Life insurance is used for retirement income A slightly more advanced topic in the world of life insurance and financial planning. Stock jockeys hate it and life insurance agents love it. No surprise there.
But is there something that life insurance brings to the table that is truly special? Or would you rather bet your chips on the market to bring you through a prosperous retirement? The market, and other investments promoted by your broker or investment advisor, seem to be the weapons of choice for building retirement income, or so your CFP says. But maybe, just maybe there’s something we’ve neglected to think about here. And it probably requires a little more gray matter flexibility than simply parroting what compliance-authorized brochures say about retirement income plans.
Risk, we talk about it…a lot
Risk is a funny thing. Most people have some implicit idea of what it is and what it entails. But few of us really think much about how it affects our lives, or how much, if any, it exists. Perhaps this is because we naturally tend to be optimistic. Or maybe it’s just because thinking about how much risk we could be exposed to for something as simple as working out every day would make us all clinically depressed—good for Pfizer, bad for our pocket books.
In probability theory, we often learn and talk about types of risk and their quantification. Some risks are easily quantified, such as the probability of losing a bet on a slot machine in Vegas. Others are a bit more complicated to calculate, such as the risk of your house burning down tomorrow.
For risks that have a higher degree of complexity or are challenging in number crunching, we typically assign their values to vague assumptions. For example, I can’t tell you exactly what the probability is that my house will burn down tomorrow, but I’m sure it’s very low.
When it comes to retirement planning, there are many risks that one can expect a retiree to face throughout her or his journey to the last golden girl-hood. There are some very obvious topics that anyone licensed to sell securities can discuss such as market risk, interest rate risk, systemic risk and liquidity risk. And there are others that go beyond the typical textbook for level one financial advisor-dom such as longevity risk and cash flow risk.
My goal today isn’t really to add a bunch of new risks to your list of doom and gloom, but rather to change a bit of the paradigm under which we operate regarding risk.
Timing risk, easily negative by average, or serious threat?
One form of risk that is up for debate among financial planning firms is the concept of timing risk. For those more educated about personal finance, this is probably pretty self-explanatory, but for those of you who are less equipped, I’ll help with a little explanation.
The risk you face when entering a market is timing risk. The idea involved in risk is that you enter the market at an inappropriate time—such as when the market is really high—and you lose money as the market contracts (ie sell high and buy low).
There are many in the bond and equity sales world—especially among the mutual fund focused crowd—who will tell you that risk can be avoided with time and a nifty technique known as dollar cost averaging. To these people, fearing time averaging returns and therefore entering the market is foolish because you are giving up the opportunity to make money in the long run. Some sound like really good pitches to sell investment products, but I’ll admit that there’s sound reasoning behind their average reasoning, at least until you retire.
Risk during retirement
Despite what most of the investment sales world will tell you, even if you’re only 22 years old, you don’t have to wait forever for the market to come back. 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 those 40 to 50 years will define how we end our lives. You only get a crack at it.
So what are the chances of losing your investment?
It’s actually a bit easier to calculate than you might imagine—or at least it’s arguably easier than calculating the probability that I’ll be sifting through the ashes of my house tomorrow, assuming your investments are primarily in stocks. But that specific question isn’t one I really care about, because risk during retirement is less likely to cause market contractions and more about the timing of such contractions.
When the market brings you a bear for your retirement party…
If the market brings a bear to your retirement party, cry. A bear market that hits early in retirement can be disastrous. We’ve known this for a really long time, but most of the investment world is pretty quiet about it because there really isn’t a good answer to avoid the consequences.
Here’s an example that helps illustrate the point. Let’s use a hypothetical $1 million portfolio that is used to generate retirement income of $50,000 per year. It uses a 5% withdrawal rate which has been the industry standard for decades.
I ran a random list of portfolio returns over a 20-year period. The average return for all years is 6.85%, better than the S&P 500 over the past 10 years, and a comfortable number according to the largest mutual fund companies that tell me I’m well-diversified in retirement. Can get bond and equity portfolio Let’s start with the bull market situation first.
Our first 3 years were really great market years. We then see a few bears along the way, and towards the end we see some strong bears, but it doesn’t bother us too much. We still leave the 20-year term intact with a million dollars due to market valuations. This is the dream scenario plastered on every sales brochure for every mutual fund company in existence.
Now the bear comes quickly.
I did nothing but reverse the order of returns, that’s it. The average return is still the same, of course, but this time we ran out of money…a year earlier.
This is what I mean by retirement risk. We can’t control when the market will fall, and therefore we often can’t prevent a dramatically changed retirement if the market takes a bad turn as we cross that last day on the calendar.
How life insurance helps to negate this problem
Life insurance is a low-risk asset. We have mentioned these odles time and time again. And while most of you would agree that it is reliable for what it is, the fact of the matter is that this low risk profile makes it a star student when it comes to generating income. Why? Because it is not affected by market fluctuations.
If we go back to our previous example and remove all the hypothetical annual returns and replace them with a 2% return every single year, our hypothetical retirees would make it 20 years with about a million dollars left over. . Here are the numbers:
If you give me a million dollars indefinitely and a guaranteed 2% yield, I can guarantee that if you withdraw $50,000 per year from the account, you won’t be broke after 20 years. It is a mathematical fact. And the guaranteed rate on most whole life contracts is 100% better than our 2% return (and we haven’t even started talking dividend)
Life insurance works very well for income purposes because it is incredibly stable. I’ve commented before that you wouldn’t normally be excited about it, but all around you’d be really happy when it rained.
Life insurance for income growth Works, and it works well because we can eliminate many other risks staring you in the face that you probably haven’t even considered. If you want to know more get in touchAnd if I didn’t answer right away the chances of my house burning down were a little higher than I thought.