The Finance of Longevity

Creating A Span of Security

Even the most sound retirement income plans encounter unforeseen financial risk

by Michael J. McNeil, CLU, ChFC, CASL

Mr. McNeil is a wealth management advisor with Northwestern Mutual. He has been an MDRT member for 39 years and has nine Court of the Table and two Top of the Table qualifications, and also serves as a trustee for the Million Dollar Round Table Foundation.

A secure retirement strategy is a goal most of our clients work towards throughout their professional lives. Regardless of how meticulously we plan for our clients over the decades, there are risks and events that threaten to destabilize their livelihoods and retirement income.

These risks can emerge before or during retirement without our clients becoming aware of them with considerable consequences for them and their families.

A recent study conducted by the Million Dollar Round Table (MDRT) revealed that a majority of Americans who appear to be financially successful at first glance are not prepared for these common financial risks. Many of these households could be devastated with one unforeseen financial or personal emergency.

The study found many participants’ financial plans fragile in the face of income loss and unexpected financial obligation. Only about half could survive for three months or less if they lost their primary income source. Eighty percent were unprepared for a short of long-term disability; less than 39 percent of those with disability insurance believe they have sufficient resources to pay for long term care and medical expenses. To make my clients aware of these facts, I find that using illustrations and hypothetical scenarios to be helpful tools with which to demonstrate how these common risks might affect a family’s financial plan. It is these kinds of risks and others that I believe must be addressed in the planning process when designing a secure retirement income strategy for our clients.

Risk factors in the planning sessions

A risk-based planning strategy in tandem with appropriate portfolio management, I believe, is necessary to produce a secure retirement income plan. The single most potent threat to an otherwise secure retirement is an unplanned or uncontrollable financial obligation or significant health event that results in an accelerated distribution from a retiree’s assets. Such emergencies can prevent clients from making contributions to or withdrawals from their retirement accounts and in severe cases, even trigger taxable distributions.

It is critical that we as advisors assist our clients in developing a big-picture view of their own plans and how these risks might destabilize their plan. Addressing these risks will allow the advisor to help clients understand how their financial position might be impacted by the strain of an unforeseen financial or medical event, and demonstrate to them the importance of planning for a more predictable outcome. To do this, we should focus on three primary categories of retirement risk: financial, health and something I refer to as family risk.

Financial Risk

Risk factors like investment performance, sequence of returns and market timing are often outside of an advisor’s actual control yet they often can have the most significant impact on a portfolio’s performance and soundness. Rather than ceding a client’s investments and or behavior to such unpredictability, in particular, during the first few years of retirement, the optimal solution is to create a diversified portfolio.

Assets that are invested in a well-managed and diversified portfolio for income and growth coupled with the added hedge provided by a guaranteed income source such as guaranteed income annuity, have proven to offer a more stable retirement outcome than had the retiree simply try to base his or her income on the performance of their portfolio.

On this point, I suspect I’m preaching to the choir. I still feel it important to mention to the reader that what some refer to as a holistic strategy, can provide a retiree significant peace of mind and predictability. In fact, the more a retiree can rely on a guaranteed income source to cover basic lifestyle expenses, the more he or she will enjoy a more predictable outcome and the quality of their retirement. It also allows the retiree be free to use dividends from investments or additional account withdrawals for leisure activities like travel and/or spoiling grandchildren.

For many though, the greatest barrier to a comfortable retirement is the simple lack of a retirement savings plan which, unfortunately, is the case for many Americans. Only about half of the respondents (45 percent) to an MDRT survey currently indicated that they have a retirement savings plan or fund, and of those, 23 percent contribute to it less than once a year. Clients will have already won half the battle if they’re able to at least articulate and put in place a formal plan.

Health Risk

In the years prior to and throughout retirement, health issues are major influencers of financial wellbeing and security. After a person retires, the risk of an illness or disease significantly increases, along with potentially significant medical expenses and often chronic care.

