Maximizing Retirement Assets by Minimizing Losses
All planners and clients are familiar with the maxim, “buy low and sell high.” However, predicting these events is a challenge. Clients buying near the top of a market followed by a market drop may often wait years before an asset recovers its original starting point or basis.
The same holds true in retirement. Prior to retirement, a client may weather multiple market ups and downs. However, all those fluctuations become moot at retirement. At that point, clients have concluded their accumulation phase; they then begin a new phase of their planning—decumulation. But, market performance continues to be important. Clients who start retirement at a market peak may face market losses, possibly exacerbating the decline in their retirement assets by being forced to sell into the loss to meet income needs. The effect on a client’s long-term retirement can be enormous.1
If clients had an alternative source of funds that they could draw on to relieve the pressure on their traditional retirement assets, their near- and long-term situations might then change. For the right client, a cash value (CV) life insurance policy can help mitigate the impact of a negative sequence of returns. During a client’s working years, life insurance offers a client’s family protection against the loss of a breadwinner. During those years, CV life insurance can also provide a source of funds for emergencies or special planning goals. However, in retirement, life insurance CVs may act as alternative sources of funds for a client’s retirement during market loss years. These are selective withdrawals, as opposed to the traditional way life insurance CVs are positioned for retirement. They’re here as a potential cushion instead of a supplement. Let’s see how this approach works and address many of the questions that planners often raise around this technique.
Traditional Retirement Assets
Life insurance has long served as a valuable planning tool in helping protect clients and their families against losses and providing a liquid source of funds at death. When there’s a life insurance need, CV insurance can also build a potentially tax-free source of retirement funds to help supplement traditional retirement assets. For clients who’ve maximized contributions to traditional retirement assets, such as 401(k)s and individual retirement accounts, excess contributions into a CV life insurance policy offer a way to help build additional funds that a client can access in retirement.2
Traditionally, life insurance used to supplement retirement is illustrated at maximum levels—the maximum premiums that can be used to fund a life insurance policy relative to the death benefit and the maximum withdrawals and loans that can be taken out of the policy starting at retirement. These maximum funded policies are often shown under a variety of names, including supplemental income with life insurance, a life insurance funded retirement plan or a Roth IRA supplement.
All of these are valid and established approaches in working with life insurance. However, another less traditional approach with life insurance using less than maximum funding might help enhance a client’s traditional retirement funds and preserve assets for wealth transfers. Rather than focus on the traditional maximum funding into a CV life insurance policy, followed by maximum withdrawals and loans, I’ll focus on this alternative approach that simply requires reasonable funding into such a policy and then strategic withdrawals timed only around market losses in a client’s retirement assets.
Here are the benefits of taking withdrawals and loans from a life insurance policy only after market loss years:
• The client may have the ability to refrain from taking funds from the traditional retirement accounts after market losses, allowing those funds time to recover.
• Were the client to draw on those assets, he’d exacerbate the losses by selling into the loss and further drawing down on the funds to support retirement.
• The life insurance CV offers an alternative source of funds to carry the client in those years when it’s not advantageous to draw on traditional retirement assets.
This approach may dovetail with traditional retirement assets and assets under management to help clients during their retirement years.
Remember that loans and withdrawals of a life insurance policy’s CVs will reduce the CVs and the face amount of the policy. The client needs to weigh taking loans and withdrawals against the potential of possibly paying higher or additional premiums in later years to keep the policy from lapsing. Clients should always work with their financial advisors to help balance their near- and long-term planning and tax objectives.
Example: Use of
Tom is a 65 year old who’s accumulated
•
• Pension:
• Tom’s savings: He needs to make up the other
Tom knows he needs to draw down on his
In examining models using a mix of market gains and losses, retiring in a year with early market loss severely erodes Tom’s retirement assets even at just 1 percent inflation. Using a snapshot of S&P 500 market performance from 1973 to 1993 (a period with two early market losses although only five negative years over the 20-year period), Tom is projected to erode his assets by 56 percent. At that point, he would be drawing down on his remaining assets at nearly
A possible solution: Tom’s financial advisor shows him another item to bring into his retirement picture. At age 45, Tom bought a
The financial advisor shows Tom that accessing his policy cash surrender values (CSVs) in the years following a market loss helps preserve his traditional retirement funds so that they might recover. The effect of adding life insurance policy CSVs to his retirement asset mix is that Tom can avoid selling in down years and locking in those losses. The combination might even enhance Tom’s retirement.
