In a conversation recently I got the following question; “Do I need life insurance after I retire from Virginia Tech?” Now, this question is not specific to just Virginia Tech employees. Anyone who is within 10 years of retirement should be thinking about this.
My response, as is often the case, was “It depends”.
Purposes of life insurance
There are a number of reasons someone would have life insurance during their later years. Some people use it to ensure an inheritance for their heirs or gift to a favorite charity. Others with a family business use insurance to make equitable bequests to the children who are not involved; allowing the business to stay intact and with the children who are managing it.
For those who expect their estate to be large enough to exceed the exemption, life insurance is commonly used to reduce or eliminate estate taxes. And a few even use it as an alternative asset in their investment portfolios.
However, like most people, the purpose of life insurance for this client was to replace their income should they die prematurely.
Retirees still have income
Just because a person has stopped working in their primary career doesn’t mean they aren’t generating an income stream. And if there’s a spouse or other person counting on that income, losing it prematurely could have a significant financial impact. Here are a few of the more common cash flows for retirees that may be reduced or stop entirely when they pass away.
- Social Security
- Freelance consulting work or a part-time job
Pensions and annuities
Depending on the payout option the retiree chose, a pension or annuity may pay a reduced spousal benefit or stop paying out entirely at their death.
For married couples who are both collecting Social Security; once one spouse dies, their benefit goes away. If it was the spouse receiving the larger check, the surviving spouse’s benefit will be bumped up to equal that of their deceased spouse’s. In any event, the surviving spouse only receives the larger of the 2 monthly checks.
Don’t forget unpaid work
In addition to any income from part-time work, there could also be work the retiree does that would have to be hired out if they weren’t around. For example, if they own rental property and do some of the upkeep, find tenants and collect rents, they’re essentially acting as a management company.
So even in retirement, the question of whether to have life insurance is the same as when they were working. Would the retiree’s loved ones be able to meet their financial goals if something happened?
The savings gap
There usually comes a time where there is enough savings to cover the family’s financial goals even if one of the spouses dies prematurely. The conventional wisdom is this point would be sometime before retirement.
In the past this normally was the case. By the time retirement came into the picture, the largest expenses were in the rear view. The children had graduated college and were on their own. The mortgage was paid off. The reduction in expenses allowed more to be saved for retirement.
Times have changed. Now, both spouses may have career aspirations and delay starting families, pushing college expenses out later. More adult children are taking longer to become financially self-sufficient. Job relocations mean buying a new house and resetting the mortgage clock. Adult parents are living longer and may require direct or indirect financial support.
These and other reasons along with “lifestyle creep” can reduce retirement savings. The result is that during retirement many people have become more reliant on both spouses retirement income streams to help bridge the gap. And should one spouse die unexpectedly, having life insurance during that first period of retirement can help fill the gap.
Is there a gap?
To determine whether some life insurance should be kept in retirement for income replacement, you first have to find out if there is a savings gap. While financial planners have sophisticated software to accurately make this determination, there are some back of the envelope methods that can be used to get an idea. The most common is the 4% rule, originally published by Bill Bengen in 1994 and validated many times since then.
The 4% rule
Simply stated, the 4% rule means that a portfolio of 60% stocks and 40% bonds should last at least 30 years when no more than 4% of the initial portfolio value is withdrawn each year, adjusted for inflation.
For example, with a $1M portfolio, $40,000 could be withdrawn the first year. Assuming 3% inflation, $41,200 would be taken the next year, $42,436 the third year and so on.
Another way to phrase this; 4% is a safe initial withdrawal rate (SWR) when looking at a 30 year time horizon. With shorter time horizons, higher SWR’s may be used. For 20 year horizons, a 5% SWR has been shown to be adequate.
Don’t think 30 years is too long to assume you’ll need your savings to last. If you both are alive at age 65, there is almost a 50% chance that at least one of you will live to 90 or longer. (Source: SSA.gov, Society of Actuaries)
Determining the savings gap
To see if there’s a gap, add up all the income streams expected in retirement. Pensions, social security benefits, part-time work, and the SWR from the investments. This total should be at least the amount of income needed in retirement.
