Life insurance in retirement income planning

The healthier spouse has a large pension with a range of payout options: lump sum, various joint and survivor options, life only, etc. The optimal strategy in this case is to take the pension as life-only and hedge the risk of premature death by buying life insurance, which is cheap because of the retiree’s good health. Essentially, Hultstrom concludes, the individual is arbitraging the mortality tables: collecting an annuity that assumes average health, while hedging with insurance that is priced for low risk.

Richey cautions that maximization is not a simple analysis. The first question is how much of a death benefit to buy to replace the survivor pension. Also, can the amount carved out for the insurance premium buy sufficient coverage using guaranteed policy projections?

There’s also a risk that the retiree lets the policy lapse or changes the beneficiary, which effectively cuts off the survivor’s projected benefit. If that happens, the survivor will have to deal with the loss of all pension benefits, plus part of the couple’s combined Social Security benefit. “There’s so many moving pieces in retirement planning anyway,” she says. “Investments and Social Security and taxes and all these things are complicated enough without adding that as a complicating factor.” Roth IRA on Steroids

The previous uses of life insurance focus on using the policy’s death benefit to preserve retirement income. Another possibility is to take advantage of the product’s unique tax advantages during retirees’ lifetimes.

Mike Weintraub, CLU is president of the retirement planning division for Ascension Benefits & Insurance Solutions in Walnut Creek, Ca. A longtime Million Dollar Round Table (MDRT) member, he frequently consults with advisors looking to set up retirement plans for businesses. In that work, he encounters owners and executives who can’t save as much in their retirement plans as they wish to because of deferral restrictions. 

Weintraub often recommends the owner create a Section 162 bonus plan using cash value life insurance to work around those restrictions. The employee-recipient uses after-tax compensation to buy a life insurance policy. The amount going into the plan combined with the employee’s other compensation must be reasonable, he says, but otherwise, there is no limit on the contribution.

The premiums are paid with after-tax dollars, so the employee does not receive a tax deduction. Like a Roth IRA, however, the amounts grow tax-free. The insurance contracts are structured to avoid the modified endowment contract designation, but they still provide a much higher cash value than traditional policies, he says. “In year one, instead of having a cash value of zero or maybe 20 percent of what the premium was, the cash value will be 80 percent or 90 percent of what goes in,” he explains.

The Section 162 plan generates several tax-advantaged retirement income planning benefits. Distributions from policy cash values are treated first as accumulations of basis and then policy loans; both types of distributions are non-taxable. Assuming the policy remains in force until the insured dies, any outstanding loans and interest due are deducted from the death benefit.

The plan also “buys time” for the insured to fund his or her retirement plan. Weintraub gives an example of an executive who wants to accumulate $2 million by her retirement date. With a Section 162 plan, she can have $2 million of life coverage in place that will fund the retirement plan in case of her premature death.

“With the life insurance in this bonus plan, they would get the amount of money they would have had, if they’d been able to complete the plan over the next 15 or 20 years,” he says. “Their beneficiary will get the amount of money tax-free that they were trying to save but just didn’t have enough time for the savings to happen.”

Covering the Costs of Illnesses

Unexpected medical expenses can derail a retirement income plan. Steve Roche, vice president, Product Solutions, Individual Life Insurance with Prudential Life in Hartford, Conn., observes that today’s life insurance policies can help cover these costs by providing access to the full death benefit, if the insured qualifies. With Prudential’s policies, he explains, insureds can access up to 2 percent of the policy’s death benefit each month if they become chronically ill. The withdrawals are treated as advances on the death benefit and are not included in taxable income. 

“You don’t know how much income you might need as you’re accumulating assets and life insurance,” Roche says. “And you don’t know if you’re going to become chronically ill and have that kind of event occur. But life insurance gives you all that flexibility and, if you don’t use it, it allows you to take the cash value withdrawals or to take access to the death benefit for a chronic illness, and it passes tax-efficiently to your heirs.”