“With and Without Life Insurance,” this page, provides a summary of how the approach might enhance Tom’s overall retirement and ease his concerns.
How the Numbers Work for Tom
Concerns about market losses eroding retirement funds are legitimate. Since 1950, every 20-year period in the market has featured from four to six years of decline reflected by the S&P 500.4 In planning for Tom, modeling using the 20-year period from 1973 to 1993 showed a middle ground of five years of losses. The impact on retirement assets can be particularly severe when these losses occur early in retirement, as was the case in 1973 and 1974, the first two years of the model period used for Tom. If Tom withdraws the
56 percent.5 (See “No Life Insurance Planning,” p. 57.)
By taking strategically timed withdrawals and loans from life insurance policy CVs in years following market losses, a client has the ability to potentially change the performance of his retirement assets, while still preserving a death benefit. “Using the Cash Value,” p. 58, shows that if Tom stops withdrawals in just five selected years, he can increase his retirement assets, potentially substantially. In this example, with this sequence of returns, he might see an increase from $1 million to
In fact, by alternating between traditional retirement sources and life insurance CVs following negative market years, Tom can increase his retirement fund withdrawals to
Sequence of Returns
The performance of a client’s assets in the years following retirement makes a significant difference in the long-term stability and longevity of assets during retirement. In Tom’s example, a
However, no client or financial advisor can predict market performance. A client fortunate enough to retire into an “up” market might have very different results. Consider modeling the same
S&P 500 results recorded from 1990 to 2010. This similar 20-year period, with five years of market losses, had a radically different sequence of returns. The 1990s were one of the strongest performing decades in the history of the stock market. Although they were followed by the 2000s, arguably one of the weakest decades ever, the early years made a significant difference. In this instance, the strong performance of the first decade provided a cushion against the poor performance of the second 10-year period. (See “Results May Vary,” p. 59.)
A client won’t know what performance he’ll see in retirement. If clients are fortunate enough to see a repeat of market performance in the 1990s, they wouldn’t have needed an alternative asset source in retirement, such as that offered by a CV-rich life insurance policy.
Common Questions
Let’s address a few questions that frequently arise about CVs.
Why is a lower amount coming out of the life insurance policy CVs than the client might take from his traditional retirement assets? In the case of life insurance, withdrawals and policy loans from a properly structured non-modified endowment contract (MEC) can be received income tax-free. This strategy offers the client the ability to receive policy income without the erosion faced by taxable assets. As a result, a client in a 28 percent tax bracket can receive the pre-tax equivalent of almost
As inflation increases, a client’s income need over the 20-year retirement period increases, and “Using the Cash Value,” p. 58, shows larger amounts coming out of a policy to roughly match that need.
Isn’t a 4 percent draw down on retirement assets the appropriate rate versus the 7 percent rate shown? Many practitioners in the planning community strongly embrace the 4 percent draw down rate on retirement assets. The origins of that rate are based on a 1990s article that focused on reviews of segments of the market, over decades, to determine the safest rate of interest. As discussed below, the circumstances that produced the 4 percent
drawdown number may not fit all clients.
In 1996,
Due to factors such as a high standard of living and a low savings rate, many clients may not have the option to draw down at a 4 percent rate and meet their standard of living. In many instances, a client may have a reasonable standard of living and a reasonable source of fixed retirement income (
What type of life insurance makes sense? The life insurance used in this approach differs from the traditional accumulation approach in that clients don’t need maximum funding of their life insurance policy for annual retirement income. Instead, they simply need to adequately fund their policy to generate CVs that can be selectively tapped in retirement. Because a client only draws down on the policy CVs in selected years (historically the four to six down market years over each 20-year period), maximum funding may not be necessary. However, the funding needs to be sufficient to build meaningful CV.