Health events can severely limit the prospects for a comfortable retirement since, if the illness occurs prior to retirement, the person may be unable to save as much as he or she had hoped to. This in turn can impact the outcome for a couple who had hoped to have save enough between them and provide to provide a certain lifestyle income.

Married couples who expect to combine retirement resources should consider these health risks and their implications. The premature death of a partner prior to retirement, for example, can often impact the survivor since often the couple might have expected to have more years for them both to save and invest.

Another problem is that a premature death of one of them often halves Social Security retirement benefits that the couple anticipated sharing during retirement. Similarly, an illness or disability that forces an early exit from the workforce can deplete retirement accounts especially if long-term care is needed because of the illness and there was no long term care insurance available. The sick or disabled will most likely receive Social Security benefits but not financially prepared for certain unexpected out of pocket medical costs. Those costs may be financially debilitating even if the injured was a high wage-earner and insured by a disability income policy.

The most efficient way to minimize health risk is to get ahead of the problem before it develops. Long term care insurance products today can be an effective solution to minimize what could be a significant financial strain. It is also a fact that the cost of long term care insurance is lower when purchased before retirement and any medical conditions become apparent. Clients generally qualify for more coverage at a lower premium when they’re younger and healthier rather than after retirement when they’re more likely to actually need the coverage and not able to buy coverage due to compromised health.

One effective way to finance long-term care insurance premiums is with a Section 1035 exchange from either a whole life insurance policy or an annuity. Following the introduction of the Pension Protection Act of 2006, it is now possible to surrender cash from either a permanent life insurance policy or an annuity on a tax-free basis if those distributions are used to pay premiums for tax-qualified, long-term care insurance.

The requirements dictate that the long-term care policy and the life insurance policy or the annuity be on the same insured. To accommodate this, some carriers have established internal processes to accommodate this option almost seamlessly. The appeal to most clients who use this 1035 option is twofold. It provides a resource with which to pay premiums for the long-term care policy without incurring income taxes on what most often would be a taxable distribution and it provides an almost a seamless process for maintaining both the life insurance or annuity policy and the ongoing premium payments for the long-term care policy.

Family dynamics often have a financial impact on a person’s retirement income even without an illness or death

The key to taking advantage of such a strategy is to have previously owned permanent life insurance for some time and for the client to have their long-term care plan in place before they enter retirement. Not only is it more cost effective to do so, but they will often have an easier time qualifying medically for coverage. We need to advise clients to develop a long-term care strategy sooner rather than later and to make it part of their overall financial plan. Doing so will allow a family to better prepare for an event and clarify to all involved how care is ideally to be provided, by whom, and how it will be paid for.

Family Risk

Family dynamics often have a financial impact on a person’s retirement income even without an illness or death. Inter family loans and investments made to relatives can create a unique tension between a parent and an adult child for example.

Often times what begins as a benign request by an adult child for financial help to start a new business or career results in an unnecessary risk to a retirement portfolio. Emotions and close family relationships often influence clients to make investment decisions they would otherwise decline and unprepared for an unhappy outcome for all parties.

One common trend involves well-intentioned retired parents choosing to make an investment in support of an adult child who has perhaps not yet found his or her way in the business world. Parents finance investment “opportunities” such as a new mobile app for example or other speculative business ventures that the parents are ill-equipped to fully appreciate the risk involved in helping a child or other close relative.

Often, because of naivete and inexperience of the child or a parent simply investing in the wrong product or idea, the venture fails before the business launches and the parents never recover their investment. They are then left with diminished assets that they had expected to live on throughout their retirement.

Aside from the financial risks of these family loans, these situations can also be toxic to otherwise healthy family dynamics when loans do not see a return and the parents left are left with reduced income and a less secure retirement. This situation may trigger discord between other siblings who may resent their entrepreneur brother or sister for losing assets that their parents would have eventually needed to live on or what may have been legacy assets that the siblings will no longer inherit. Unless the client can successfully retire without the funds that they invest with their child, I believe that it’s best to counsel our clients to avoid this potential conflict.

