Retirement Income Security and Life Insurance

We will start with a new example and return to the Smiths later in the chapter.

Richard and Mary Doe are a married couple, both aged 66 in 2017. Each of them qualifies for a $2,000-a-month Social Security payment at full retirement age (FRA), which is 66 in their cases because they were born in 1951. Of course, this means that when one of them dies, the survivor will be able to collect only one Social Security payment, which means a severe reduction in family income of 50% compared with the situation where both are still alive and collecting their Social Security payments.

In such a situation, it shouldn’t be too surprising that the worst-case scenario is that one of the spouses (the one with the shorter life expectancy) dies immediately, whereas the other spouse lives to the end of their reasonable life expectancy. This cuts off the second Social Security payment as early as possible while the survivor requires retirement income to continue for the longest possible time.

In this particular case, the worst-case scenario is that Richard dies in 2017, whereas Mary lives a long time on just one Social Security payment that amounts to $24,000 a year. Thus, it is possible that Mary will have to live on about $24,000 a year for the rest of her life.1

That is a severe drop in income. Is there any way that she can mitigate this without going back to work?

Yes, there is; and the answer is surprising—life insurance. The truth is that most people, at best, look at what they have and how long they might live, divide the first number by the second number, add their Social Security or other retirement income sources, and decide that is the amount they can spend. Sadly, they do not take advantage of the opportunity afforded by life insurance to enable what in many cases is a significantly higher level of spending; or to realize that in already having insurance, they have more spending power than they know. Even worse, many people assume that they can spend all their current Social Security income without considering the significant drop in income if one of them dies early.

Furthermore, until now, there has been no way to calculate the amount they can safely spend. Without that knowledge, it does little good to know that you can spend a bit more. The remainder of this chapter will explain why life insurance can increase the level that can be safely spent and make it clear that the level of insurance required to fit a given situation can be determined.

Let’s go back to Richard and Mary and see what an optimal amount of life insurance could do for them. If we were to add $250K of 15-year term life insurance on each of them, at an estimated yearly premium of $1,763 for Richard and $1,127 for Mary,2 the worst-case scenario is still that Richard dies in 2017. But with the life insurance in force, Mary can spend about $31,000 a year for the rest of her life, an improvement of about $6,500 a year, after paying the insurance premiums, even if Richard dies in the worst year (2017)!3 How is this possible?

The answer is that the life insurance payout of $250K after Richard dies in 2017 allows Mary to fund her retirement at a higher level of spending. We are assuming that she lives to her 90th percentile life expectancy, which is the year 2052, so that extra $250K has to be spread out over all of those remaining years. Since Richard’s dying in 2017 is the worst case, assuming no other factors change significantly, she can expect to be able to spend at that $31,000 level.

But I’m sure some of you are already saying “What good does term life insurance do if they both live beyond the term of the insurance?” The answer is that if they both live that long, then they have had a long time to collect both Social Security payments and should have been saving some of that Social Security money to sustain the survivor after one of them dies; this is why the maximum safe spending level with the recommended insurance is only about $31,000 even though their two Social Security payments total $48,000. We’ll get into that in more detail later.

Of course, this analysis is a gross oversimplification of the nature of Social Security, especially as it applies to married couples. It is no exaggeration to say that Social Security is complicated. The ages of both spouses, both when starting to take payments and at the death of the first spouse, the tax implications of Social Security payments and how they interact with other sources of income, the special rules for widow’s benefits, and a number of other factors make calculations regarding Social Security payments difficult. This is why there is an entire industry devoted to helping people decide when and how to take Social Security. Yet none of the services I have investigated mention the applicability of life insurance to the severe hazard to living standards of early death of one spouse.