Conventionally, any type of permanent CV life insurance policy might fit. However, some policies may be stronger fits than others in providing cost-effective accumulation while protecting a client against risk. The major types to consider are whole life (WL), variable universal life (UL), fixed universal life (FUL), and particularly indexed universal life (IUL). Each type offers pros and cons.
WL. This is a permanent fixed CV policy in which a policyowner receives dividends from the insurance company based on the carrier’s own financial performance and, sometimes, on the performance of a block of insurance policies. Generally, a policyowner commits to a premium stream for a specified death benefit. Dividends, based on the profitability of the carrier or product line, are credited back to the client’s policy and may be used to buy up paid-up insurance coverage, build CV or offset premiums. Because there’s a pre-set commitment to a premium stream, there’s sometimes less flexibility for the policyowner, and the premiums may be pricier than with some of the UL products discussed below. This higher price is often credited back to the client as a dividend, provided the insurance carrier has a strong year.
It’s also important to consider that WL life coverage is often sold on the basis of its dividends but that these dividends aren’t guaranteed. Most carriers will offer a guaranteed component, but there may be non-guaranteed elements. Moreover, different WL policies vary relative to a client’s ability to withdraw or borrow all or some of the policy CVs. With some contracts, the access to CVs may be limited to items such as dividends or paid-up additions, but not one’s basis in the contract.
As a result, WL may be a popular option, but it may not always offer as cost-effective or flexible a method compared to UL or IUL policies.
UL. This a broad category for several types of flexible-premium insurance. The flexibility offers clients more latitude in paying premiums in ways that might meet cash flow needs from year to year. With many UL policies, owners can: (1) vary their premium payments, (2) frontload or backload premiums, and (3) sometimes stop premiums and sometimes pay more into a life insurance policy, provided they comply with guidelines set by Internal Revenue Code Sections 7702 and 7702A.
This flexibility can be both advantageous and risky. Clients need to monitor their policies to make certain they stay on track with the original sales illustration or make adjustments along the way. UL comes in several varieties including fixed, variable and indexed. A few words are in order about each, although the complexities involved with variable UL make for a discussion beyond the scope of this article.
FUL. This design shows that for a certain premium amount, a client will receive a stated death benefit. Depending on how interest rates are credited to the policy, how consistent interest rates are compared to the original illustration and how charges in the contract remain in place, the client will receive the planned death benefit. The crediting is based on the carrier’s underlying portfolio within its general account; in fact, with interest rates near an all-time low, some believe that clients may benefit from future interest rate crediting as rates rise. Some carriers offer guarantees on their FUL contracts, but for those guaranteed contracts, the CV is either little to none, or there are limits in how it can be accessed in these guaranteed contracts. With fully guaranteed contracts, there may be little flexibility, so the current assumption (non or reduced guaranteed contracts) may be better for this CV alternative retirement fund approach.
IUL. This variation on UL allows a client to elect one or more index options into which premium contributions can be allocated. Carriers then purchase these indices within their general account. Depending on how the index performs, a client might receive some or all of the index’s performance over a pre-determined period (typically one year, but 3-year and 5-year windows are common).
The attraction with IUL is that a client has the potential to lock in market gains earned in a given year and not suffer the losses that might be seen with a variable UL type of contract. Most IUL contracts offer a floor through which a client’s crediting rate can’t fall. A floor of 0 percent is the most common. In exchange for this downside protection, the index is hedged, and there’s frequently a cap put on the crediting a client might receive (even if the index itself outperforms the cap). At the time this article went to print in
This 0 percent floor is a powerful incentive for clients who may still be wary of the market. Clients have the potential to receive some of the market’s upside potential, based on the caps offered and the market indices they select. IUL also offers the ability to lock in the prior policy crediting through the use of a floor during loss years. This floor (0 percent) helps protect accumulated CVs during a down market year, as clients can’t see negative returns based solely on a down market. IUL offers: (1) the flexibility of all UL contracts, (2) the potential for a better crediting rate than traditional FUL, and (3) protection from negative market performance in VUL.
