Strategic retirement planning: an integrated approach
Michael J. McNeil, CLU, ChFC
• Hedge their portfolio’s risk
• Protect their assets from inappropriate retirement decisions
• Address a desire for leaving an intact financial legacy
• Ensure a predictable retirement outcome regardless of economic or personal conditions
During my talk, I hope to demonstrate the benefits of offering to our clients a thoughtful and comprehensive approach to retirement planning. I will try to convey, using actual case outcomes, how important it is to understand the interrelationship between three key risks and investment tools that, when combined, provide a plan that is greater than the sum of its parts. I believe that by employing an integrated approach and demonstrating competency in these key areas, we can achieve or maintain relevance for our clients by insuring that they are properly positioned for a successful and satisfying retirement.
The three tools are permanent life insurance, income annuities, and long-term care insurance, in conjunction with appropriate portfolio asset allocation.
I believe that, considering the information available to the public about this product, some good and some not, we as advisors need to be able to filter out the noise, product bias, and sales jargon that contribute to the public's confusion, procrastination, and failure to take the necessary steps in pursuit of a successful retirement. I also believe if we are able to meet this challenge, not only will our revenues increase, but we'll also realize more meaningful relationships with our clients and be more referable.
Let's get started. The first is permanent life insurance. This core product that we're all familiar with provides both protection against premature death and a tax-deferred vehicle for accumulating cash values that, later in life, may be converted to one of several life income plans if the death benefit is no longer required. Permanent life insurance has been around for over 150 years and while there are many product variations, we all can appreciate the Swiss Army knife characteristics that it provides.
When we evaluate our clients' financial assets, how many of us appreciate the value that this product provides when someone retires? Here are a few reasons I have recommended that clients either keep their policies or, in some cases, buy new coverage as they move toward retirement.
The most obvious benefit of life insurance is when someone dies soon after retirement, the proceeds, in most cases, provide a tax-free benefit to a spouse or to other loved ones who may have anticipated sharing in the deceased's retirement. When a married person dies, usually one of the Social Security incomes stops. There is also the fact that one's income tax bracket changes to head of household unless the survivor remarries, and the rules change as it pertains to spending down financial assets under Medicaid rules relative to long-term care funding.
Another benefit of having life insurance is to provide a source of funds that might be used by a spouse who may be inheriting a qualified plan asset, such as an IRA or 401(k), and who understands the benefit of converting the inherited account to a Roth IRA.
For example, if someone dies with a $1 million 401(k) account balance and passes it to his or her spouse upon death, and that surviving spouse is also a beneficiary of a life insurance policy, the survivor may use the tax-free life insurance proceeds or some portion with which to pay the income tax due if the survivor elects to convert the inherited 401(k) to a Roth IRA or if a spouse inherits an IRA, she or he may be able to convert that IRA to a Roth as well. Then, throughout the remaining lifetime of the survivor, there would be no required minimum distributions from the Roth IRA, and the survivor may choose to withdraw only what is needed, when needed, without any income taxes due when distributed, as well as enjoying the ongoing tax-free growth of the Roth IRA. Then, upon the death of the surviving spouse, the Roth IRA passes to the next generation, income tax free. Often this strategy can also provide an incentive for clients that own term life insurance to convert it before they retire and before the conversion period expires or the policy simply lapses at older ages. This is helpful especially since, when converting a policy, the underwriting would not be of concern, which at later ages can be problematic or simply not an option.
Another use of life insurance that has been in force for 20 plus years is the ability to convert the policy cash value into an income plan that is often a contractual feature provided by the policy. This eliminates the need for the payment of future premiums once the insurance benefit is commuted to an income, and the insured then receives a guaranteed income based on his or her life expectancy or a specific guaranteed period.