Let’s get back to our example of Richard and Mary Doe, but now we will assume that he still qualifies for a $2,000 benefit at FRA in 2017, but she qualifies for a spouse’s benefit of only $1,000 at FRA in 2017. In this case, they should buy $150K of 15-year term apiece, at estimated premiums of $1,347 for Richard and $870 for Mary.4 In this case, the worst-case scenario is that Richard dies right after the insurance expires, so there is no insurance payout. However, the maximum sustainable spending in the worst case is still improved from about $24,000 a year without insurance to about $28,000 with insurance, after paying the insurance premiums. This is still a worthwhile result of about $350 a month higher sustainable spending for the widow if her husband dies in the worst possible year, 2032.

Now let’s add the same assets that each Smith family had in the first chapter, namely $200K in investible assets, comprising $30K cash, $100K in traditional retirement accounts, and $70K in a taxable brokerage account with a tax basis of $50K. The results are obviously going to be better than with the previous scenario due to the additional assets, but the improvement from buying insurance is the same, about $4,000, as the contribution of Social Security is the same in both cases, and the Does stay in the 0% tax bracket with less than $34,000 of family income.

At this point, we are ready to look back at the Smith scenario itself to see how June’s financial adviser could show her a far bigger $15,000 improvement in sustainable after-tax spending. In their case, the biggest problem is what would happen if John died in 2017, in which case June would have to wait until 2026 to reach her full retirement age. If she took her survivor’s Social Security benefit before 2026, it would be reduced substantially due to her taking it early.5 As a result, the amount of life insurance needed to make up for the lost Social Security income until she gets to that full retirement age is far greater, coming out to $550,000 for each spouse. This results in an estimated yearly premium of $2,088 for John and $1,124 for Jane.

The obvious question at this point is how we (or the financial planner in our story) could figure out how much insurance is needed to optimize sustainable after-tax spending, so let’s look at that next.

Prerequisites for Calculating Sustainable After-Tax Spending

First, let’s discuss what we would need to know in order to do such a calculation. Let’s assume that we have a program that can do all the calculations for us as long as we have the correct data to enter.6

The input data can be divided into a number of segments:

Now, of course, there is other data that such a calculation would need, including:

And one of the most complex parts of the whole process is calculating the tax effects of taking money out of various types of accounts (i.e., pretax savings, taxable accounts, or Roth accounts), along with the special tax treatment of Social Security payments.

Now that we have the general idea of what input data and algorithms are needed, how would such a program actually solve for optimal sustainable after-tax spending?

Calculating Sustainable After-Tax Spending

One step in this process is to make an initial estimate of spending for the entire conservative lifetime of the longer-lived spouse, simulate withdrawals, taxes, and spending for all the years over which the money will be needed, and see whether there is money left over or not enough to sustain that level of spending. If there is money left over, increase spending, and if there isn’t enough, decrease spending.

However, this is just the beginning of the calculations, because we don’t know when each spouse is going to die. So, to be able to compute maximum sustainable spending in the worst case, we have to see what happens to that number if one of the spouses dies early or late, and the same for the other spouse. Obviously, this can generate a lot of possible combinations, but fortunately the worst case is generally when one spouse lives a long time and the second spouse dies either immediately or immediately after the termination of a life insurance policy covering that second spouse, so we can reduce the number of simulations and still get good results.

So now we have the base case, with the existing financial and personal picture of the couple. Next, we simulate the results of adding life insurance policies with different face amounts and terms, then running the calculations again to see which, if any, of those additions is effective in increasing sustainable spending.10

It would be possible to examine any of these scenarios “by hand,” using a spreadsheet for the calculations, looking up the life insurance premiums on the web and running the tax calculations using a commercial tax program. But that is an enormous amount of work that most people either can’t or won’t undertake, especially if they don’t know how much improvement in sustainable spending might result to compensate them for the effort. On the other hand, a program that executes all the calculations searching for the best result would be a lot less work to use, although such a program would require several developer-years to write.

As I have mentioned earlier, there is indeed such a program. To see what it can do to help a married couple figure out how much they can spend, and how they may be able to improve on their current sustainable spending level, let’s return to our two sisters from Chapter 1 as they visit their financial planner.