American Investment Services, Inc.

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The Pre-Retirement Checklist: Insurance and Annuities

People approaching retirement often own a hodgepodge of investment assets and insurance policies. Individuals are encouraged to accumulate assets throughout their working lives. However, this money often sits in various savings vehicles with no clear plan. Assets may be spread across qualified retirement plans, taxable brokerage accounts, and checking accounts. Many people also have acquired cash value life insurance or variable annuities. Now is the time to analyze how these insurance policies or annuities fit into a broader retirement picture. 

This article describes the most common types of life insurance policies and annuities, discusses how one might use these assets in retirement, and presents a framework for assessing whether additional life insurance or annuities are right for you. A brief discussion of homeowners, auto, umbrella, and disability insurance concludes the article. Note that AIS does not sell insurance, though life insurance and annuities are a common point of analysis in our clients’ financial plans. 

Term Life Insurance  

Life insurance is a critical risk management device for working people with families. Life insurance can provide the peace of mind that a surviving spouse and children of a worker will have the assets and income they need if the worker were to pass away. For young and healthy people, life insurance is a relatively low-cost way to provide this protection in the event of such a catastrophe.  

Pre-retirees should reassess their current life insurance needs and determine a plan for any policies currently in force. Although there are a variety of life insurance products available, such protection generally falls into two buckets: those with a cash value and those without.  

Life insurance without cash value is usually called “term life” or “group term life” insurance. Term life and group term life policies provide no investment component. These policies only promise a death benefit, or a lump sum paid in the event the insured passes away during the stated term (e.g., 20 years from the issue date). Individually owned term policies are common, as are group term life insurance, which is often provided as an employment benefit.  

Since term life insurance expires at the end of the term, these policies can generally be purchased at a relatively low cost. For example, a healthy 35 year old can buy a $500,000, 20-year term life policy for a few hundred dollars per year. There is a good chance that the policy will expire worthless after 20 years, but such protection is often worthwhile to protect against one’s untimely passing. Term life insurance provides relatively cheap and simple protection to the young and healthy. However, term life insurance costs are higher for older people or those in poor health. 

We encourage those approaching retirement to review the provisions of any outstanding term insurance. Special care should be paid to the coverage period. Some individuals may decide they no longer require life insurance protection, as their dependents become independent, and their retirement savings grow to a desired level. These individuals may choose to terminate coverage and eliminate premium payments.  

Cash Value Life Insurance 

Cash value policies are more complicated. The most common type is called “whole life,” but there are alternatives called variable life and universal life.  

Whole life policies do not expire after a set term if the policy is kept in force; the death benefit extends over the entire (whole) life of the insured. These policies offer a death benefit plus an investment component known as the cash value. This cash value is potentially accessible for spending needs in retirement. Since there is a cash value and no expiration date, these policies are more expensive than term life policies.  

There are a range of life insurance products with numerous ways to access cash value. Such particulars fall beyond the scope of this article. The central consideration is whether and when one might need to access the accumulated cash value in retirement.  

Individuals first must decide whether and how long to keep death benefits. One may decide the death benefit is an important part of his or her estate plan. These individuals may wish to designate the death benefit to certain heirs or earmark these assets for potential estate expenses. After all, life insurance promises an immediate, income-tax free lump sum at one’s death. Those that choose to retain whole life insurance protection should then identify a plan for the policy’s cash value component. Policy holders are strongly encouraged to utilize the policy’s cash value in retirement as any unused cash value is surrendered at death. 

 Some individuals may determine that a whole life policy death benefit is not a central priority.  These individuals may consider cashing out the policy, though there will likely be tax consequences in doing so.  Those considering this option should consult a tax professional and the insurance company. Regardless, investors should not let inertia keep them from making a change. Whole life insurance is an asset that requires careful thought and, perhaps, deliberate action. 

Annuity Basics 

Annuities are of two basic types – immediate and deferred. “Immediate annuities” allow investors to make a lump-sum purchase of an income stream that will continue for a certain period, typically the remainder of the annuitant’s life. Immediate annuities can guarantee that the investor will never outlive his or her income. Furthermore, insurance companies offer many payout variations, such as joint and survivor annuities, that ensure payments will continue after the death of the primary annuitant. 

Annuities may be a valuable planning instrument, especially for those anticipating a long-life expectancy. The insurance company is willing to offer this deal because some annuitants will surely live longer than others. Of course,no one knows the longevity of any one individual in the “risk pool”, but on average, insurers can promise to pay benefits to everyone.  In a way, people who die at a younger age end up paying for those who live a long time.1  

The simplest version of an immediate annuity is called a single premium immediate annuity, or SPIA. For example, if you put $100,000 into a SPIA at age 65, the insurer might be willing to pay you $5,000 per year forever. If you die young, you “lose the bet”, but if you live to 100, this proves to be a good deal. SPIAs are simple and relativelylow-cost. They are considered fixed annuities because the income stream is a contractually stated amount. Those that desire more guaranteed income in retirement may explore SPIAs. 

Immediate annuities can also have payouts that are variable. Variable annuity contracts typically hold underlying stocks and bonds. There is a decent likelihood that market-based payouts will, on average, keep pace with the cost of living. However, market-based payments may be volatile from year-to-year. 