When these benefits are paid out, only that portion of the payment that represents gain would be taxable. In many cases, converting the cash value in an existing life insurance policy into an income plan generates a higher income than if the insured had simply surrendered the policy (usually by using a 1035 exchange) and purchased a new income annuity with the associated loads. I believe a critical role the advisor plays is helping the client establish a plan for income distribution from among the client's various investments and qualified plans. Failing to address this important activity may ultimately cause the client to exhaust his or her funds for a variety of reasons. Reasons, I might add, that might not apply with the use of a guaranteed income plan. Another point to remember is that when someone elects an income from life insurance cash values, funds are not subject to any required minimum distributions.
This valuable feature can provide a significant and reliable hedge during one's retirement years by generating income benefits during retirement that may never have been considered when the policy was purchased for protection against death. I often refer to permanent life insurance as a financial shock absorber, especially during periods of significant market downturn as we experienced in 2000 and 2008.
Let me illustrate what I mean. Let's assume that a 65-year-old retires with a nest egg of $1.5 million in retirement assets. He expects to withdraw $100,000 a year from the account each year in order to meet his lifestyle needs when added to his or her Social Security retirement benefits. A simple calculation confirms that as long as his portfolio earns at a rate equal to the withdrawal rate, (taxes not being considered in this example), the account, theoretically, should not run out. However, in a year when the market swoons as it did in 2000 and in 2008, the impact on the portfolio is magnified if he maintains his planned withdrawal amount. This is because when you withdraw funds when values are down, the portfolio whenever it recovers, it will do so but with a lower asset base due to the ongoing withdrawals.
So when the market recovers, the gains are on a reduced portfolio balance. Over time, if this were to occur several times, you would see a significant reduction in the overall portfolio value. However, if the same retiree had purchased permanent life insurance when he was in his early 40s, by the time he begins to take his retirement distributions, say at age 70, the policy values could provide an alternate resource by using dividend surrenders, policy loans, and/or withdrawals without any tax impact, thus allowing the retirement account to continue to grow with greater value when the market recovers.
I've included a hypothetical example [visual] of the impact of such a scenario using the actual performance of the S&P 500 from 1973 to 1987 to demonstrate the impact on a portfolio where one has access to other funds found in some life insurance policies to supply the needed income during times of severe market downturns.
A retirement plan that includes permanent life insurance affords the client a secure and tax-efficient, alternative resource, and as such, a hedge against market volatility throughout one's retirement.
The next topic we'll cover is an income annuity or, as I refer to it, "an income plan." This financial tool is getting a lot more attention lately, some good and some not so good. For today, given the many different plans in the annuity landscape, I will be referring to a generic income annuity.
Of the various products available to retirees today, annuities seem to be very often misunderstood and, unfortunately, the source of many consumer complaints, especially in the elder-age market. Now, with so many baby boomers retiring, about 10,000 a day, I suspect the noise and confusion will only increase as will, I suspect, compliance initiatives. I believe this is because some annuity sales are simply inappropriate and made for people who don't understand what they are buying by people who often don't really understand what they're selling. For now, let's just talk about situations where an annuity is appropriate.
Last year, I received a call from an 82-year-old, retired client who wanted to change a beneficiary on a small life insurance policy that I had sold her in 1981 when my practice was beginning. In reviewing her current finances, I learned she was living on a modest monthly income of about $2,500. This included $1,250 of Social Security benefits and another $1,250 that was being withdrawn monthly from a nonqualified mutual fund account with a balance of $170,000. Her only other asset was a $60,000 IRA from which she was taking out only the RMD of about $265 a month, which she then reinvested. Over the last year, the mutual fund account earned 2.6 percent, yet her withdrawal represented almost 9 percent of the account balance. Yet at age 82, if she continued to realize returns of 3 to 4 percent as she apparently had been, and if she continued to withdraw at that rate each month, she would most likely exhaust the account before age 90.
I was also concerned because I learned from my fact finding that she had two unmarried, adult children, one with physical issues and the other clinically depressed and often homeless living 3,000 miles away from her. As such, she often found herself providing emergency financial support that she could ill afford without putting her own retirement in jeopardy.
