Thus far, the risk pooling discussion has focused on annuities. Another form of risk pooling for longevity is available through life insurance, and this chapter* explores the ways that life insurance can potentially be incorporated into lifetime financial planning. This discussion is mostly about whole life insurance in comparison to term life insurance, but other forms of permanent insurance will be discussed briefly at the end of the chapter*.
Whole life insurance can provide a foundation to allow the household to spend more and still be able to provide a bequest, or to increase spending even further by using the cash value as a volatility buffer for the investment portfolio. Whole life insurance can provide a source of funds to support legacy, liquidity, and even long-term care if a rider is added for that purpose. With life insurance playing this role, the retiree may also feel more comfortable using an annuity with lifetime spending protection, which provides the benefits of risk pooling to meet a retirement spending goal using a smaller asset base.
As well, when viewed as an investment, whole life insurance can provide an attractive alternative to holding bonds in an investment portfolio. Premiums are invested in the insurance company’s general account, which, as we have discussed, can provide advantages for fixed-income investments relative to what a household can obtain on its own. Life insurance also provides tax deferral for its cash value, and when properly structured, the cash value can be accessed on a tax-free basis during life (meaning that the cash value of life insurance behaves similarly to a Roth IRA). The death benefit is also provided on a tax-free basis. Because of limits on how much that can be invested into tax-deferred retirement plans, this aspect of life insurance can provide a way to obtain more tax-deferral for savings after exceeding other limits.
That being said, the traditional purpose of life insurance is to provide a death benefit to help support surviving family members or a family business in the event of the policyholder’s untimely death. In this context, the amount of life insurance one seeks to hold is what dependents would need to sustain their lifestyle or meet other obligations in the absence of the policyholder being able to contribute to the family through wages or other caretaking. As noted, life insurance can play other roles in a retirement income plan as well. This chapter* investigates life insurance from the broader retirement income perspective.
Just as annuities with income guarantees use actuarial science and risk pooling to support a spending level consistent with living to life expectancy, life insurance is also based on actuarial science and provides mortality credits and risk pooling. Life insurance works as the counterpart to lifetime income. While lifetime income protections reduce the cost of funding a long life, life insurance provides higher realized returns to a household in the event of a shorter life. These two contrasting uses of risk pooling can work together effectively in lifetime financial planning.
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During the preretirement period, human capital is an important asset for households. Human capital is the present value of all the wages individuals expect to earn during the remainder of their working years. For those with families or other fixed obligations that depend on receiving human capital in the form of those future wages, the life insurance death benefit can serve as a replacement for lost wages in the event of an early death during the working years. We usually think of life insurance as a tool for replacing lost income, but even a homemaker who does not earn wages may consider life insurance to help the household that would then have to pay for more services related to childcare and household management in the event of the homemaker’s death.
For this basic human capital replacement framework, one generally does not associate a need for life insurance after retirement begins. The value of human capital approaches zero as the working years end, though those continuing with part-time work in retirement may still be reliant on and need protection for their human capital. Once fully retired, the household subsequently funds lifestyle with assets accumulated during the working years. They have converted their human capital into financial assets.
Term life insurance supports the role of human capital replacement. With term life insurance, one purchases a contract to receive a death benefit should death occur within a certain number of years or by a certain age. The term could be chosen to end once family needs or other financial obligations no longer depend on the future earnings of the worker. A mantra of “buy term and invest the difference” developed in the investing world as the way to approach the life insurance decision. Because the death benefit is temporary with term life insurance, and it also does not include a savings component, term life premiums will be smaller than with other forms of life insurance. For a given pool of funds, this affords a greater remaining amount to be invested after life insurance obligations are met, as long as the individual follows through and invests those additional dollars not spent on life insurance premiums.
For lifetime financial planning, is it really best to pay the smallest amount possible for life insurance in order to invest as much as possible in the financial markets? This chapter* puts the concept of “buy term and invest the difference” to the test by investigating whether there are better ways to approach life insurance from the context of comprehensive lifetime financial and retirement income planning. The focus of this chapter* is about whether other forms of permanent life insurance should be considered by the household as part of a longer-term retirement strategy that can be set into motion during the accumulation phase. Even though term insurance premiums are lower, this type of life insurance may not always provide the best value in the context of financial planning outcomes related to getting the most spending power and legacy from the available asset base.
I will focus particularly on whole life insurance as an alternative to term insurance. For life insurance, there are natural parallels between different types of insurance products and different types of annuities. Whole life insurance corresponds most closely to income annuities. For both, premiums enter the insurance company’s general account and the insurance company invests those premiums with a heavy focus on fixed-income assets and asset-liability matching. Whole life insurance consists of a death benefit and a cash value savings component. A difference between whole life insurance and income annuities is that whole life policies are frequently participating policies that can earn dividends when realized outcomes fair better than the insurance company’s conservative pricing projections, while participating income annuities are still relatively rare. Unlike income annuities, whole life insurance is underwritten, and different pricing is available based on health classification.
*This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon
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