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Balancing the retirement income plan

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There are two major approaches to generating retirement income.

The first favors the use of guaranteed lifetime income to cover fixed living expenses, at a minimum. Annuities and bonds, for example, work well in this method.

The second approach focuses on designing investment portfolios that can produce sustainable withdrawals that have a high probability of lasting for the client’s lifetime and perhaps leaving a legacy. These portfolios typically have diversified holdings with a sizable percentage in equities to provide growth. Both approaches can work, of course, and it’s not always an either-or decision. Many advisors with whom I speak blend the two methods when doing so best fits the client’s requirements.

Life insurance, either whole life or term, rarely figure into retirement income plans, however. While whole life policies can provide a living benefit through access to cash values, life insurance is still considered essentially an estate-planning tool.

A recent paper by Wade D. Pfau, Ph.D., CFA, “Optimizing Retirement Income by Combining Actuarial Science and Investments,” explicitly considers a potential role in retirement income planning for term- and whole life. The paper, which was commissioned by OneAmerica®, examines three retirement plan scenarios: (1) investments and term life insurance; (2) investments, joint and 100 percent survivor annuity, and term life insurance; and (3) investments, single life annuity, and whole life insurance.

Pfau, a professor of retirement income at The American College for Financial Services in Bryn Mawr, Pennsylvania, describes himself as agnostic about the different products that can be used in retirement income plans. When he was developing the paper, though, he realized that many times whole life insurance is viewed in contrast to an equity position.

“Why use whole life insurance when you can earn 8 percent on an investment portfolio on your own?” is the usual framing of this objection, he says. It makes more sense to think about the insurance as a replacement for bonds, he maintains, and that led to whole life’s inclusion in the simulated models.

The paper develops two client profiles, a 35-year-old and 50-year-old couples. Each couple’s finances are considered for the three financial scenarios described above and their income and legacy wealth are tracked through age 100. The paper provides the full details on the assumptions and simulations but here are some of Pfau’s key findings:

    • “Our simulations show that the risk pooling features of the income annuity are essentially a more significant factor in boosting retirement income than is the greater upside potential offered through increased reliance on investments. This is because incorporating the whole life insurance, even though it requires larger premiums than the term life insurance, supports a higher income level (by justifying partial annuitization) while also supporting a larger legacy.”
    • “We find substantive evidence that an integrated approach with investments, whole life insurance, and income annuities can provide more efficient retirement outcomes than relying on investments alone. Because whole life insurance can play an important role in producing more efficient retirement outcomes, younger individuals planning for both retirement and life insurance needs may view whole life insurance in a new light as a powerful retirement income planning tool.”

There is an important caveat, Pfau cautions. The analysis assumes that the policyholder will not lapse the whole life coverage. If he or she does, it can’t play its proper role in this strategy. 

It’s a well-written paper that provides a welcome and realistic alternative to the either-or debate. You can download it here.