It’s important to keep in mind that not all IUL products are alike. Many IUL products offering the highest caps often illustrate well because most illustrations show the same crediting rate year after year. However, those products showing high crediting rates typically carry very high internal charges. In down market years, the crediting that a client thought was protected by a floor might be eroded by these charges.
For clients who wish to obtain some benefit of the market with their premiums and use their life insurance to protect themselves against market fluctuations and have reasonable cash accumulation, it’s important to watch for a conservative, low cost life insurance policy. Financial advisors should focus on these products for this approach to help protect clients, as opposed to putting them in a costlier, potentially higher risk product.
What are the considerations? CV life insurance has many other considerations that your client should review carefully before selecting a policy.8
Keep these points in mind:
• If clients don’t keep paying premiums on their life insurance policies, they’ll lose substantial money paid in early years.
• To be effective, clients need to hold their policies until death. A life insurance policy generally takes years to build up a substantial CV.
• Tax-free distributions will reduce the CV and face amount of a policy. Clients may need to pay higher premiums in later years to keep the policies from lapsing.
• Clients must qualify both medically and financially for life insurance.
• Generally, there are many additional charges associated with a life insurance policy, including a front-end load, a monthly administrative harge, a monthly segment charge, a cost of insurance charge, additional benefit rider costs and surrender charges. These charges may run 15 years or longer (this will vary by carrier and contract) and will affect the amount available for withdrawal or the amount that may be borrowed from the policy at any given time.
Wouldn’t a client be better off buying term insurance and investing the difference? Some might argue that term insurance is a more cost-efficient product offering protection during a client’s working years and that the client would be better off simply investing the difference. Assuming a client is disciplined enough to do so, he could have a few hundred thousand more dollars. It might provide a client like Tom in our example with an additional cash cushion. However, for clients with any longevity, that added cushion would be eroded fairly quickly, even at the modest 1 percent shown in the above example.
With low-cost life insurance, the CVs can grow on a tax-deferred basis and be accessed in a potentially tax-free manner. Moreover, by using a conservatively priced and illustrated indexed UL policy, a client can capture some of the upside of the market while protecting gains against market drops below zero. Using a conservatively illustrated policy, a client can be certain that he won’t be paying into a policy that may not perform as well as illustrated.
Will required minimum distributions (RMDs) affect this planning? Most clients will have some or all of their retirement funds in qualified retirement plans, 401(k)s, 403(b)s or IRAs that mandate RMDs—usually beginning the year following a client’s reaching age 70½.9 As a result, a client won’t be able to cease all withdrawals from his retirement accounts.
Each client’s situation will be different. Some may have all of their assets in accounts that mandate RMDs. Others may have little or no assets in these accounts. Moreover, how much money clients will have in these qualified accounts will vary widely, particularly with the advent of Roth IRAs and Roth 401(k) accounts.10
The prior discussion using life insurance to “smooth” a client’s sailing into the uncertain waters of retirement generically showed what would happen if a client could eliminate drawing down on assets at the time of a loss. However, in real life, not every client has retirement assets with complete flexibility, and we should also address the RMD question.
Keep in mind:
• Assuming a client retires at age 65, RMDs won’t be required until the year following a client turning age 70½. That’s likely be five years to six years beyond the early years of retirement, when market losses will have their most severe impact. In the Tom example, RMDs won’t come into play until after three of the five years of losses.
• Because of the way the RMD calculation works, the mandated withdrawals in the early years are low because the divisor offered by the Treasury and IRC regulations to calculate RMDs is high. As a result, minimal dollars might need to come out of a retirement account in these early years.
• Clients can distribute assets from their IRAs in kind (shares of funds or stock), thus maintaining their existing equity position(s). A client would still have to pay income tax on the value of the distributed assets, but liquidating assets can be avoided.
