Life Insurance: A Retirement Plan?

Life insurance is a tool that can protect your family and loved ones after you die. But is it necessary during retirement? Deciding whether to retain a life insurance policy after retirement depends on your family and financial circumstances. While it's not mandatory, there are several reasons to keep a policy. For instance, if you have a child or relative with special needs who is financially dependent on you, it may be wise to keep your policy. Similarly, if your spouse's retirement income will significantly drop when you die, you may want to keep your policy to help make up the difference. On the other hand, if you have adult children who are financially independent and you have sufficient resources to cover retirement costs, the need for ongoing life insurance may be minimal.

Pension replacement

While life insurance and pensions are meant for different purposes, there are some financial instruments in the market that combine the benefits of both in a single product.

Some older workplace pension schemes were set up to include life insurance. If you have a workplace pension that includes life insurance, the insurance pays out either a lump sum or regular payments on your death, providing your dependants with financial support. The amount paid out depends on the level of cover you buy, and you decide how it's paid out and what it will cover.

You can also buy life insurance through some qualified retirement plans, like a 401(k) or a pension. This can be beneficial as you can pay for the coverage using pre-tax dollars, saving you money on taxes. However, these plans tend to be complex and must follow strict rules for managing the life insurance policy.

If you've been paying into a defined contribution pension over the years, your loved ones can usually inherit your retirement savings when you die, so you might decide you don't need life insurance too. Depending on your age at death, your pension may pass to them tax-free and it won't be subject to Inheritance Tax. However, if you've used your pension to buy an annuity, your retirement income will usually stop when you die and cannot be passed on to your dependants.

When deciding between a pension plan with insurance and a pure pension plan, it's important to consider your financial situation, retirement goals, and the need for life insurance coverage. If you already have sufficient life insurance coverage and are more focused on growing your retirement fund, a pure pension plan might be more suitable.

Estate planning

Life insurance can be used as an estate planning tool, especially if you have a large estate valued at over $12.92 million (2023 figure). If you own a large business that you want to keep in the family, the proceeds from a life insurance policy can be used by your heirs to pay estate taxes when you die. This way, they won't have to sell assets at an inopportune time.

A life insurance death benefit can also be used to equalize gifts among heirs. For example, if you want to leave your stock portfolio to one child and your house to another, you could use the life insurance death benefit to balance out the value of those gifts for a third child.

If you have a large estate, it is recommended that you consult an estate-planning expert or a fee-only financial advisor to help you weigh the pros and cons of your options.

Protection against stock market downturns

Life insurance policies can be used as a tool to protect your portfolio from stock market downturns. Permanent life insurance policies, such as whole life insurance, have a cash value component that can be used as an investment vehicle. While it is not usually recommended to use life insurance as an investment tool due to minimal returns, it can provide some protection against stock market volatility.

The cash value of a permanent life insurance policy is subject to market forces and can be affected by inflation, recession, and other economic factors. Traditional cash value policies, like whole life insurance, offer a fixed interest rate set when purchasing the policy, shielding your policy from market volatility. Indexed universal life insurance and variable universal life insurance policies are more volatile, as their cash value growth is associated with stock market performance.

Indexed universal life insurance (IUL) offers a unique way to achieve market-linked growth while minimising the stress of timing your investments. IULs provide downside protection, with a built-in floor (usually 0%) to safeguard your money from market crashes. They also offer market-linked growth, allowing you to track a stock market index like the S&P 500 and benefit from market gains. Additionally, by making regular premium payments, you can utilise dollar-cost averaging, buying at different market levels and smoothing out volatility over time.

IULs also have the advantage of annual resets. When the market dips, your existing investments remain safe, and when the market rebounds, all your invested money, including contributions made during the dip, benefits from the growth. This feature ensures that your accumulated wealth is protected during market downturns, allowing you to focus on building your financial future without constantly worrying about market movements.

It is important to note that life insurance policies with a cash value component may have fees that erode returns, and in some cases, the fees may exceed the interest credited, leading to a decline in cash value over time. Therefore, it is crucial to understand the fee structure before investing.

In summary, while life insurance policies, especially IULs, can provide some protection against stock market downturns, they should not be solely relied upon for investment purposes. Diversification across multiple asset classes and seeking advice from financial advisors are recommended strategies to shield your portfolio from severe market downturns.

Covering unexpected expenses

Life insurance can be used to cover unexpected expenses during retirement. A cash value policy could help you pay for unexpected costs either by withdrawing some of the cash value or by taking out a loan against the policy. However, doing this will reduce the death benefit.

Some people opt for a small life insurance policy to cover funeral expenses, as insurance benefits are usually available to heirs immediately. This is known as funeral insurance or burial insurance. It is affordable, easy to qualify for, and permanent.

If you have a large estate (over $12.92 million in 2023), life insurance can be used as an estate planning tool. The death benefit can be used to pay estate taxes instead of selling assets.

If you have a pension, you might need life insurance if your spouse or another dependent cannot receive your pension after your death.

Life insurance can also be used to distribute assets equally among heirs. For example, if you want to leave your stock portfolio to one child and your house to another, you could use the life insurance death benefit to equalize those gifts for a third child.

However, if you don't have life insurance in place as you approach retirement, the high premiums may make it an unattractive option. Life insurance companies charge higher premiums the older you are, and premiums in your 60s can be very expensive. You may be better off investing the money you would have spent on premiums.

Distributing assets among heirs

Life insurance can be used to distribute assets among heirs, and there are various ways to do this.

Firstly, you can create an estate plan that benefits your heirs. This can be done by writing a will, selecting beneficiary designations, and creating a trust. A will is a legal document that directs how your property will be distributed upon your death. If you die without a will, a court will distribute your assets according to the laws of your state, which may not align with your wishes. Trusts fall into two categories: revocable and irrevocable. A revocable trust allows you to maintain control over your assets during your lifetime, while an irrevocable trust has terms that generally cannot be altered once created.

Another option is to leave assets outright to your heirs with no restrictions on how they access their inheritance. This approach is straightforward but may have drawbacks, especially for heirs who are inexperienced at managing large sums of money. Alternatively, you can distribute assets in stages, providing heirs with access to a certain percentage of their inheritance at specific ages or upon achieving certain milestones. This allows them to manage their wealth without putting the entire inheritance at risk at once.

You can also leave assets in a discretionary lifetime trust, which offers the highest level of protection from outside risks such as divorces, lawsuits, and poor money management. This approach allows you to create a lasting legacy for future generations, as the assets are maintained in a trust for the entire lifetime of the heirs.

Additionally, you may consider combining distribution strategies. For example, you can provide heirs with full access to a certain amount of money upfront while leaving the remaining balance in a trust. This gives them financial support while pursuing their ambitions without being wholly dependent on the trust.

Frequently asked questions