Beyond the 401(k): New Research Shows Why You Need More Than One Source of Retirement Income

By the Northwestern Mutual Life Insurance Company

Worried about running out of money in retirement? Two-thirds of Americans believe there is some chance that they will outlive their savings, according to a 2016 Northwestern Mutual study. But new research shows you can replace some of that uncertainty with a greater level of confidence when you think beyond investing in your 401(k) and add to it a mix of other retirement assets.

The research, conducted by Dr. Michael Finke, American College dean and chief academic officer, used statistical analysis to simulate the financial experiences of thousands of hypothetical retirees. In each simulation, Dr. Finke assumed the persons retired at age 65 with $2 million in taxable and non-taxable retirement assets and withdrew 4 percent of their assets.¹ Each subsequent year, the withdrawal amount increases with the rate of inflation.

Here’s what he found:

  • Retirees with only investments had a 29 percent chance of outliving their assets.
  • Cash value from permanent life insurance² can provide tax-efficient income in retirement. In contrast to a dollar in bond investments, having an equal amount in life insurance cash value reduces the likelihood of a retirement income shortfall to 21 percent.³
  • Adding a Portfolio Deferred Income Annuity4 to the mix reduces the risk of a shortfall even further—to 16 percent.5

What’s behind the numbers?

The research, “The Value of an Integrated Retirement Income Approach,” showed that retirees with an investments-only approach were much more vulnerable to running out of money as they age. In simulations in which the market was down during the early years of retirement, retirees depleted their assets faster than planned.

“Those returns you get in the very first 10 years of retirement are more important than the returns that you get in the subsequent 20 years of retirement in determining whether or not your portfolio is going to be able to fund that income goal over a 30-year time horizon,” said Finke.

The cash value of permanent life insurance grows over time and gives the retiree the option to withdraw income if investments are spent down over time. A deferred income annuity can help provide a steady paycheck that continues as long as a retiree is alive. Buying an income annuity protects against another risk: longevity. With today’s increased life expectancy, retirees need to be prepared to fund a retirement that may last for 30 or more years.

That’s where income annuities shine.

Annuities offset the risk of living a long time. An income annuity is much like a personal pension. The annuity becomes a steady stream of income that can be guaranteed for life.

While receiving an annuity “paycheck” reduces the risk of running out of money late in life, many investors hesitate to buy an annuity because once the purchaser dies, the payments typically end. Some fear they won’t live long enough to receive a significant benefit or worry there won’t be assets to pass to their heirs.

That’s where permanent life insurance shines.

Life insurance offsets the risk of dying too soon. If a retiree is covered by permanent life insurance, the death benefit paid to his or her beneficiaries is likely to be more significant if the insured dies early in retirement. That’s because the cash value of permanent life insurance is often tapped to supplement retirement income if a retiree lives long into retirement. So, if the retiree dies early, he or she wouldn’t necessarily have had time to spend down the cash value or, in other words, reduce the death benefit. That means beneficiaries would be more likely to receive a significant payout from the life insurance policy.

Regardless of how long a retiree lives, the three income sources—life insurance, income annuities and investments—combine to create a powerful retirement income strategy. With the steady income of an annuity as a base, the research shows that the retiree could slow the pace of withdrawals from life insurance cash value and from investments to stretch his or her retirement dollars even further.

The strategy of integrating a mix of income sources delivers two added benefits, according to the research. First, it results in more money passing to the next generation than an investments-only approach. By the time a retiree reaches his or her early 90s, the research shows, the legacy—the amount of money available to beneficiaries—is significantly higher with a mix of income sources, compared to an investments-only approach. And second, the confidence that comes from a three-pronged approach contributes to happiness in retirement.

Get more insights like this at Northwestern Mutual Insights & Ideas.

“Our research shows people are the happiest when they know how much they can safely spend, month after month, for life,” said Finke.

1All the individuals retire on their 65th birthday and will experience a simulated random lifetime with a distribution based on the 2012 annuity mortality tables.

2Permanent life insurance is defined as whole life policies that offer guaranteed level premiums, guaranteed death benefit and guaranteed cash value. Whole life policies also offer nonguaranteed dividends, which can be used to increase the death benefit, increase the cash value and/or reduce premiums.

3If policy performs at guaranteed level, the likelihood of a retirement income shortfall increases to 35%.

4Refers to Select Portfolio Deferred Income Annuity, which provides guaranteed income that lasts as long as the annuitant lives and can increase through potential dividends (dividends are not guaranteed). It does not refer to a deferred annuity (fixed and variable) that has a withdraw-able cash value.

5If policy performs at guaranteed level, the likelihood of a retirement income shortfall increases to 31%.

The Portfolio Deferred Income Annuity (PDIA) has no cash value. Once issued, it cannot be terminated (surrendered), and the original premium paid for the annuity is not refundable and cannot be withdrawn. In addition, it is not possible to exchange the PDIA for another annuity except as permitted under the Exchange Option Amendment, which is included on certain annuities purchased with non-tax-qualified funds. Distributions taken from a PDIA may be subject to ordinary income tax. A 10% federal tax penalty may apply if any type of distribution is taken from the contract before age 59 ½. All guarantees associated with annuities and income plans are backed solely by the claims-paying ability of the issuer.

Each method of utilizing your policy’s cash value has advantages and disadvantages and is subject to different tax consequences. Surrenders of, withdrawals from and loans against a policy will reduce the policy’s cash surrender value and death benefit and may also affect any dividends paid on the policy. As a general rule, surrenders and withdrawals are taxable only to the extent they exceed the cost basis of the policy, while loans are not taxable when taken. If the policy is also a Modified Endowment Contract (MEC), distributions are treated first as distributions of gain and subject to ordinary income taxation and possibly subject to an additional 10% penalty tax if the owner is under age 59½. Loans on an MEC, including capitalized loan interest, are treated as distributions at the time they are taken and taxed as described above. Policy loans and automatic premium loans, including any accrued interest, must be repaid in cash or from policy values upon policy termination or the death of the insured. Loans taken against a life insurance policy can have adverse effects if not managed properly. Before taking a policy loan, the policy owner should consult with his or her financial advisor, as there may be other ways to meet a financial need that are more appropriate under the circumstances.

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