Because of these items, RMDs may have some effect on the calculations, but the approach still offers the client a safety net. Continuing the Tom example from earlier, and assuming that 100 percent of Tom’s assets were in accounts with RMDs, the overall impact would be approximately 10 percent at age 85. Tom’s account balance would change from
What’s the proper ownership of the life insurance policy? Ownership of the policy can be critical. In most instances in which the intention is to access the life insurance CSVs, individual ownership of the life insurance policy may be the common default approach. However, in certain cases, a trust may meet a client’s overall planning needs.
Individual ownership allows a client unrestricted access to the policy CSVs and control over premium payments but won’t put a trustee in a dilemma of caring for both current and remainder beneficiaries—especially as this approach often decreases the policy death benefit.
In many instances, given the current high individual exemption, ownership issues may be irrelevant. For the moderately high-net-worth client (that is, those with a net worth between
A trust could serve as a vehicle that allows the policy to remain outside of the insured’s estate, while still preserving at least indirect access to the CSVs. A traditional irrevocable life insurance trust would be inappropriate. Such a trust couldn’t allow access to the policy CSVs without triggering estate inclusion. However, it may be possible for a policy to be owned in a spousal lifetime access trust (SLAT), in which a client’s spouse might have access to the policy CSVs. In such a situation, careful planning will be required. First, you must design the trust to allow trust principal distributions when there’s an ascertainable standard to benefit the client’s spouse. Additionally, this ownership approach is only available if a client is in a stable marriage, or a trust can be designed to allow flexibility as to permissible beneficiaries to receive trust distributions. Take care if there’s a risk that the beneficiary spouse might predecease the insured. If so, the ability to indirectly access the SLAT income and principal, even indirectly into the household income, might be lost. However, if the plan is to have the policy CVs available in the earliest years of retirement, the risk of a spouse beneficiary’s premature death might be minimal.
Endnotes
1.
2. Your client must pay the minimum premium to maintain the life insurance, and there’s an upper cap on how much can be contributed and still allow the contract to fall within the definition of life insurance under Internal Revenue Code Section 7702. Policy loans and withdrawals will reduce the cash value (CV) and face amount of the policy and increase the chance it may lapse. Without careful planning with a financial advisor, clients may need to pay higher premiums.
3. As explained in detail later in the article, the S&P 500 period reflected runs from 1973 to 1993 to show the effect of starting in a negative timeframe followed by positive returns. This piece also shows the impact of starting retirement at a later point in time (1990 to 2010) to show the effect of retirement in a positive period of market returns followed by an extended period of market losses.
4. Clients can’t invest directly into the S&P 500 index.
5. See “Sequence of Returns,” p. 56, for how the timing of retirement can significantly affect the performance of retirement assets.
6. As noted earlier, in any 20-year period, the S&P 500 showed anywhere from four to six periods of negative returns (some larger than others). The 1973 to 1993 period showed a medium number of loss years (five), some larger and some smaller losses, but losses nonetheless. Other 20-year timeframes showed larger numbers of loss years.
7.
(
8. Under current federal tax rules, your client generally may take federal income tax-free withdrawals up to his basis (total premiums paid) in the policy or loans from a life insurance policy that isn’t a modified endowment contract (MEC). Certain exceptions may apply for partial withdrawals during the policy’s first 15 years. If the policy is a MEC, all distributions (withdrawals or loans) are taxed as ordinary income to the extent of gain in the policy and may be subject to an additional 10 percent premature distribution penalty prior to age 59 1/2, unless certain exceptions are applicable. Loans and partial withdrawals will decrease the death benefit and CV of your client’s life insurance policy and may be subject to policy limitations and income tax. In addition, loans and partial withdrawals may cause certain policy benefits or riders to become unavailable and may increase the chance your client’s policy may lapse. If the policy lapses, is surrendered or becomes a MEC, the loan balance at such time would generally be viewed as distributed and taxable under the general rules for distribution of policy CVs.
9. This date will vary by the type of plan, the client’s age and entry into the plan.
10. At the time this article went to print,
11. This sentiment is also echoed in articles such as
Should You Keep a Trust Quiet (Silent) From Beneficiaries?
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