As for the IRA, as I mentioned, she was only taking her RMDs, this year $3,120, or about 5.2 percent of the account balance. However, like her other investment account, the IRA had only earned 3.4 percent. If that rate of return was a pattern or a predictor of her future expected returns, then the RMD alone would most likely exhaust the IRA as well before she was 90. While not a savvy investor per se, she did understand math and knew that if she continued as she had, she would run out of money. And even if she didn't, it was clear she would not leave her children any legacy assets.
After evaluating the asset allocation of her account and her specific risk tolerance, it was clear that she had to make some changes. Given her age and her low tolerance for risk, I suggested two adjustments. The first was the purchase on an immediate income annuity with her IRA. Doing that would continue to satisfy the RMD and generate $508 a month for life instead of the $268 she was currently withdrawing and without the possibility of the account being exhausted or affected by any market volatility. The second adjustment was to invest 70 percent of her nonqualified mutual fund account in a second immediate income annuity. Doing that would generate an initial monthly income of about $1,075, which, while less than her current $1,250 monthly withdrawal target, was an income that would never be exhausted and would only be minimally impacted by the annuity's specific fund's performance. And since the funds were nonqualified, most of the payment would be a tax-free return of principle.
The combination of these two new incomes brought her monthly income to $1,533, which would be paid for her entire lifetime, with a 10-year period certain that her children might benefit from. This left her with $50,000 of liquid assets still invested, and a 23 percent increase in monthly income that she could never outlive or be accessed by her children.
Let me tell you about another case at the complete opposite end of the financial spectrum. Two years ago, I was contacted by an orphan policyholder who had questions about a life insurance policy he had bought 30 years ago. In our phone conversation, he mentioned that he had recently applied for a second-to-die life insurance policy in order to provide liquidity for estate and income taxes when he and his wife die. I naturally offered to provide a second opinion with another life insurance proposal since he had only recently had a medical exam done, and the new coverage had not been approved yet. While he agreed to give me a shot at the business, the policy he had issued by me was not as competitive as the first policy he had issued, due to some medical issues, so I was unable to secure him that life insurance. However, he appreciated the planning model that I developed for him, and we stayed in touch.
A year later, in reviewing his file notes, I recalled that he had a rollover IRA with about $700,000 in it along with a nonqualified deferred annuity with about $200,000. The IRA was invested in a low-yield, near-cash allocation earning less than 1 percent, and the nonqualified annuity was in a guaranteed fixed annuity he had bought 15 years ago. He also shared with me that the reason for the IRA investment choice was because he planned on taking withdrawals from the IRA each year, about $70,000 a year, in order to pay the annual premium of the second-to-die life insurance policy, which was $52,000. The problem with this funding plan, as I saw it, was that the account the IRA was invested in was only yielding 1 percent, yet he was withdrawing almost 10 percent of the account, paying income taxes, in order to pay the premiums for the life insurance policy.
I figured that at that rate, the IRA would exhaust itself in about seven years. Of course, he had other assets to draw from once the IRA was exhausted, as well as a pension and Social Security benefits. Yet even so, I asked him what accounts he would then draw from after the IRA was spent or, if he died before his wife, which accounts might she use to continue to fund the life insurance premiums. Moreover, did he feel confident in his wife's ability to navigate their $9 million estate and insure that the policy premiums were always paid and on time as she got older? He said it would be up to her to decide from which funds she would draw from to pay the premiums, or possibly one of his four children might get involved in that process. But he really didn't have a plan.
Naturally, I suggested an alternative. I proposed a plan that would not only fund the policy premiums, but would also provide an annual income guarantee for their remaining lifetime regardless of who died first or where the funds might come from to pay premiums. I recommended that he invest the $700,000 IRA into an immediate income annuity with a 100 percent joint and survivor option and a 10-year period certain. I also recommended that he annuitize a $190,000 nonqualified annuity that he'd had for 15 years, also suggesting a 100 percent joint and survivor income for 10 years for period certain.
