Most people start considering life insurance when they have spouses and families who would be financially devastated if they were no longer bringing home a paycheck. It’s not just about the obvious basics such as mortgage payments and food on the table—but the normal elements of “life-goes-on,” such as children’s allowances, vacations, smartphones, graduations and weddings—and retirement.
To answer a client’s question of, “how much do I need?” several different approaches have emerged. So-called wrongful death lawsuits typically address damages from the standpoint of the dollar amount the surviving family has been deprived based on the economic value of future earnings, and this was the approach taken by the 9/11 Commission in addressing payments made to families of those lost in that disaster. This concept is referred to as human life value. Another approach is to estimate ongoing expenses that aren’t otherwise covered from existing resources—and possibly a surviving spouse’s income—a calculation often referred to as capital needs analysis.
Whichever method is used by the client to determine their protection need, the typical two-earner family income (and expenses) of a combined $150,000 a year could generate an insurance need in excess of $3 million. In fact, a 33-year old professional currently earning $150,000 with anticipated three percent increases over a 42-year work career (“75 is the new 65”) will earn $8.4 million. Income increases averaging 5 percent will push career earnings to over $14.2 million.
Faced with such significant calculations, it’s not unusual for people to start with term insurance for their current protection needs. Then perhaps gradually convert to forms of life insurance designed for lifetime needs and the amount of death benefit desired, no matter how long they live.
Especially when using the human life value approach to determining initial insurance needs, one would assume at the point they are no longer working for a paycheck, their need would have accordingly diminished. Most non-insurance trained financial advisors would concur and recommend the surrender of any remaining policies. Yet there are a number of reasons why life insurance has a place even when they’re living solely on resources accumulated for retirement and used for income distribution.
The following points are helpful in advising your clients.
Moving From Protection To Other Uses
1. From Protection To Investment
Whether term or “permanent” coverage, life insurance starts out providing death benefit protection to the beneficiaries. With policies that rapidly create cash value, there is a transformation from value primarily oriented to protection to―over time―tilting more toward asset accumulation as the balance shifts from net death benefit to cash value. There are those who will criticize this natural result: “there isn’t enough death benefit―most of it is your money!” But that overlooks how life insurance is made affordable as people age. In fact, with a view toward lifetime needs that begin with protection and migrate to asset protection and retirement income distribution, life insurance is a dynamic and almost perfect complement to any investment portfolio.
2. Maximize Pension Payouts
A pension benefit will typically be offered in a number of formulations―from the extreme of single life with no refund or period certain―to joint life/100 percent benefit while either spouse are living. But in those two extremes, there could be as much as a 25 percent difference, every month for many years, in monthly benefits.
Steps to take to make use of a “seasoned” whole life insurance policy (purchased in a person’s late thirties or early forties and for which premiums are paid and not “borrowed”):
• Place on “paid-up” or “reduced paid-up” status;
• Initiate the single life annuity option on the retiree—maximizing the monthly benefit without regard to a survivor benefit;
• If the annuitant dies before the spouse, annuity benefits stop but the life insurance proceeds can acquire a new annuity for the remainder of the survivor’s life.
3. Supplement Retirement Income—Pension Maximization
A “seasoned” policy should have a substantial build-up of cash value by retirement age, and the net amount at risk will be correspondingly less. But that’s good! It may be possible to reduce or eliminate the premium through “offset” or “reduced-paid-up” strategies and the cash value is available on a tax-favored basis to provide annual supplemental retirement income. As long as the policy remains in force until death, the withdrawals and loans taken on the policy for retirement cash flow will not be taxed and the residual death benefit paid upon death will also be free of income tax.
4. Supplement Retirement Income—Market-Sensitive Strategies
While many proposals involving life insurance used for supplemental retirement cash flow assume annual withdrawals/loans, it may be more appropriate to use cash value on a discretionary basis, e.g., only when “the market” is in one of its periodic declines. Rather than liquidating equities at depressed value to generate income, your client can use the life insurance policy to supplement income until “the market” recovers. Then switch back to redeeming equities for retirement income. Cash flow taken from life insurance policies will not be subject to income tax—requiring less borrowing for a given net-after-tax need.
5. Uncorrelated Asset
Life insurance cash values and death benefits are uncorrelated to the typical array of risk-based investments within a retirement portfolio. The cash value never declines in participating whole life policies with all premiums paid by the policy owner, and cash values are not subject to market value adjustment. Similarly, death benefits are triggered only by death and are not subject to adjustment based on “market” conditions. Participating whole life, properly acquired and actively managed, can be an appropriate asset in the context of a diversified investment portfolio configured to optimize retirement income.
6. Enhancing QLAC Limits
Qualified life annuity contracts (deferred immediate annuities designed to be held and paid for with qualified plan funds) can be a useful strategy for optimizing retirement income. Unfortunately, those for whom it would be appropriate can’t deploy as much as they might want; QLAC is limited to 25 percent of plan resources of $125,000, whichever is less. “Seasoned” life insurance policies can be exchanged via IRC Section 1035 into non-qualified deferred immediate annuities with no limitations and no immediate income tax.
7. Legacies For Family/Charity
Most retirees today are concerned about outliving their retirement resources. Yet those same people may have a desire to leave a legacy for children, grandchildren and/or charities. Needless to say, life insurance is an ideal way to fulfill those intentions. Consider having them use a life insurance policy to fund an immediate annuity on the life of the grandchild—the income of which is received on the grandchild’s birthday.
8. Finally—If None Of These Reasons Resonates And Your Client Wants To “Cash In” Their Policy…
Calculate the advantage of continuing to pay premiums for an ultimate death benefit—and the internal rate of return on those future premiums compared to that future death benefit. Often it will considerably exceed a new investment in a similar fixed-income asset class. At the EthicalEdge, we recently conducted just such a review for a long-time policy owner of Guardian. Purchased in 1985 when the client was 38 and needed maximum protection, the policy owner felt it was no longer needed on the eve of his retirement. We looked at all the options discussed in this article, and he was delighted to learn that the dividend of the participating Guardian policy was now sufficient to completely pay the premium–likely for the rest of his life. Retaining the policy on that basis to his likely average life expectancy would not only provide his children with far in excess of the original $1 million income tax free death benefit, but would represent a long-term tax-free “investment” going forward well in excess of 5 percent. This was significantly more than the current return in the fixed-income asset class portion of his portfolio, and keeping the policy for the ultimate death benefit was going to make a very positive difference to his family.
The reasons people buy life insurance in their thirties are different than when in their fifties or sixties. Contrary to classic planning “wisdom,” there are a number of reasons to keep and maintain life insurance in a person’s senior years. The reasons, as enumerated herein, go beyond protection into such useful strategies as tax-favored withdrawals and loans from cash value, tax advantaged death benefit to replace a life-only annuity, supplemental retirement income and legacy. Two action items for financial professionals:
1. Perform a life insurance review to consider the right balance between temporary and lifetime needs for death benefit;
2. From that audit and for those consumers with sufficient financial resources—insurance owners should be encouraged to progressively convert their term insurance to whole life insurance, at least for the amounts desired for lifetime coverage to fulfill non-traditional benefits of lifetime life insurance.
Richard M. Weber, MBA, CLU, AEP, is president and principal of The Ethical Edge Inc., a consulting firm providing fee-only analytics and services to insurance firms, family offices and high-net-worth individuals. Weber reviews new and existing policies for policy-holding clients from several dozen of the top carriers.