Life insurance is used to generate retirement income is a slightly more advanced subject in 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 investing your lands in the market to see you through a prosperous retirement? The market and other investments touted by your broker or investment advisor seem to be the weapon of choice for generating retirement income, or at least that’s what your CFP says. But maybe, just maybe, there’s something we’ve neglected to think about here. And maybe it required a little more gray matter flexibility than parroting what the compliance-approved brochure said about retirement income planning.
Risk, we talk about it…a lot
Risk is a funny thing. Most people have some inherent idea of what it is and what it means. But few of us really think about how it affects our lives, or give much thought to how much if any there is. Maybe it’s because we want to be naturally optimistic. Or maybe it’s simply because thinking about the number of risks we face for such a simple task as coming to work each day would make us all clinically depressed—good for Pfizer, bad for our pocketbooks.
In probability theory, we often learn and talk about types of risk and their measurability. Some risks are easy to quantify, like the probability of losing a bet on a Vegas slot machine. Others are a little more complicated to calculate, like the risk of your house burning down tomorrow.
For risks that present a higher degree of complexity or challenge in crunching the numbers, we generally assign values to them in vague estimates. For example, I can’t tell you exactly what the probability is that my house will burn down tomorrow, but I am convinced that it is quite low.
When it comes to retirement planning, there are a number of risks that the retiree will hopefully one day face throughout their journey towards an eventual golden girl. There are some very obvious ones that anyone licensed to sell securities will likely 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 level one financial advisor like longevity risk and cash flow risk.
My goal today isn’t really to add a bunch of new types of risk to your list of doom and gloom, but rather to just slightly change the paradigm that we operate under when it comes to risk.
Timing risk, easily negated by averages or serious threat?
One form of risk that is up for discussion among the financial planning establishment is the concept of time risk. For those more educated on the subject of personal finance, this one is probably pretty self-explanatory, but for the less equipped among you, I’ll help with a little explanation.
Timing risk is simply the risk you face when entering a market. The risk is the idea that you enter the market at an inappropriate time – like when the market is really high – and you will lose money as a result of a market decline (ie buy high sell low).
There are many in the bond and stock trading world—especially among the more mutual fund-focused crowd—who would say that timing risk can be avoided with time and a smart strategy called dollar cost averaging. For these people, it is foolish to fear an entry into the market, because your opportunity to make money in the long run foregoes making money. Sounds like a really good pitch to sell some investment products, but I will admit that there is sound logic behind their smoothing argument, at least until you retire.
Time risk for retirement
Despite what most people in the investment sales world will tell you, you really don’t have to wait forever for the market to come back, even if you’re only 22 years old. Whether we like to admit it or not, there is a relatively limited number of years between our first and last day in office. And that 40 to 50 years will define how we end our lives. You only get one crack at it.
So what is the probability that your investments will fail?
It’s actually somewhat easier to calculate than you might imagine—or at least it’s arguably easier than calculating the probability that I’ll sift through the ashes in my house tomorrow, assuming your investments are largely in stocks. But that specific question is not one that I really care about, because retirement risk is less about the likelihood of a market downturn and much, much more about the timing of such a contraction.
When the market gives you a bear for your retirement party…
If the market gives you a bear for your retirement party, cry. Bear markets that strike early in retirement can be disastrous. We’ve known this for a very long time, but most of the investment world is pretty quiet on the subject because it doesn’t have a really good answer to avoid the consequences.
Here’s an example to help illustrate the point. Let’s use a hypothetical $1 million portfolio that is used to generate retirement income at $50,000 per year in income. This uses the 5% withdrawal rate that has been the industry standard for decades.
I’ve made a random list of portfolio returns over a 20-year period, the average return for all years is 6.85%, which is better than the last 10 years of the S&P 500, and a comfortable number that most major fund companies say to me that I can bring a well-diversified bond and stock portfolio into retirement. Let’s start with the bull market scenario first.
Our first 3 years are really good market years. We then see some bears along the way, and towards the end we see some strong bears, but it doesn’t bother us too much. We still end the 20 year period with a million dollars still intact due to market appreciation. This is the kind of dream scenario that is on every sales brochure of every mutual fund company in existence.
Now the bears come early.
All I’ve done is reverse the order of the returns, that’s all. The average return is of course still the same, but this time we ran out of money… a year earlier.
This is what I mean by pension risk. We cannot control when the market declines will take place, and as such we often cannot prevent a dramatically altered retirement if the market takes a bad turn at the time we crossed the last day of the calendar.
How life insurance helps counteract this problem
Life insurance is a low-risk asset. We have mentioned this many times. And while most of you will accept that for what it is, reliable, the fact that this low-risk profile makes it a star student when it comes to income generation. Why? Because it is not affected by market downturns.
If we go back to our earlier example and wipe out all the hypothetical annual returns and replace them with 2% returns every single year, our hypothetical retiree will have made it through 20 years with about a quarter of a million dollars left over. . Here are the numbers:
If you give me a million dollars and a guaranteed 2% return indefinitely, I can guarantee that you won’t be broke after 20 years if you withdraw $50,000 a year from the account. It is a mathematical fact. And the guaranteed rate on most whole life contracts is 100% better than our 2% yield (and we haven’t even started talking about dividends).
Life insurance works so well for income purposes because it is so incredibly stable. I’ve commented before that you generally won’t be excited about it, but you’ll be really glad it’s around when the rain is pouring down.
Life insurance for income generation works, and it works well because we can eliminate so many other risks you have staring you in the face that you probably haven’t even thought about. If you want to know more, contact us, and if I don’t answer right away, maybe it’s because the probability of my house burning down was a little higher than I thought.