A fear for most individuals is the inability to maintain the standard of living they grew accustomed to before retirement. This fear could be challenging for many to overcome, especially, believe it or not, for the affluent.

Why? A general misconception is that highly compensated individuals are more able to save and invest for retirement, even on a tax-favored basis. Because they earn more money, one assumes they can more easily accumulate enough to maintain their standard of living throughout their retirement years.

But with contribution limits on 401(k) plans, IRAs and other conventional retirement savings vehicles, highly compensated individuals will find it difficult to accumulate enough wealth to replace their current income, even if they contribute the maximum amount allowable to qualified retirement plans.

To illustrate a highly compensated individual’s tax-favored investing limitations, consider this example comparing three individuals who are all age 50 and work at the same company. Edward earns $275,000; George earns $100,000; and Bill earns $50,000 per year.

George and Bill each contribute 6% of their salary to the company 401(k) plan and receive an additional 3% match from their employer. Edward is only able to contribute 4.7% of his salary because the 2004 maximum individual contribution is $13,000.

Edward, the highest earner, can contribute an additional $3,000 due to catch-up provisions, bringing his total contributions to $16,000 and 5.8% of his salary. He wants to contribute to a Roth IRA but does not qualify because his income exceeds $160,000, which is the 2004 maximum income amount.

George, the middle earner, contributes $3,000 each year to his Roth IRA. Bill, the lowest earner, would like to contribute more to his 401(k) and establish a Roth IRA, but he cannot afford to do so.

For illustration purposes, we will assume the employer provides a 50% match on employee contributions into the 401(k). Edward’s employer 401(k) match is based upon his $13,000 contribution limit and does not apply to his $3,000 catch-up contribution. (See Chart 1.)

Among the three retirement savings accounts, Edward earns the most but contributes the smallest percentage of his income. In the next example, you’ll see how Edward’s present contribution limits during his income accumulation phase will negatively impact his income distribution phase during retirement.

Let’s assume that each employee continued the same savings pattern until age 65 and earned an average 8% rate of return on his qualified retirement account. If Edward, George and Bill retire at the same time, Chart 2 shows the following:

o How much they can save;

o Estimated annual retirement plan distributions;

o Estimated Social Security benefits each year;

o Total income each year during retirement; and

o Annual income during retirement as a percentage of income prior to retirement.

Edward’s standard of living will be substantially lower during his retirement because he’ll only receive 30% of his pre-retirement income each year–much lower than George’s 55% and Bill’s 60%.

Before we start feeling sorry for Edward, he might consider boosting his retirement income using non-traditional alternatives. The question is this: Does Edward’s financial advisor know which solution can produce the highest after-tax supplemental retirement income?”

Consider these retirement investing alternatives:

o A mutual fund with dividend reinvestment that earns a hypothetical total 8% annual return. Assume also 4% in unrealized growth (not currently taxable); 2% in short term gain (taxed and re-invested); and 2% annual dividends (taxed and reinvested) on no-load shares with standard charges, including administrative and management fees.

o A variable annuity with a total hypothetical growth factor of 8%, including standard mortality and expense and administration (M&E&A) charges of 2.18%.

o A variable universal life insurance (VUL) policy with a minimum face amount of $378,144. Because TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) allows this death benefit, it is not considered a modified endowment contract (MEC).

The VUL policy also has a hypothetical 8% growth factor, which assumes no specific investment subaccounts, but includes typical premium loads, M&E&A charges, expenses and policy fees. A VUL is a life insurance policy combining death benefit protection with professionally managed investment options. It is important for investors to realize that, like other variable products, the cash value in the VUL can decrease with a fluctuating market.

We assume an annual deposit of $25,000, a dividend tax rate of 15%, a capital gains tax rate of 15%, and a federal tax rate of 28%. In addition, we assume that taxes on the mutual fund are paid from the fund’s proceeds, although dividends are reinvested annually, and that the mutual fund invests in growth stocks with no current capital gains distribution.

Taxes are not paid on the earnings until they are realized (i.e., when withdrawals from the mutual fund occur to fund retirement income). (See Chart 3.)

As you can see, the variable annuity and the VUL surpass the mutual fund accumulation. And even though the variable annuity performed slightly better than the VUL, the client has an additional $375,000 of life insurance protection for 15 years. This protection cost Edward $20,000 in reduced accumulation value as compared to a variable annuity. Contrasted with the mutual fund, the life insurance is a bonus.

Now consider the after-tax distribution amounts for Edward during the 20-year retirement phase, comparing a variable annuity systematic withdrawal method and annuitization. Although studies indicate that few individuals annuitize their contract, Chart 4 illustrates that annuitization provides higher after-tax distributions to the client. The downside of annuitization would be account erosion at death, and no remaining legacy for beneficiaries.

To make a fair comparison, we will match the before-tax distribution amounts using the annuitization scenario as our basis because the income from annuitization is a fixed amount based upon prevailing single premium immediate annuity rates. Assuming a before-tax distribution of $45,449 annually we have the following results before and after tax. (We assume that investment returns are the same before and during retirement.)

The VUL, although finishing a close second in accumulation, outperformed the annuity and mutual fund for the 20 years in after-tax distributions for two reasons.

First, the policyholder was able to access the tax-deferred accumulation account, tax free, through a “withdrawal to basis” and through policy loans. Policy withdrawals to basis are tax free if taken after the 16th year; policy loans are tax free if the policy is not an MEC.

Second, the mutual fund runs out of assets during the 18th year. Therefore, only a partial distribution is made in year 18, and distributions are not made in years 19 and 20.

Based on the withdrawals stated above, the client would have these potential legacy amounts to leave his heirs. (See Chart 5.)

The policyholder must not allow the life insurance policy to lapse and must be careful not to let the cash value drop below the minimum amount. If a policy is no longer in force, any borrowed money is reported as taxable income.

Unfortunately, too many financial planners focus solely on retirement account accumulation and fail to recognize the most important aspect of retirement income planning: after-tax distribution planning, where a VUL policy can help.

While VULs are not for everyone, they may be a good fit for highly compensated individuals seeking more tax-deferred accumulation and after-tax retirement income. Clients who need additional life insurance coverage can benefit from the purchase of a VUL policy through the dual purpose of beneficiary protection and tax-deferred retirement accumulation and income.

C. Ray Trueblood, CLU, ChFC, CFP, is vice president of life insurance marketing strategy at Jackson National Life Distributors, Denver, Colo. You may e-mail him at ray.trueblood@jnli.com.