The two combined annuity incomes would then provide the guaranteed funding of the insurance premiums on an after-tax basis, and since the life insurance policy had a guaranteed fixed premium, it fit them both perfectly. He considered the loss of the principal were they both to die after 10 years, but he recognized that at the rate he was withdrawing from the IRA, he would soon exhaust it anyway. Even if he died before that could happen, he understood that his wife would still need to pay policy premiums for the rest of her life. This plan, as such, also assumed that the required minimum distribution would be satisfied as well. As you can see, an income annuity may be an excellent resource with which to guarantee the funding of life insurance in later years. The only way this might have worked out better for me is if I had been able to write the life insurance, but I was more than compensated for my efforts, and my client was very pleased.
Philosophically, I believe income annuities, when clearly explained and fairly priced, can provide value to your client in several ways if one is diligent in fact finding and the goal is to solve the client's problems. My caution to you is to be sure to have all the facts about the client and not try to sell a solution where there is no problem. We must be very clear about the merits of income annuities, and also when they are not appropriate.
Now, let's examine the third component of an integrated retirement plan, long-term care planning. My office began selling long-term care insurance in 1997 when many of my clients were getting to an age and a stage in life where they were dealing with their parents who needed varying degrees of physical and financial assistance and, in some cases, actual hands-on care.
At the time, I was referred by a client to her parents, a retired couple interested in buying long-term care insurance. I decided to bring in an established advisor, experienced in this market, to meet the couple. From that first sale, I understood the added value I could bring to my existing clients as well as the market potential given the demographics in the United States at the time. I made it a point to become proficient in this phase of retirement planning and have continued to do so since then. Today, our planning process always includes a discussion on asset protection and anticipating the risks of a health care event and how they can impact a retired couple's financial security.
Fast forward 20 years, and now we see the 77 million baby boomers who now, themselves, are prime prospects in this fast-growing area of risk planning.
Given these facts, I believe it's important that, as planners, we must have this often uncomfortable conversation given our responsibility to fulfill our duties as financial advisors. Yet, I sense many financial planners and investment advisors often overlook this key financial risk outright or they simply ignore it. Of course, I've also come to understand that not all clients appreciate the financial risk they take in ignoring the need for planning for a long-term illness during retirement.
Sometimes, even our best clients express a bias against the whole idea of nursing homes and the vision of them being incapable of caring for themselves, or they simply ignore it. This head-in-the-sand reaction is one that, truthfully, I have not been able to counter once clients declare their aversion to the whole idea of long-term care planning. I find it more productive to explore clients' personal experiences with their families to determine if they have any thoughts about such risk and whether or not they are open to learning more about protecting against this risk. Then, and only then, will I address this important aspect of retirement planning.
Let me explain how this particular facet of retirement planning is addressed. First, as I mentioned before, you need to explore the client's history with family members who they recall needed, or currently need, some level of assistance. It is critical to explore a client's position and experiences as part of your fact-finding process. I find that many prospects and clients have often had to deal with a relative who needed care. That, in many cases, is the primary motivation that drives people to discuss this risk and to actually secure some level of long-term coverage for their overall retirement strategy.
One point I emphasize is that the decision to buy long-term care coverage is not so much about the probability of needing care in the future, it's about the consequences of not having coverage if you do need it. In simple terms, it's not about the risk; it's about the consequences.
But be prepared for some unconvinced clients. Human nature often causes people to wish or hope for things to go away, especially if they include the emotional impact of being unable to perform the simplest of activities of daily living as we age. For this presentation, I want to presume you have a willing prospect who is interested in hedging this risk with conventional long-term care insurance. As many of you know, the most popular form of long-term care plans include a standard reimbursement arrangement, either with a daily or monthly benefit.
Today, there are also the newer, hybrid plans that offer long-term care benefits combined with either a single premium life insurance policy or a universal life policy. And yet, while the variety of products offered has increased, the number of US long-term care carriers has shrunk to about 14 companies.
Once you've decided on what plan fits your client the best, the funding of the premiums must be addressed, especially since in most cases, premiums will need to be paid for the rest of their lives. Since I work with several carriers that offer conventional reimbursement policies, I often use a retirement distribution model that assumes that at a future age, say 85, the family suffers a long-term care illness.
