A simple strategy to use life insurance for income protection

As a Marine helicopter pilot, I was the unfortunate witness of too many young families losing a loved one. The pain of sudden death is overwhelming. Our hearts and minds seem to lack the ability to comprehend the magnitude of such loss. Time may heal all wounds, but it is excruciatingly slow at healing the wounds of untimely death. This is particularly acute when those lost are young and they leave behind a family that depended on them.

Life insurance can minimize the financial strain experienced by untimely death. It can help provide stability and keep a family in their home, in the same school district, and around their friends and community. These stabilizing influences in the face of such a destabilizing event can help families heal over time.

But how much insurance do we need to protect our families? Without delving too far into the differing methodologies that focus on either a capital needs analysis or the economic value of the life of the insured, I want to offer a simpler, more flexible methodology. It’s one that we planners use all the time. And it’s one that is particularly suited for the possibility of an untimely death, as it marries up needed inflation-adjusted income with actual expenses of the protected loved ones. As I would tell the investment advisors that I worked with — a death benefit is an income distribution portfolio waiting to happen.

Let’s flesh out some of the questions that this approach may raise.

Why are we protecting for the rest of the spouse’s life? When a family loses a parent, the surviving spouse must effectively become both parents. The emotional load is effectively doubled. The surviving spouse now has emotionally traumatized children to nurture, as well as the deceased spouse’s parents. Do we want the surviving spouse working full time as well? I would think we all would agree that we would want to plan to give our surviving spouse all the resources they need.

Why aren’t we paying off all the debt? First and foremost, as a planner and as a business owner, I want to protect cash flow. Paying off debt in this situation is not always the best decision.

Paying off an expensive car loan is fine but paying off the mortgage on a family residence may not be. The effective mortgage interest rate can be lowered by accelerating the payments. We still get a deduction for home mortgage interest if we itemize. We can reduce the financial cost of the loan on a month-by-month basis to where arbitrage can be realistically obtained repurposing assets — say, to preserve our income distribution portfolio. Is the current mortgage rate low in comparison to where we are trending?

Lastly, my mortgage payment is fixed. My income distribution portfolio is pacing with inflation. We can incrementally pay off the mortgage as we gain space from our rising income distribution. I’m not saying that paying the house off is the wrong idea; I just don’t want to siphon assets from an income distribution portfolio.

If we are going to employ an income distribution portfolio, how do we solve for it? The calculation can be straightforward. We can provide an estimate of our income requirements based on our real and envisioned expenses. We can add accumulation goals such as investing for the children’s education or ensuring that the family can go on a yearly vacation, if those were not already budgetary items.

Importantly, we may be talking about a super long distribution portfolio. We need to think conservatively when deciding on a withdrawal rate. The best research I have seen on super long income distribution portfolios is Optimal Withdrawal Strategy for Retirement-Income Portfolios by David Blanchett, Maciej Kowara and Peng Chen.

It suggests a 2.7% withdrawal rate to start, and then adjust for inflation moving forward. So if you need $50,000 of after-tax income, for example, you will need around $60,000 of pretax income assuming 20% average federal, state and local tax combined. Divide the income stream of $60,000 by 2.7% and you get $2,222,222. Recall that our life insurance death benefit is income tax free but the income distribution portfolio we run from it is not. If the amount of insurance is too large as we get older, we can reduce death benefit along the way.

It seems to make sense to employ widely accepted, time-tested methodologies where they have application. To my mind, an income distribution portfolio designed for retirement would be very similar to what our loved ones would experience over time through the loss of a parent. What are your thoughts?

Jim Karthaus, CFP, is an adjunct professor with the CFP Certification Education and ChFC programs at The American College of Financial Services. As managing principal of Nautic Financial Group, Karthaus has been offering his clients investment and insurance advice for more than 22 years. He may be contacted at [email protected].