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The most natural use for permanent life insurance is to fund a legacy goal. Exhibit 7.4 compares the effectiveness of two strategies for meeting a legacy goal during retirement: “buy term and invest the difference” in Scenario 1 and using whole life insurance in Scenario 2. Values are expressed on an after-tax basis with a combined 25 percent tax rate applied to qualified plan distributions and legacy values. The cash value and death benefit from the whole life policy are not treated as taxable assets.
As Jerry and Beth are now getting more serious about their financial planning, they begin to also think about their legacy goals for their children. The couple anchors onto their $500K current life insurance need and believe that an appropriate overall legacy goal would be to leave the children this amount upon Jerry’s passing no matter the age. The couple would like to support the highest living standard possible while still maintaining a 90 percent chance that a $500K after-tax legacy goal can continue to be met by age 100. His legacy goal for the investment assets inflates to $666,667 so that the after-tax amount of $500K can be achieved. With permanent life insurance, a substantial safety margin with investments is not needed for legacy.
The question becomes: what is the most efficient way to meet a $500,000 after-tax legacy goal while also being able to support the highest retirement lifestyle from this same pool of assets in a way that does not jeopardize the legacy goal? The couple targets a 90 percent success rate for their financial plan.
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If Jerry uses whole life insurance, he can now seek the highest spending rate for his remaining investment assets that maintains a 90 percent chance that the portfolio is not depleted by age 100. He no longer needs to preserve a safety-margin of $667K at age 100 for his after-tax legacy goal to be met with 90 percent confidence. This allows for a higher spending rate from investments. This is the trade-off that we must test empirically: can the couple spend more when using whole life insurance after considering the higher insurance premiums and less 401(k) assets at retirement, but the ability to use a higher distribution rate from investments since there is no longer a need to maintain the safety-margin with investments for legacy?
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In Scenario 1, the couple purchases term insurance to provide a death benefit for human capital replacement until age sixty-five. For the remainder of savings, they invest in their 401(k) and use this pot of investment assets to support their spending and postretirement legacy goals.
In Scenario 2, the couple maintains a whole life policy into retirement to cover legacy and invests the remainder in their 401(k) to cover retirement spending. Because the whole life premiums are larger, the couple can generally expect to have less in their 401(k) at retirement. The difference ranges from 17 percent less at the 10th percentile of the distribution to about the same amount at the 90th percentile. Accumulations are generally less because less is invested, but it is possible to accumulate more because of the asset allocation impact in which the cash value is treated as a fixed-income asset, and so the 401(k) asset allocation can be more aggressive in response. The more aggressive asset allocation helps the most when markets perform well. Median 401(k) assets at retirement are $883K in Scenario 1 and $836K in Scenario 2.
Note that if we add the cash value in Scenario 2 to the 401(k) assets, overall wealth is greater because the whole life policy supports lower life insurance costs in the preretirement years, and because taxes will not be paid on the cash value. This outcome alludes to the efficiencies of cash value as a fixed-income investment when life insurance is otherwise needed for the financial plan.
Next, the exhibit shows that the sustainable withdrawal rate is 2.71 percent in Scenario 1 and 3.48 percent in Scenario 2. They are different for two reasons. First, in the second scenario, the asset allocation is more aggressive for investment assets because of the role played by cash value as a fixed-income asset. Second, and more importantly, Scenario 1 requires a substantial safety reserve to support legacy. To meet the legacy goal, Scenario 1 requires a lower spending rate to support a 90 percent chance that remaining assets are not less than the after-tax legacy goal at age 100. The IRA must maintain $667K to support the $500K goal after taxes. In Scenario 2, it is only necessary to maintain a 90 percent chance that investment assets remain above $0 by age 100. Life insurance supports the legacy goal. This allows for a higher distribution rate to be used with investment assets.
The higher distribution rate allows for more spending in Scenario 2 while also meeting the legacy goal. In the median outcome, these assets can support 22 percent more inflation-adjusted spending throughout retirement. At the tenth and 90th percentiles, the percentage increases in spending for Scenario 2 are 7 percent and 29 percent.
Finally, the exhibit shows legacy wealth at age 100. The couple sought a 90 percent chance to meet their legacy goal and we see that approximately $500K is left after taxes in both scenarios at the 10th percentile of the distribution. For the remainder of the distribution, legacy wealth is slightly larger in Scenario 2 despite also supporting more spending. Legacy is 5 percent more at the median and 2 percent more at the 90th percentile. The couple must spend less in Scenario 1 to ensure that investments can support their stated legacy goal.
Nonetheless, with the addition of the death benefit, whole life insurance can consistently support more legacy. Whole life insurance provided the couple a more efficient way to meet the legacy goal, which allows them to enjoy a higher standard of living in retirement with these assets without the tradeoff of a lower legacy when markets perform well in retirement. Scenario 2 is more efficient than Scenario 1 in terms of meeting legacy goals while supporting more spending and legacy.
Though not the case here, in cases when spending is higher and legacy is less, it can be difficult to compare the tradeoff. The last measure of discounted lifetime spending power in the exhibit helps to remedy this. It is the discounted value (at the 3 percent interest rate) of the lifetime spending and age 100 legacy supported by the strategy. We can also observe that Scenario 2 supports more lifetime spending power across the distribution of outcomes.
Exhibit 7.4 Whole Life Insurance for the Legacy Goal
Retirement Researcher
Because investments are used as the source of legacy in Scenario 1, it becomes necessary to remain extra cautious about retirement spending to maintain the desired legacy safety margin for investments. Scenario 2 allows for a higher standard of living in retirement with more inflation-adjusted spending, while still providing the desired confidence that the legacy goal can be met.
Exhibit 7.5 also helps to visualize this process by showing the median spending and legacy across the age range. If the couple’s goal is to maximize their standard of living in retirement while still ensuring that their heirs received $500,000 after taxes as a legacy, Scenario 2 accomplishes this more effectively than Scenario 1. As well, the legacy in Scenario 2 has contractual protections, while in Scenario 1 there is still an accepted 10 percent probability that legacy assets will fall below the intended goal. Across the range of ages, spending and legacy is higher when whole life insurance is used. Whole life insurance can be incorporated into a lifetime financial plan as a more efficient means for meeting a legacy objective, which allows for a higher standard of living to be supported from the remaining assets.
Exhibit 7.5 Whole Life Insurance for the Legacy Goal: Median Spending and Legacy
Retirement Researcher
*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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