Whole life insurance can be a great option as a complementary asset for retirement planning. But there are good and bad options, so we'll walk you through what makes whole life insurance worthwhile for retirement planning.
The main reasons to use whole life insurance as a means to prepare for retirement are:
Whole life insurance offers superlative principal protection. The cash value is guaranteed to increase year-over-year and this means you'll never have to worry about losing money because of a market correction or some other catastrophic economic condition. What's more, whole life insurance policies come from some of the strongest, best capitalized, and most profitable life insurance companies within the insurance industry. These companies have a culture of prudent asset management and operate in an industry with numerous oversights that keep your money safe.
Whole life insurance benefits from numerous tax favorable features. This greatly augments the net return you achieve on the cash value of your whole life insurance policy. The tax-deferred or free nature of life insurance values provides several strategic benefits that are difficult, if not impossible, to achieve with other savings and investment options.
Lastly, diversification is a prudent measure to avoid catastrophic economic downturns. But most investments available for retirement preparation are rather tightly correlated with one another. This means it's difficult to find options that don't tend to move in the same direction as one another. For example, as the stock market declines, the real-estate and bond market often tends to decline with them.
This leaves a lot of people in a tough situation as they try to find some option that removes the risk of loss from their portfolio. Whole life insurance can be a great shock absorber in uncertain economic times because of its stellar principle protection aspects.
This makes it a prime option to use as a way to diversify again economic losses when markets turn bad. It can be especially important to retirees who are vulnerable to additional losses during market declines.
When Should you Start your Whole Life Retirement Plan?
Just like any other investment or savings plan, sooner is always better. The sooner you begin a whole life policy you intend to use for retirement, the better your results. Compounding cash values over time is the surest way to extract the most amount of benefit out of a whole life insurance policy.
Let's look at an example to help understand this.
Kyle is a 35-year-old male who plans to put $10,000 per year into his whole life plan he'll use for retirement. A whole life policy designed for cash accumulation shows a balance of $716,000 at age 65 when he plans to retire.
If Kyle waits just five years to start his plan he'll need to increase the amount he pays to the policy by about $4,500 in order to arrive at the same account balance at 65. That means Kyle lost $62,500 over his lifetime simply because he waited to start his plan a little earlier.
When it comes to retirement planning, time is not your friend. Whole life insurance will lose the benefit of compounding and become more expensive the longer you wait.
How Does the Whole Life Policy Work During Retirement?
There are a number of different ways you can use your whole life policy during retirement, but most people who buy whole life to help prepare them for retirement intend to use it for retirement income.
Using whole life insurance in this fashion once retired means that the policy owner will begin taking money from the policy either as a withdrawal of cash or loan from the policy. Most people drawn to whole life insurance for this purpose like the stability and tax-free aspect of the income whole life can provide.
Using the example with Kyle above, he should be able to begin an income from his whole life policy at retirement of about $35,500. That income is entirely tax-free and it also doesn't count as provision income. This means Kyle doesn't have to worry about the income from his whole life policy causing his social security income to become taxable. This $35,500 income has an extremely high likelihood of lasting Kyle's entire lifetime.
What's more, Kyle doesn't need to worry about how dramatic economic conditions impact his whole life policy. Unlike investments in the stock market (or even the bond market) Kyle's whole life cash balance won't decline due to some sell-off or troubling economic data. In fact, it will increase by its guaranteed accumulation amount and most likely continue to earn a dividend further increasing his cash balance. This makes Kyle's income from the whole life policy incredibly stable and significantly reduces the chances he runs out of money too early.
Isn't the Rate of Return on Whole Life Insurance Too Low?
Whole life detractors like to suggest that whole life insurance generates returns far too low for a retirement planning strategy. Instead, you need to put all of your portfolio at risk with supposed higher-yielding and riskier bets like stocks. A lot of the justification for this comes from fanciful projections on what stock market investments will ultimately produce for returns–the majority of which no one has any empirical data to support.
First, I want you to understand that we absolutely believe that the long term rate of return on stocks will be higher than whole life insurance. We live in a very irrational world if this isn't the case. But just because stocks might beat out whole life insurance, doesn't mean you should go all-in on stocks and avoid whole life insurance.
The difference in terms of rate of return may not be as dramatic as others led you to believe. But more importantly than that, whole life insurance is a rock-solid safety play that complements a healthy stock market investment because whole life doesn't lose value during recessions, depression, etc. This means you'll have a spectacular plan B no matter what stage in your life we have an economic boom or bust.
This all being said, what sort of return can you expect from whole life insurance?
Looking at Kyle in our above example, his projected rate of return by retirement age is a little over 5% compounding year-over-year. His overall return on value by his life expectancy is roughly 6% compounding year-over-year. This is a gross figure. If we account for the fact that Kyle will pay no taxes on his distributions and his heirs will pay no income taxes on the death benefit paid upon Kyle's death, we can likely bump these figures up by 1 to 1.5%.
A 5 to 7.5% net effective rate of return is a pretty healthy result even by stock market standards.
Is it too Late to Buy Whole Life if you are already Retired?
If you're planning to use the cash value in whole life insurance for retirement income, it may be too late to purchase whole life insurance if you are already retired. Unfortunately, you won't have the benefit of compounding accumulated cash values over many years, and this might make the results too poor when compared to other options.
There may be other ways to use whole life insurance if you are already retired. This mostly falls in a category where you intend to let the death benefit augment savings you will pass on after death.
Also, if you happen to have assets that make you subject to estate taxes, whole life insurance is one of the tools often used to provide the needed liquidity to pay these taxes.
A quick note on the term investment. Certain U.S. regulatory bodies don't like it when insurance agents and/or financial advisors use the term investment and life insurance together. We used it in this blog post in the colloquial sense because we know most people do not think in terms of the vernacular laid out by the insurance and investment industries' regulator bodies. Usually, investments involve risk of loss. As a result of this, whole life insurance doesn't meet the definition of investment. That said, you absolutely can buy whole life insurance with the intention of accumulating cash values to use at a later date.