrawn without introducing the risk of running out.
This chart shows the likelihood of having one dollar left after 30 years at different withdrawal rates. As you can see, the likelihood of success drops dramatically when the withdrawal rate is increased from 4 to 5 percent. Notice that the success rate is mostly unaffected by the ratio of stocks to bonds in the portfolio.
For this reason, most economists and planners agree that retirees should not withdraw more than 4% of their assets in any one year in retirement.
How does a Life Income Annuity work?
On the day my dad retired, he chose to purchase a life income annuity with most of his retirement assets.
With a life income annuity, the customer transfers his asset to a financial institution and receives a lifetime stream of payments in return (backed by the claims paying ability of the insurance company).
There are several ways to structure a life income annuity but Life Only creates the highest income. With Life Only, the customer receives a paycheck for as long as he lives and the payments stop at his death. As of this writing, a 70-year old male with $1M could expect to receive approximately 8%, or $80,000 per year for life.
So the Life Only annuity provides an income payment that is well beyond the traditional 4% income and it removes any market risk. Perhaps most importantly, the customer now knows for certain that he will never run out of money in retirement.
This article from Wharton states that economists worldwide agree that “annuitization of a substantial portion of retirement wealth is the best way to go” and that “substantial annuitization (is) generally prescribed by a sophisticated model of economic decision making”. The article also points out that “if you do not annuitize a substantial portion of your retirement wealth, you pass the financial risk of outliving your resources along to your relatives and children”.
As mentioned in the video, I take great comfort in knowing that dad not only has retirement income well beyond his expenses but also that the income will never stop.
The problem is that the Life Only option leaves nothing behind for a spouse or children at death. This concern leads many to consider an option called Joint and Survivor, which often sounds attractive at first.
What about Joint And Survivor Annuities?
Let’s say that our 70-year old retiree has a 69-year old wife. A joint and survivor annuity, or one that will pay income for both of their lifetimes, could be expected to pay approximately $60,000 per year at today’s rates.
Remember that the Life Only option in this example pays approximately $80,000 per year. It’s important to understand that since Life Only is the highest annuity income available, anything less represents a cost.
So what does he get for this $20,000, or 25%, reduction?
He gets a plan that will pay $60,000 per year to his wife for as long as she lives following his death. Until his death there is no benefit for the $20,000 reduction, and the benefit stops at her death.
So the benefit is truly unknown. If he dies early and she lives a long time, the benefit will be significant.
But what if she dies first? The annual $20,000 reduction continues with no benefit paid to anyone at his death.
The most hoped for scenario, of course, is that they’ll both live a long time and die within a few years of each other.
If he dies in 18 years and she dies 6 years later, he will have given up $360,000 in reduced income and she will have received $360,000 in benefits.
So in the most hoped for scenario, they barely break even.
How do we generate the most income and still protect those we love?
In observing my dad’s retirement, it is clear that his life insurance decisions were foundational to the success of his retirement plan. There are two basic types of life insurance, term and whole life.
Let’s take a hypothetical 40-year old male who is in good health and is deciding between the purchase of $500,000 of 30-year term for $1,100 per year or $500,000 of whole life for $6,800.
If he chooses whole life, what does he get for the additional $5,700 of premium? First, he is guaranteed that the death benefit of $500,000 will continue for life and that the policy will accumulate cash value.
Second, the insurance company may declare annual dividends. Once declared, the policy owner can choose to receive the dividends in cash, use them to reduce premium, or use them to purchase additional life insurance.
If this third dividend option is chosen and if dividends are declared as currently projected, by age 70 this $500,000 policy will be worth $720,000, representing an 8.1% internal rate of return on the premium difference of $5,700.
If, for any reason, the policy owner decides at age 70 to cancel the policy, he receives the cash surrender value, in this case $385,000. This represents a 4.8% internal rate of return on the premium difference.
A consumer should of course consult the guaranteed portion of an illustration before making a decision.
As mentioned in the video, dad retired with whole life insurance that was equal to his retirement assets.
So why was owning permanent life insurance so important?
