Art Brown, as I’ll call him, scoffed when I suggested that he buy life insurance. “I’m 55 years old,” he said, “ready to retire in 10 years. My kids are grown and doing well. I have $3 million in investments to provide for my wife if I go first. Why should I pay premiums for a life insurance policy?”

I had heard this traditional thinking before, so I had no problem answering. “At this stage of your life,” I told him, “if implemented properly, life insurance might be one of the best decisions you’ve ever made. It gives you permission to spend down all of your assets over your life, thereby dramatically increasing your retirement income, all the while knowing your spouse is protected with income-tax-free life insurance.”

Art was skeptical, still not sure what life insurance could offer. I explained that people are living longer, taxes are rising and costs of health care are increasing. Even a $3 million portfolio wouldn’t ensure a comfortable lifestyle for Art and his wife Claire.

Life insurance, though, can be an ideal backup plan and the perfect asset to maximize his ability to comfortably take retirement income. With such a policy in place, the Browns could spend much more income than they otherwise could have spent with traditional financial planning, therefore having a better lifestyle in their golden years.

Delving Into The Details

Art wanted to learn more, so I obliged. Historically, I told him, retirees have been indoctrinated to leave principal alone—they’ve always heard that they should spend only investment interest and dividends and never, ever touch their principal, in order to protect their spouse and heirs.

Today, though, interest and dividend yields are scant. A retiree relying on income from bank accounts, money market funds, high-quality bonds and blue-chip stocks might be receiving only 2 percent to 3 percent a year. Someone with a $3 million portfolio probably would get only $60,000 to $90,000 a year from those sources, pre-tax.

Such cash flow might be insufficient, impacting the ability to enjoy all the traveling, dining out and other activities the retiree had envisioned. Moreover, future inflation will mean that a couple retiring in their 60s probably will find that by their 80’s, their money will go only half as far as it did.

The 4% Solution

One way to boost buying power in retirement is to spend principal as well as income. What percentage of their portfolio should retirees tap to make their portfolio last? The conventional wisdom has come to be known as the “4% Rule.”

That is, a retiree should draw down 4 percent of his or her portfolio in the first year of retirement. Going forward, that withdrawal can increase to keep up with reported inflation. With a $1 million portfolio and 3.5 percent annual inflation, for example, a retiree might withdraw $40,000 in Year 1 (4 percent of $1 million), $41,400 in Year 2, $42,850 in Year 3, and so on. Judging by historical investment results (5 percent post tax), the chances are great that the portfolio will be able to maintain this pace for 30 years or longer.

Of course, retirees will have more spending money with a 4 percent withdrawal rate, increasing with inflation, than they will have with a flat 2 percent to 3 percent from investment income. Still, the 4 percent rule has many flaws:
•    Success is not guaranteed. Even if future investment results match historic returns, there is still some chance a portfolio will be depleted during the retiree’s lifetime.
•    The possibility of portfolio depletion is increased by what is known as “sequence of return risk.” If a bear market occurs right after retirement, the 4 percent rule will accelerate portfolio depletion.
•    Even without such poor retirement and sequence of return timing, following the 4 percent rule may use up a retiree’s money. Some studies conclude that today’s investment yields (2 percent post tax), far below historic norms, mean that the “safe” initial withdrawal rate now is 3 percent rather than 4 percent.
•    Life expectancies are increasing, so the 4 percent, 30-year goal of keeping a portfolio intact may not be sufficient. For a married couple, with both spouses in reasonably good health, there is a significant chance at least one spouse will need retirement income for 35 years or more.
•    All of the above issues aside, the 4 percent rule is still far from ideal. People who work and save throughout their careers might not be thrilled to hear they can spend only $40,000, annually, for every $1 million they have in their portfolio (or even $30,000 if the new 3 percent rule is used).

Making Sure

Faced with all these concerns, retirees and pre-retirees have one solution that will allow them to spend a higher percentage of their portfolio after they stop working, tap emergency cash if needed, and pass more wealth to their spouse and heirs: life insurance. On the surface, it may seem unusual to think about life insurance this way. We are accustomed to believing that life insurance is primarily for the benefit of heirs. However, in this context, life insurance can provide an extraordinary benefit to the living during their retirement, allowing them the peace of mind to fully enjoy accumulated retirement income, while ensuring heirs will be well provided for.

For this purpose, it’s best to buy permanent (cash value) life insurance, which is designed to remain in place as the insured individual grows older. Cash value insurance can provide lifetime death benefit coverage and the cash value living benefit, which provides flexibility for emergency funds or additional retirement income. I generally prefer universal life (UL) insurance, which offers flexibility, options and control in an uncertain economic environment. Policy applicants typically like the idea that they can cut back on premiums without losing coverage (although the length of the coverage period will be reduced) if they run into unexpected cash flow problems.

Double Play

As I explained to Art, he might buy a universal life policy, with himself as the insured individual, with a $1 million or larger death benefit, depending on how much he’d like to leave to his wife or his children. Then Art’s beneficiary or beneficiaries will receive a seven-figure amount of cash at his death, free of income tax.

Now that such a legacy is assured, Art can spend more of his retirement funds with fewer worries. This can be considered a “permission to spend.” Instead of the 3 percent or 4 percent dictated by historical standards without insurance, he will be able spend, say, 6 percent or 7 percent of his investment portfolio annually with insurance.  

For example, someone retiring with $1 million could spend $30,000 or $40,000 per year from his or her portfolio with traditional planning. With life insurance in place, that retiree can now spend $60,000 or $70,000 per year by spending down principal. That’s an increase of 70 percent or more with no extra risk.  

Moreover, married couples often face what’s known as a “widow’s penalty.” After the first death, the survivor faces a higher tax rate, as a single taxpayer, along with lower income because of the loss of one Social Security check and perhaps a reduced pension.

An income-tax-free life insurance payout can offset the widow’s penalty, providing permission to experience a comfortable retirement while both spouses can enjoy it. No other asset can offer the flexibility, options, control and peace of mind that income-tax-free life insurance can.

As for Art Brown, he and his spouse would have more money to enjoy in retirement, knowing that they’re protected after one of them passes away because the assets would be replaced with income tax-free life insurance.

Many people use “mental accounting” to put their assets and cash flows into different categories. With a life insurance policy in force, policyholders can put their entire portfolio into the “to be spent while I’m alive” box, without feelings of guilt that they might be short-changing those they care about. The end result is that Art and Claire have a better lifestyle in retirement with more income and pass along more assets to their loved ones with tax-free life insurance that replaces all the assets they spend. Everyone wins.

David Buckwald is a founding principal of Atlas Advisory Group, an M Member Firm in Cranford, N.J. He specializes in estate planning and wealth transfer issues.