I offer one scenario that simply funds the cost of a hypothetical care event directly from the retirement assets as needed. I then provide a second scenario that assumes LTC benefits are available in lieu of the funding cost from the client's retirement assets or income and compare the two outcomes. Doing this, I am able to quantify the impact on the remaining retirement assets in both scenarios. For example, I will assume a monthly cost of services at $10,000 or $333 per day, lasting two and a half years.
Depending on what planning software you are using, I suspect most can demonstrate visually the considerable impact of such a loss on a family's retirement resources at that point. It is at this point often that clients voice concern about being able to afford the LTC premiums after they retire, which is actually a good indicator that they believe it is solving the problem. They just need to know that what they buy today is affordable to them throughout their retirement.
To address this, I offer a second retirement illustration that simply increases the client's stated retirement income goal by the annual premium required to provide the proposed long-term care coverage. Doing so, I'm able to demonstrate that the success rate of retirement is most often intact even with the added expense of paying long-term care premiums throughout the client's lifetime. How clients pay premiums is very important.
One effective way I found very appealing is to finance the LTC premiums with a Section 1035 exchange from either a whole life insurance policy or an annuity. As you know, it's now possible to surrender cash from both a life insurance policy and an annuity on a tax-free basis if those distributions are used to pay premiums for tax-qualified, long-term care insurance coverage. The requirements dictate that the long-term care insured also be the insured of the life insurance policy or the annuitant for the annuity. Depending on the specific carriers, some have established internal processes to accommodate this method. The appeal to most is having a seamless process for premium payments for the long-term care policy and by doing so, avoiding an income tax on distributions that otherwise would trigger a tax on part or all of the distributions from the policy.
The ability to access what would normally be taxable gains, to pay premiums for long-term care insurance, is really a strong selling point, I believe. Of course, it requires that your client had the foresight years ago to purchase life insurance or an annuity and that you had equal foresight to sell it to him or her.
When I speak to younger advisors, who oftentimes sell life insurance to their peers, I remind them that doing so today when their clients are young and healthy can possibly create a tax-efficient resource that they can access years in the future when it comes time for the advisors and their clients to add long-term care insurance to their program.
Another strategy to be aware of is using surrendered life insurance policy dividends to pay long-term care insurance premiums. This method is useful if the life insurance policy is on the life of one spouse, yet we'd like to use dividends on his policy to pay LTC premiums on the other spouse. And until the total value of dividends surrendered exceeds basis, the dividends are not taxable.
In several situations last year, I was able to fund long-term care premiums for a husband and wife from one life insurance policy using a combination of a 1035 distribution for one insured and surrendered dividends for the other, noninsured spouse. I believe it is our responsibility to not only address the financial risk clients are exposed to from a long-term care, health care event, but we also need to provide creative and sustainable ways to fund the LTC premiums not only now but throughout their retirement and minimize the impact on their retirement living expenses.
So far, we have seen life insurance, annuities, and long-term care coverage, when part of a retirement plan can complement another part by providing a funding mechanism from one plan to the other or by providing an integrated hedge for the risk most retirees will face throughout their retirement.
Now I'd like to talk about an important topic that most retirees seem to focus on most about their planning, which is how they expect to manage their portfolios and succeed in living a comfortable retirement. As we all know, managing a portfolio involves risk, timing, and all too often, emotion. These are all important elements that we, as advisors, must understand before we can provide the guidance necessary to help our clients.
I'm sure some of you often meet new clients in situations where, after having spent time analyzing the client's goals, risk tolerance, and feelings about money, you discover that the client's portfolio allocation is completely inappropriate and counter to their expectations or stated sense of risk tolerance. I believe this happens often when the client fails to engage with an advisor and/or when the market is on the upswing and a client chooses to "run with the bulls" until there is a correction. But until then, many feel that they have a hot hand and cannot lose. Until they do. And then retreat ultimately into cash. We've seen this all too often with our clients or prospects.
In the end, they ultimately buy a loss when they shift out of a portfolio into a place of safety and fail to regroup by the time the market comes back. Unfortunately, we, as advisors, have to acknowledge these all-too-basic human traits: greed and fear.