Remember that one of the biggest problems for retirees is creating sufficient income from their retirement accounts and that most economists and planners recommend a retirement withdrawal rate of no more than 4% per year. The retiree then has to manage the asset throughout retirement, never knowing for sure that he won’t run out.
Or he could purchase a Life Only annuity that presently would pay about 8% for life, but the income would stop at death. It is certainly understandable that people are nervous about purchasing Life Only annuities because they are concerned about leaving their family with nothing.
But what if they didn’t have to worry about that? What if, as in our sample case, the customer reached age 70 with $720,000 of whole life death benefit? What difference would that make?
He would now have the freedom to purchase a Life Only annuity with a significant portion of his retirement assets, allowing those assets to do what they do best. He would not be concerned about disinheriting his family from these assets because they will all be replaced at his death, whether that’s next month or in thirty years. He and his family would know that he will never run out of money. Concerns about long-term care would be greatly reduced.
And because he started his whole life policy at such a young age, the dividends, while not guaranteed, are projected to be sufficient to pay the premiums throughout retirement. So he doesn’t have to redirect any of his retirement income towards protecting those that he loves. He is free to use that money for whatever he enjoys most.
Also, the annuity and the life insurance run on auto-pilot so the retiree is free to spend his time with those he loves instead of meeting with financial advisors.
That is my dad’s story.
But wouldn’t someone have less in their retirement accounts because they had redirected money towards the whole life premiums during their working years?
Possibly, so let’s look at a sample case to help demonstrate exactly how this strategy could work.
Won't I have less in retirement because I purchased permanent life insurance?
Let’s say that our hypothetical 40-year old male makes $150,000 per year and has $250,000 saved in his 401k. He is contributing 11% to the 401k and receives a 50 cents on the dollar match on the first 6% that he contributes. We’ll assume a 6% return on these assets and that he will retire at age 70.
Also, let’s assume that he owns $500,000 of 30-year term.
First, we establish a baseline, or how much income will be generated at age 70 if he never saves another dollar. By age 70, his current balance of $250,000 will have grown to just over $1.4M and can then generate a 4% annual income of $56,000. So $56,000 is the baseline.
Next, we add in his current annual contribution of $21,000, including $16,500 from him and $4,500 from his employer. This brings his account balance at 70 to $3.2M generating a 4% income of $128,000, or an increase of $72,000 over the baseline.
By comparison, let’s redirect his $7,500 of unmatched 401k deposits to convert his 30-year term policy to whole life. He will now owe about $1,800 in taxes since he is no longer putting this $7,500 in a tax deductible plan, leaving the $5,700 needed to convert his term to whole life.
Because his 401k contribution has been reduced, he will now have $2.5M in his 401k at age 70. But because he has $720,000 of life insurance in place, he can use $1M of his 401k to purchase a Life Only annuity. $1M from the 401k is nearly equal in value to the $720,000 of life insurance because 401k proceeds are taxable but life insurance proceeds are tax-free.
This $1M to the Life Only annuity will create around $80,000 per year of income at today’s annuity rates, and the remaining $1.5M in the 401k will generate about $60,000 of income. The policy is projected, but not guaranteed, to have dividends that exceed the premium by $6,000 per year, so those could be paid as income also. This brings the total to $146,000, or an increase of $90,000 over the baseline.
Buying the whole life policy, then, represents a 25% increased efficiency ($90,000 vs $72,000) over unmatched 401k deposits, with less risk.
Is it possible to purchase the policy and give up nothing?
What if this person had been paying a 1% advisory fee but, after implementing the strategies outlined above, chose a platform that eliminated this cost? What impact would that have?
If we still redirect $7,500 from his 401k contributions to purchase the policy but then increase the 401k return by 1% (because we’ve removed the 1% fee), the 401k balance at 70 is back up to $3.2M.
Now $1M could purchase the annuity to generate $80,000 per year, the remaining $2.2M could generate $88,000, and the non-guaranteed policy dividends are projected to generate $6,000 for a total of $174,000. This represents a 63% increased efficiency versus unmatched 401k deposits, with less risk.