“Deferred annuities” on the other hand, do not provide income until at least a year (often many years) after the investment is made. During the accumulation phase, investors either make periodic payments or a lump-sum contribution in an investment subaccount. This subaccount then grows tax- deferred. When the payout phase begins, the annuitant may choose to initiate payments for a fixed period or the rest of the annuitant’s life (“annuitize”). If annuitized, part of each payment will be tax-free depending on the annuitant’s life expectancy and the amount of after-tax contributions. Alternatively, the annuitant may simply withdraw funds as needed. Withdrawals are taxed on a “first in, first out” (FIFO) basis. This means that one-time withdrawals are fully taxable at the owner’s marginal tax rate until all the earnings have been paid out; subsequent withdrawals of principal are tax-free. 

Deferred annuities are of two general types, fixed and variable. During the accumulation phase fixed annuities earn interest at a rate that is adjusted periodically by the insurance company, while the returns on variable annuities depend on the investment performance of the underlying subaccounts. In this respect, variable annuities are very similar to mutual funds. One’s preference ultimately depends upon personal objectives and risk tolerance. 

Pre-retirees and Annuities 

AIS often encounters clients who own a deferred annuity, but with no rhyme nor reason regarding its role in the overall portfolio. Typically, these are deferred variable annuities. All too often these products carry unneeded features, high fees, and prohibitive surrender penalties. It is critical to determine how a deferred annuity will fit within one’s retirement plan. Chief among these considerations are the available payout options. Retirees should assess how annuity income might supplement Social Security and/or pension income.  

Investors holding seemingly purposeless annuity contracts should not let them languish. While insurance companies would love to keep this money forever, it behooves investors to take action. Contact the company directly and start asking questions about all associated costs, how the value can be accessed, and how much income it might provide in retirement. In a way, annuities contracts parallel life insurance cash value. These contracts are only useful to the extent they are utilized

Individuals considering annuities should conduct thorough research. The plethora of available products can be difficult to understand for even experienced investors.  

Life Insurance and Annuities: Pros and Cons 

Annuities and life insurance are a divisive topic among financial planners. Many planners discourage the use of annuities under any circumstances, while others use them as a primary planning vehicle. While annuities tend to be a more expensive option than simply investing money in a retirement account, these products may be a useful part of one’s comprehensive retirement plan.  

Holistic analysis may provide a clear planning framework. Whole life policies offer conservative investment growth in addition to a death benefit. In turn, one might consider the whole life policy a conservative part of his or heroverall portfolio of retirement assets. This means that the individual might be able to take more risk with their other retirement assets. Individuals should also develop a plan to spend from the policy in retirement. A careful review of one’s expected retirement expenses may inform this decision. Unfortunately, these policies are often sold as a standalone entity instead of a piece of a more comprehensive plan. They are too often forgotten or unused as a result.  

Annuities can also be useful in creating a guaranteed source of income in retirement. It can be comforting to have a guaranteed cash flow. This income stream may fill the gap between Social Security and retirement spending needs. Again, deliberate planning can define the annuity’s role within a broader financial plan. Such analysis will also ensure that the annuitant takes full advantage of the product’s benefits. 

Like most financial planning topics, there is no “one-size-fits-all” approach for annuities and life insurance. Retirement needs and objectives are highly individualized. Considerations can be objective and subjective; empirical and behavioral. For example, one might purchase a Single Premium Immediate Annuity (SPIA) if he or she is afraid of market risk. Another individual might purchase that same contract for an entirely different purpose, such as to meet a precise a retirement spending shortfall. Similarly, some individuals may purchase whole life insurance for the comfortthat the conservative cash value component provides. Others may purchase life insurance for more practical reasons, such as to provide estate liquidity. 

Cost mitigation is central to any long-term financial plan. Financial planners rightly scrutinize investment costsand tax outlays to maximize each client’s financial capacity.  It is true that annuity contracts and life insurance policies often carry high fees and other extraneous expenses. However, such costs may be worthwhile in exchange for a distinct and discernable benefit. Annuities may be particularly useful for the risk averse, as investing in an annuity contract is certainly preferable to not investing at all.  

Review Other Insurance  

Homeowner’s, auto, umbrella liability, and disability insurance are all critically important to ensuring peace of mind. While the various aspects and features available fall beyond the scope of this article, such policies are relatively easy to understand. Household investors can generally make sound decisions regarding these policies if they read carefully and proceed methodically.  

Pre-retirement is a good time to review existing coverage in these areas. Individuals should ask themselves whether the coverage is still needed, and if so whether it is adequate. One may want to shop around to see whether a better rate is available.  

For owners of homes and cars, homeowner’s and auto insurance policies are prudent and likely required. Homeowner policies include liability insurance, but, to the extent that the insured’s net worth is in excess of that coverage, they may also consider umbrella liability insurance, which is a relatively low-cost product. 

Disability insurance is critically important during one’s working life, but as retirement approaches it will become less important. However, those working into their later years should ensure they have adequate disability coverage in those final years, since that is when it is most needed. Many employers extend the opportunity to participate through group plans.  

Neutral Assessment 

Risk management is integral to any long-term financial plan. Unfortunately, many consumers are confused by complicated policy language or misled by predatory sales tactics. These investors may find themselves either underinsured or over insured as a result.  

While neither AIS nor its staff sell insurance products, we are deeply familiar with coverage options, policy characteristics, and potential risk exposures. Please contact Luke Delorme at 413-645-3327 or for a complimentary insurance review and analysis.