In putting together a comprehensive plan that includes the three aforementioned risk areas, helping our clients understand basic concepts of investing within their complete retirement matrix is really our task. One of the first things we need to secure from our clients is an agreement that we keep open channels of communication and accept that both parties trust each other. This means telling clients that we cannot predict performance, but we can guide them to be patient and provide continuous support and a sounding board when things get rough in the financial markets.
One way I do this is to use two different visuals as a way for clients to understand what my role is relative to managing their assets. I explain that if the clients agree to have me manage their portfolio, then they should think of me as their pilot on a flight that they are taking across the country. My job is to get them from JFK in New York to LA safely. I remind them that along the way, we're going to experience turbulence, but that as long as they stay seated with their seatbelts fastened, we'll get to Los Angeles and in one piece.
I used a second visual with a very conservative client about the benefits of equities in a portfolio. I asked her to visualize a man on an elevator going up while playing with a yo-yo. As he slowly ascends, even though the yo-yo is continually going up and down, the man is slowly continuously going up. It's very similar to the long-term history of the US stock market. Most people, when they can visualize these two examples, understand risk and reward better.
These days, many people are focused on saving a certain amount of money by a certain age, but they don't really understand what they're going to do with the money once they retire. What do I spend? Which account do I go to? One analogy I like is that this problem is like climbing Mt. Everest. Most climbers spend years preparing for the challenge, but even when they finally reach the summit, the challenge isn't over. They still have to get down. Did you know that 80 percent of the accidents on Mount Everest happen on the way down? This is often because climbers focus so much on getting to the top, but not on getting down.
So when it comes to investing, conventional wisdom suggests that all one has to do is withdraw only 4 percent a year from savings and, assuming a return of 4 percent or more, not really worry about running out of money during retirement. Not today. Market uncertainty, human emotions of greed or fear, and unexpected changes in one's health care costs all contribute to challenge that wisdom.
I believe that unless we help our clients build a retirement plan that integrates planning for dying too soon, living too long, or becoming physically dependent on others, we are not doing the best job for them.
During the time that I've been in business, I've found that most people want to know their advisor is there for them and that he or she has their best interests in mind and that of the client's family as the basis for their recommendations.
So I ask you, does your office provide good service, and is your team willing to assist a client when a problem arises? Do you take the time to consider the real risk that your clients bear beyond just market volatility and a suitable asset allocation?
I don't believe it's as much about the fees the clients pay or their accounts' performance (within reason). It's about addressing their fears, their concerns, and encouraging them to address these all-too-human risks.
Let me close with another visual that I've shared with my clients over the years. I can't remember when I first heard this from someone, probably at an MDRT meeting, but it really resonated with me. I ask clients to picture themself in the middle of the Sahara Desert at noon, 20 years from today. I ask, "If that happened, what two things would you want to have then?" Sometimes they know. Sometimes they guess. I tell them the answer is, "You want shade and water." I explain that the plan we build today is for the future like a palm tree. For a future they may not fully appreciate today. And some of the reasons I recommend things today are because, in the future, their needs will change, and they may need that shade.
Buying life insurance as a young adult protects a family from an immediate financial loss. Yet owning it as a retiree may eventually provide considerable value for things that weren't apparent when initially purchased. Investing in annuities prior to retirement can provide a hedge against portfolio volatility as well as providing income security long after one retires. And LTC insurance, if purchased at a reasonable age, usually before one has any expectation of needing it, is really the best time to get it since health declines eventually happen to many soon after retirement.
These are all palm trees that we're planting for a time when our clients retire, and they need that "shade" to protect them. Which is why you have to help them plant these "trees" and do those important things, so that they don't find themselves feeling the heat of the sun without any shade at noon, in the middle of the Sahara Desert.
Michael J. McNeil, CLU, ChFC, is a 39-year MDRT member with 10 Court of the Table and two Top of the Table honors from Fairfield, Connecticut. A wealth management advisor with a general practice involving both risk-based planning and investment management, he focuses on retirement and estate planning for professionals and family businesses.