Now, take away income contributed by the higher earning spouse. Could the surviving spouse continue with their expected lifestyle without exceeding the SWR?
Keep in mind that usually household expenses go down after the first spouse passes. That’s not guaranteed however. I’ve seen cases where the surviving spouse decides to travel more, become more generous with the grandkids, etc.
If the remaining retirement income plus the safe withdrawal rate from the investments will still be enough to cover the surviving spouse’s financial needs, then life insurance probably isn’t needed.
However, if there is a shortfall, a potential solution would be to carry some life insurance during the beginning retirement years to help bridge that gap.
Back to our retiring Virginia Tech professor and her husband. Let’s call them Jill and Jack. They are both 67 and just recently retired. Jill was eligible for a pension and chose the 50% joint and survivor option. This means that if she dies before Jack, he would continue to get half of the original pension amount for the rest of his life.
Jack worked as well during his career and so they are both eligible for social security. Between them they have saved $700,000 in their respective retirement plans (403b & 401k). They still owe $100,000 on their mortgage. Payments are $1,500 per month and it will be paid off in 7 years.
Jill and Jack determined they need $126,000 per year until the mortgage is paid off. Then their income need drops to $108,000, adjusted for inflation.
Calculating their financial gap
First we’ll see if they have a financial gap in the baseline scenario of them enjoying a long retirement together.
Their retirement income streams:
- Pension – $58,000 (Jill). $29,000 to Jack if she dies first.
- Social Security – $25,000 (Jill), $27,000 (Jack)
- Safe withdrawal rate from investments – $28,000 (4% of $700K)
So their total retirement income is $110,000. Add in their safe withdrawal rate from investments and they have more than enough to cover their needs.
What if Jill dies early?
However, if Jill were to die prematurely, the pension payout is cut by 50% and her Social Security ends. The retirement income left for Jack including a safe withdrawal from the investments would now be $84,000 ($29K + $27K + $28K). They decide that for Jack to continue his accustomed lifestyle, he would still need $90,000 per year after the mortgage is paid off.
Using life insurance to fill the gap
The worst case scenario would be if Jill died shortly after retiring. In that case, Jack would owe $100,000 on the house and still be short $6,000 per year in other income.
If they decided to use life insurance to account for that risk, a total of $250,000 would be needed on Jill’s life. $100K to pay off the mortgage and $150K to generate the additional $6,000 per year needed to get Jack to $90K in annual income ($150,000 X 4% = $6,000).
Since Jill gets to keep $50,000 in life insurance as part of her Virginia Retirement System (VRS) benefit, she would need $200,000 in additional insurance.
What type of life insurance?
In this case, a 10 year term policy would probably be sufficient. With each additional year that passes, the financial gap should become smaller, especially during the first 7 years as the mortgage balance continues to drop.
After the mortgage is paid off, only $100,000 in additional life insurance would be needed for Jill (total need is $150K but she already has $50K).
At this point they should reassess. If their income needs in retirement haven’t been as much as originally expected or their investments have even had just average performance, the financial gap may have been filled. Jill would then have the option to drop the policy early if she preferred.
This example is fairly typical of what I come across. If the gap is not too large, it normally closes naturally over time as both spouses continue to receive their respective retirement income streams. In that case a term policy may be all that’s needed.
If the gap is much larger or a very large portion of retirement income would be lost should one spouse die prematurely, then a permanent policy or some combination of term and permanent should be considered.
It’s usually best not to wait until the verge of retirement to determine if life insurance will be needed after you quit working. As we get older, unexpected health issues can pop up, making insurance more expensive or even impossible to get. Even if you’re healthy, a few extra years of age alone can quickly push the price up.
If you have a financial advisor, they should be able to help you determine if you’ll need to carry some life insurance into retirement. If you don’t, the process I’ve outlined should give you a pretty good idea of whether you’ll need to consider it.