Why life insurance is a rockstar retirement income generator
By Brandon Roberts
The Insurance Pro Blog
Life insurance for income generation works, and it works well, because we can eliminate so many other risks that you probably haven’t even considered.
Life insurance used to generate retirement income is a slightly more advanced subject within the world of life insurance and financial planning. The stock jockeys hate it and the life insurance agents love it. No surprise there.
But is there anything that life insurance brings to the table that is truly special, or are you better off betting your chips on the market to bring you through a prosperous retirement? The market and other investments heralded by your broker or investment advisor seem to be the weapon of choice for generating retirement income, or at least that’s what your standard CFP says. But maybe, just maybe, there is something we’ve neglected to think about here. And perhaps it requires a little more gray matter flexing than simply parroting what the compliance approved brochure say about retirement income planning.
Risk: It’s a bigger topic than you think
Risk is a funny thing. Most people have some inherent idea about what it is and what it entails. But few of us really think about how it affects our lives, or give much thought to just how much of it exists. Perhaps this is because we want to be naturally optimistic.
Or perhaps it’s simply because thinking about the number of risks we face during a task as simple as getting to work each day would make us all clinically depressed — good for Pfizer, bad for our pocket books.
In probability theory, we often talk about types of risks and their measurability. Some risks are easily quantified, like the probability of losing a bet on a slot machine in Vegas. Others are a tad more complicated to calculate, like the risk of having your house burn down sometime between today and five years from now.
For risks that present a higher degree of complexity, we generally assign values to them in vague estimations. For example, I can’t tell you precisely what the probability is that my house will burn down tomorrow, but I’m confident that it’s pretty low.
When it comes to retirement planning, there are a number of risks those who are hoping to retire someday will face throughout the journey. There are some very obvious ones that anyone with a license to sell securities is likely to discuss, such as market risk, interest rate risk, systemic risk, and liquidity risk. And there are a few others that go beyond the typical textbook, like longevity risk and cash flow risk. Retirement timing risk
Despite what most in the investment sales world will tell you, you really don’t have forever to wait for the market to come back, even if you are only 22 years old. Whether we like to admit it or not, there’s a relatively finite number of years between our first and last day at the office. And that 40 to 50 years will define how we finish out our lives. You only get one crack at it.
So, what’s the probability that your investments will go bust?
We don’t know. You could do everything right and, due to no fault of your own, a reflexive jerk in the market at the wrong time could dash your original plan in a matter of days.
When the market brings you a bear for your retirement party…
If the market brings you a bear for your retirement party, cry. Bear markets that strike early in retirement can be disastrous. We’ve known this for a really long time, but most of the investment world is pretty silent on the subject, as it doesn’t have a really good answer for avoiding the consequences.
Here’s an example that will help illustrate the point. Let’s use a hypothetical $1 million portfolio used to generate retirement income at $50,000 per year. This uses the 5 percent withdrawal rate that has been industry standard for decades (though more recently has been called into question).
I’ve drawn up a random list of portfolio returns over a 20-year period. The average return for all years is 6.85 percent, which is better than the last 10 years of the S&P 500, and a comfortable number according to what most major mutual fund companies tell me I can get with a well diversified bond and equity portfolio in retirement.
Let’s start with the bull market scenario first.
Our first three years are really great market years. We then see a few bears along the way, and towards the end, we see some strong bears. But that doesn’t bother us much. We still wrap up the 20-year period with a million dollars still intact due to market appreciation. This is the sort of dream scenario found plastered on every sales brochure for every mutual fund company in existence. Now, the bears come early.
I’ve done nothing but reverse the order of the returns — that’s it. The average return is still the same, of course, but this time, we ran out of money … a year early.
This is what I mean by retirement timing risk. We can’t control when the market dips will take place; and as such, we often can’t prevent a dramatically altered retirement if the market takes a bad turn around the time we’ve crossed out that last day on the calendar. How life insurance helps
Life insurance is a low-risk asset. This low-risk profile makes it a star student when it comes to income generation. Why? Because it’s not affected by market dips.
If we go back to our previous example and wipe out all of the hypothetical yearly yields and replace them with 2 percent returns each and every single year, our hypothetical retiree will have made it all 20 years with about a quarter of a million dollars to spare. Here are the numbers:
If you give me a million dollars and a guaranteed 2 percent yield indefinitely, I can guarantee that you won’t be broke after 20 years if you withdraw $50,000 per year from the account. That’s mathematical fact.
Life insurance works so well for income purposes because it’s so incredibly stable. It doesn’t really matter what we’re talking about either: whole life, current assumption universal life, and even indexed universal life (not variable universal life, for what should be obvious reasons). None of them vary all that much with respect to overall return because none of them ever have to deal with large or moderate negative returns. This stability greatly increases your ability to generate income at any time.
Life insurance for income generation works, and it works well, because we can eliminate so many other risks that you probably haven’t even considered. But the biggest risk it eliminates is timing risk that can make or break your retirement prospects, all the while yielding better assets that can similarly reduce or eliminate this risk. For this, it deserves attention as a possible retirement income tool.