Product-based solutions

I believe that a retirement plan that includes permanent life insurance, long term care insurance, and income annuities provides a significantly more predictable and resilient retirement outcome for a retired couple or an individual. As advisors, we have a responsibility to explore and understand these tools and then encourage our clients to secure them before they retire since both life and long term care premiums are based on one’s age and more importantly before they experience a change in their health that may prevent them from acquiring the coverage at all.

Permanent life insurance and annuities can provide a hedge against portfolio volatility while long-term care insurance protects retirement assets from an unplanned forced liquidation of those same assets when someone experiences a significant health care event. Permanent life insurance, as we know, protects a family from immediate financial loss due to an premature death; the policy cash values can be accessed via policy loans, withdrawals and or dividend surrenders prior to and during retirement; and it can provide a secure and tax-efficient vehicle for accumulating wealth that can provide a financial buffer against market volatility during a retiree’s distribution phase.

Similarly, annuities can provide income security long after retirement age when many retirees often rely on the advice and portfolio management of their heirs or in many cases from advisors or institutions that they had no decision in choosing, good or bad. Research presented in white paper titled “The Retirement Income Challenge- Deferred Annuities Before Retirement”, by Michael Finke, Ph.D., CFP, a professor in the Department of Personal Financial Planning at Texas Tech University and Wade D. Pfau, Ph.D.,CFA, professor of retirement income at the American College, explained a direct correlation between old age and the decline in financial literacy. The research found that that “retirees who suffer from dementia are far more likely to have a sudden drop in wealth in old age. And many retirees who are experiencing dementia are unaware of their vulnerability and continue to manage their assets without the help of a financial professional or family member.”

The report also explained that in addition to the loss of a retiree’s cognitive abilities, there is also a “gradual decline in fluid intelligence (the ability to quickly and efficiently process new information) and crystallized intelligence (the ability to solve problems).” They also explain that “the ability to correctly answer basic financial questions declined about 2% per year in retirement” and found that “the confidence in one’s ability to make financial decisions actually appears to increase in old age.”

The irony of this is that “this leaves many seniors who must manage their investment portfolio at the right tail of the longevity-distribution particularly vulnerable to making financial mistakes that may compromise their ability to avoid running out of assets.” Again, the key here is designing a retirement plan that combines a diversified portfolio that includes a portion of assets invested in an income annuity to provide income certainty, long term care insurance to offset the unplanned costs of a cognitive or medical impairment, and permanent life insurance cash values as resource when taking distributions from qualified plans during down markets. All three tools, when purchased before need arises, can reduce or eliminate significant risks that we all will face during retirement.

Industry shift to holistic approach

After decades of segmentation, the financial services industry continues to foster an integrated approach where advisors work may work either as a team with different roles to play with the client or they acquire the expertise and credentials to act as the sole advisor who is equipped to address these multiple disciplines for their clients.

And in some cases, investment advisors may cede risk based planning to another advisor who handles only the risk based planning for the client. So, however the services are provided, as long as those serving their clients acknowledge and can provide a risk adjusted holistic plan for the client, I believe the client is truly being served. Our clients need to understand more than just what mutual fund or ETF to invest in especially as they enter retirement. It is our job to be there for them, to ask the right questions, and to provide them with a plan that is best for them and an understanding of the risks they face. ◊

This article is not intended as legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor.
Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) (life and disability insurance, annuities, and life insurance with long-term care benefits) and its subsidiaries. Michael John McNeil is a Representative of Northwestern Mutual Wealth Management Company®, (NMWMC) Milwaukee, WI (fiduciary and fee-based financial planning services), a subsidiary of NM and federal savings bank. Representative is an Insurance Agent of NM, and Northwestern Long Term Care Insurance Company, Milwaukee, WI, (long-term care insurance), a subsidiary of NM, and a Registered Representative of Northwestern Mutual Investment Services, LLC (NMIS) (securities), a subsidiary of NM, broker-dealer, registered investment adviser and member FINRA and SIPC