by Neil Jesani
This brings us to the fifth and final bucket: whole life insurance. It should be the final bucket for several reasons. This is the one source of retirement income that has a death benefit. Remember the multitude of reasons for having whole life insurance as part of your balanced investment strategy. It provides for beneficiaries; it can pay for estate taxes; it takes care of final expenses, etc. Whole life insurance covers a variety of concerns.
Also, remember that whole life insurance builds up a cash value over the life of the policy. If you need to access the cash value, you can do so by taking loans from the policy. This means you don’t have to pay income tax on it. In our example, Dr. Sam has a $3 million policy with a million dollars of cash value. Even if Dr. Sam takes out an entire one million dollars and then passes away, his beneficiaries will still receive $2 million!
When planned out properly, whole life insurance is there to wrap up all of your investments and provide for your family when you pass away. It gives you the luxury to use up all other investments, and still provide a legacy for your loved ones. It even allows you to utilize the equity in your house for your retirement purposes through a reverse mortgage. Because of the death benefit of life insurance, your family can use that money to free the house after you die.
Doubling Your Retirement Income
You now understand that the purpose of any long-term savings or investment is to create retirement income, liquidity, and a legacy for the family. The more efficient you are at satisfying the desired income stream, the more money you will have left over for liquidity and leaving an inheritance for the family. So, what do you do with the money that you are not using to create the retirement income stream? From the visual perspective, think of this as a waterfall effect – you first need to use the available investments to satisfy your income objective then the remaining resources flow like a waterfall down into your liquidity and legacy functions.
For your retirement income, it is important to prepare for funds to last closer to life potential than just to life expectancy. Many people will live past life expectancy. Keeping this in mind, let’s understand the products and methods available to utilize for your retirement income purposes.
Let’s investigate how income from Dr. Sam’s fluctuating return investment assets work in retirement, such as his brokerage account and qualified retirement assets (IRA, defined benefit plan, defined contribution plan, etc.). A potential problem Dr. Sam will encounter is how these assets react to the fluctuating rate of return when money is being withdrawn for retirement income. Let’s take an example of his $1 million brokerage account.
Assume Dr. Sam happened to be on the right side of the stock market history and retired somewhere between 1970 to 1999 when the S&P 500 produced an average return of 14.84%. If Dr. Sam only withdraws 10%, that is $100,000 a year of his $1 million brokerage account. You can see that his account grew even after withdrawing $100,000 for 30 years.
Here is the actual return of the S&P 500 from 1970 to 1999. So, if you add all these annual positive and negative yields during these thirty years and divide by thirty, then the average yield of 14.84% is the result. Now you are going to see how to take the fluctuating positive and negative yields and put them in the same table above and see what happens.
When you put the annual fluctuating return into the table on the next page, you still have the same average yield over the thirty years. However, instead of having close to fifteen million dollars at the end of thirty years, Dr. Sam is down to zero dollars between years thirteen and fourteen. It’s eye-popping, and the question comes, “Why does this happen?”
This decrease in funds happens because of the rule changes in the distribution of income. In any year, if you earn less than you pulled out, you just killed off the dollars that were supposed to be earning a return for you in the next year. So, if you are going to try to use fluctuating return assets to provide retirement income, then the question becomes how would you go about determining what is a safe withdrawal rate?
A software program called Monte Carlo simulations tries to answer this question by using the rates of return for all types of investment vehicles over the last 100 years or so to calculate the historical probabilities of running out of money in the retirement years based on the withdrawal rate. These programs run thousands of simulations for every 15, 20, 25, 30 and 35 year rolling time periods, taking into account all types of market conditions and interest rate environments.
Let’s take a look at the results of these simulations conceptually. This chart shows the historical probabilities of not running out of money years into retirement based on the withdrawal rate chosen at the beginning of retirement. It is important to understand that these are withdrawal (distribution) rates and not interest (accumulation) rates on your money in retirement. These simulations and curves exist because of the income withdrawal rate is established before knowing the fluctuating returns you will earn on your money.
As an example, let’s say you choose an 8% withdrawal rate on your beginning retirement asset balance. This would put you on the bottom line. Thirty years into retirement, historically there is about a 5% chance of not running out of money and around a 90% chance of running out of money. So, it doesn’t take a rocket scientist to tell you that by lowering your withdrawal rate, you’ll have a better chance of not running out of money. Most financial experts agree using between a 3 to 4% withdrawal rate protects you from running out of money in retirement.
This previous chart was based on a 50/50 stock/bond allocation mix because it is generally one of the better performing mixtures throughout history, but you could choose a different allocation mix as well when running these types of simulations.
So, how can Dr. Sam double his retirement income by doubling the distribution rate without the risk of running out of the money later on? This can be done by combining two economic powers: 1) Fluctuating interest rate power and 2) Actuarial science power. The first power is to earn returns using the short-term fluctuating interest rates by the related investment vehicles such as stocks, bonds, etc. This power is generally characterized by the fluctuating returns on risk/reward based outcomes. The second power you can utilize to earn returns is the power of actuarial science provided by insurance-related investment vehicles. This power is generally characterized by a steadier return over time that doesn’t fluctuate as much and can be guaranteed. These two powers can be a good complement to one another when used together in a balanced approach.
As you get closer to retirement, begin to put together a strategy for when you are done working. As you can see, you need to plan how to spend your money as much as you planned when saving it. It would not do to agonize over all your investments and then spend it too quickly due to a bad game plan.
This book’s purpose is to give you a simple, but comprehensive overview of how you can realize significant tax savings now while preparing for your future. You now know what kind of professionals you need to look for to optimize both your current tax savings and your retirement. If nothing else, I want you to be able to start asking the right questions about what will work for you.
I always go on the premise that you worked hard to get to where you are in life. You should be allowed to keep as much of your hard-earned money as possible. If you do not take care of yourself, who will?
For updates, more reports, and additional financial advice, please visit: www.NeilJesani.com
