Retirement: Will It Look The Way We Thought It Would?

Leveraging life insurance and annuities for longevity

by Eric Henderson

Planning for living in retirement requires balancing risks, understanding trade-offs, and choosing a path that has enough flexibility to adjust as circumstances change. There are multiple types of investment options to consider in a retirement strategy, along with their corresponding tax aspects. Ultimately, individuals and families must make decisions about how their investments can mitigate the financial risks of living in retirement so that they can enjoy the retirement they envision for themselves.

Insurance products like life insurance and annuities should be considered as part of this process because they can mitigate living-in-retirement risks like outliving income, long-term care (LTC) events or decreasing purchasing power because of inflation, all while providing tax efficiency.

Tax-Free Retirement Income

For instance, a cash value life insurance policy can be structured in a way to provide retirement income through withdrawals of cost basis, and loans, so an owner can have a source of tax-free retirement income that can be accessed when needed. The life insurance policy’s growth can be based on direct investment participation if invested in a variable universal life (VUL) policy, or on the performance of certain indexes if invested in an indexed universal life (IUL) policy. That life insurance policy could also have a LTC rider added to it that would provide a pool of assets to cover the nursing home or other care expenses the individual may incur if they can no longer take care of themselves. Finally, the life insurance policy can also provide an income-tax free death benefit to the owner’s heirs, so they leave something behind.

Guarantee an Income Stream

Annuities can be used in variety of ways to mitigate multiple types of living-in-retirement risks as well. An immediate annuity can be used to guarantee an income stream for as long as the owner is alive, plus their spouse if a joint life option is selected. The income from a nonqualified immediate annuity can also provide income tax efficiency through an exclusion ratio, which means that with each payment received, a portion will be return of investment in the contract, and a portion will be earnings.

For example, a joint life immediate annuity could be purchased by a married couple to provide a baseline of income that cannot be outlived to cover the essential expenses of living in retirement like housing costs, utilities and food.

Immediate annuities can also be purchased for a specific time frame, called a “term-certain,” to provide income for a limited time period for specific needs. For instance, someone who is 62 could purchase an 8-year term-certain immediate annuity to provide income from age 62 to age 70 instead of taking Social Security at age 62 (the earliest age Social Security retirement benefits can be taken), allowing their Social Security benefit to grow to its maximum amount for their own future retirement income and their spouse’s potential survivor benefit.

Deferred variable annuities can also be used to mitigate inflation risk because the owner can invest directly in equity sub-accounts to provide market returns that may keep pace or exceed the rate of inflation, thus protecting the owner’s future purchasing power.

Deferred fixed indexed annuities can also be used as a retirement investment to provide a principal guarantee and earn interest based in part on the performance of an index (stock market or otherwise) helping to mitigate the market and inflation risks of living-in-retirement investing. Guarantees are subject to the claims paying ability of the company. Each of these types of deferred annuities (variable and fixed indexed) can also have a living benefit rider added to the policies, typically at additional cost, to provide a stream of income that is guaranteed to last for the rest of the owner’s life, and their spouse’s life if a joint life option is purchased. Living benefit riders on deferred annuities create the possibility of increasing income if the annuity increases in value due to market or index growth. Living benefit riders on deferred annuities also allow the owners access to lump sums if needed but be aware that excess withdrawals from the annuity could result in the reduction in future guaranteed payments under the living benefit rider.

Investors must navigate many living-in-retirement risks like outliving income, LTC events, inflation, liquidity, market risk, and tax efficiency. Investors should work with their financial advisor to understand how these risks affect them and come up with a plan to address those risks. Insurance products can be a key part of this plan to help the investor feel comfortable and confident as they live in retirement. ◊

Please be aware that investing in a VUL policy or variable annuity may result in losses including up to your entire investment. Neither Nationwide nor its employees provide legal or tax advice and clients should seek the guidance of their own tax advisor for answers to their specific questions. Note that the gains portion of nonqualified immediate annuity payments are subject to ordinary income taxation. Also, be aware that immediate annuities may also be purchased by IRAs, but there is no exclusion ratio on IRA immediate annuity payments. Typically, IRA immediate annuity payments are fully taxable. Distributions from deferred annuities may be subject to income taxation and surrender charges. Distributions from nonqualified deferred annuities are taxable to the extent of gains in the policy, and pre-59 ½ distributions of gain from a nonqualified deferred annuity are subject to the 10% tax on premature distributions unless an exception applies. Distributions from IRAs, including IRA annuities, are typically fully taxable, and pre-59 ½ distributions from IRAs are subject to the 10% tax on premature distributions unless an exception applies. When evaluating the purchase of a variable annuity, you should be aware that variable annuities are long-term investment vehicles designed for retirement purposes and will fluctuate in value; annuities have limitations; and investing involves market risk, including possible loss of principal.