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“Second Wind” Strategies for Retirement Income

Second Wind

A little over a year ago I ran my first half-marathon.  Being a novice, I learned many things the hard way, such as not allowing my adrenaline to get the better of me at the beginning of the race.  One decision that proved to be shortsighted was not bringing the complementary glucose gel packets I was provided along for the run – after all, who needed more baggage in a 13 mile race?  Sure enough, my body started screaming for calories at about mile eleven and, with no such resource at my disposal, I “hit the wall” and barely finished the race.

There is a strong parallel between retirement income planning and long distance running that is fairly obvious – both involve striking a careful balance between maintaining a good pace and not overdoing it.  There is also a big difference – in a road race, you know exactly how far you need to run and can pace yourself accordingly; but, in retirement we have no idea where the finish line is – will it be a sprint or a marathon?  You just don’t know.

Thinking about retirement income needs in these terms raises an important question:

If I reach a point during my retirement when my primary income sources are being depleted, where can I turn for a “second wind”?

Or, reflecting upon my ill-advised decision to not bring the glucose gel pack to the race, perhaps the more responsible question is:

What action can I take today that will provide that second wind if I need it?

In a race with an unknown finish line, having a provision for this uncertainty is a smart thing to do – a small sacrifice today can provide the financial resources when you may need them most.

Here are a few strategies that can provide that “second wind” you may need late in your retirement:

Long Term Reserve Savings

Earmark a portion of your savings for this purpose and do not use it unless you absolutely need to.  To figure out how much to set aside, you will need to build a formal plan with financial analysis that identifies all existing retirement savings and sources of income, your annual rate of spending during retirement, and your expected future cash flow and savings balances at different times during your retirement.

This analysis should give you an idea of how much you will need to invest to meet your income needs in the later years during retirement.  Typically, you can invest these savings more aggressively than the rest of your savings because of the longer time horizon, but you should plan on gradually reducing this risk as you approach the time when you will need to access these savings.

Advantage:

  • Simple and straightforward
  • Assets are readily available

Disadvantages:

  • Expensive over long run
  • Uncertain investment returns
  • Does not guarantee that you will not outlive your assets.
  • Requires discipline to not spend down these assets sooner than you have planned

Reverse Mortgage

A reverse mortgage allows you to tap into the equity in your home, either through a line of credit or by receiving a specified level of lifetime income.  Unlike a conventional mortgage or home equity line of credit, you do not have to pay back the loan while the property you are taking the reverse mortgage against is your primary residence; the outstanding balance is repaid when you sell the house or through your estate upon your death.  Reverse mortgages also allow you to lock in a minimum line of credit on your home, which will never go down, but can increase if your house appreciates in value.  Many reverse mortgages are backed by the US government through HUD, providing an additional level of security.

An important planning consideration is that you must remain current on all property taxes and home insurance in order to keep the reverse mortgage in effect.  Any available credit on the reverse mortgage must first be used to pay these obligations; a failure to remain current will result in a delinquency.

Another benefit of a reverse mortgage is when it is repaid, you (or your heirs) keep any value of the home in excess of the outstanding loan; if value of the home is less than the outstanding loan, you owe nothing!  Not a bad deal.

Advantages:

  • Allows you to monetize the equity of your home without selling it or taking out a loan that you must start to pay back immediately
  • Unlike a conventional mortgages, there is no risk of foreclosure so long as it remains as your primary residence.
  • Can provide a guaranteed lifetime income stream, if this option is elected
  • Guaranteed minimum line of credit, even if value of home declines

Disadvantages:

  • Must incur closing costs,
  • Available line of credit will be less than what you can get from a conventional mortgage or home equity loan.
  • Must payoff existing mortgage before purchasing a reverse mortgage
  • Must stay current on all property taxes and home insurance on the residence
  • May impose certain restrictions and obligations

Longevity Insurance

Longevity insurance is a type of immediate annuity that does not start to make payments for a number of years.  As a result, it can offer lifetime income protection at a much lower cost than a conventional immediate annuity that starts to make payments today.  This product can be very effective when combined with a systematic withdrawal strategy that can product the required income up until the point in time that the longevity insurance starts to make payments.

Longevity insurance can be purchased at one time, or purchases can be spread out over a period of time.

Advantages

  • Provides guaranteed lifetime income starting at the initial benefit age
  • Cheaper than conventional immediate annuities
  • Integrates well with systematic withdrawal plan

Disadvantages

  • Exposure to credit risk of insurance company
  • Low interest rates make this product relatively expensive today
  • Iliquidity; once you purchase them you cannot access the equity
  • No benefit if you do not survive to initial benefit age

Life Insurance

If you already own life insurance, there are a few ways in which it may help provide income in the later years of retirement.  If your policy has a cash value, you can take out a loan against this cash value under the terms of your life insurance, which allows you to access the equity without incurring the tax penalties that you would otherwise incur if you surrender the policy.  Another possibility way to monetize the equity is to enter into a life settlement transaction, where you sell the right to the death benefit to an institution, trust, or other individual in exchange for cash – if you are in poor health at the time of the transaction, often times the cash that you receive can be greater than the cash value.

Advantages

  • Policy loans can be more tax friendly then selling other assets
  • Life settlements can be a good hedge against poor health; if you need cash for healthcare costs, you may also get more for selling the rights to your death benefit
  • Older life insurance policies may have attractive interest rate guarantees

Disadvantages

  • Must continue to pay life insurance premiums, which may be expensive
  • Inside growth of cash value on life insurance generally does not have the same growth potential as other investments
  • Does not provide guaranteed lifetime income
  • Exposes you to credit risk of insurance company
  • In life settlement transaction, someone has a financial interest in your death – not a very comforting arrangement.

Posted by

John Bevacqua on November 28, 2011

Filed Under

Income Strategies

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in a road race, you know exactly how far you need to run and can pace yourself accordingly; however, in retirement we have no idea where the finish line is - will it be a sprint or a marathon? You just don't know


4 Comments

  1. Good article on longevity annuities however you missed one crucial piece which is, that even if these new longevity annuities aren’t providing the ideal income way down the road, at least they will still be providing income unlike many 401(k)’s and other vehicles that can’t provide contractual lifetime income. Like any retirement vehicle, you should never have all of your eggs in one basket. In particular, these longevity annuities should be used in conjunction with other plans as a supplement.
    - Tom from http://www.lifeant.com


  2. Thomas

    Thanks for the comment and you raise a very good point. Immediate annuities and longevity insurance involve the pooling of risk, which why they can support much higher levels of lifetime income than fixed income investments, so they do have some big income advantages over investments you might typically find in a 401K plan. As you mentioned, longevity insurance is really best understood when viewed as a part of an overall retirement income portfolio; you can draw down savings up until the time at which the income from a longevity insurance policy starts. A good way to think about this is that the income you provide from the start of retirement up until the start date of the longevity insurance policy is your “deductible”; if you live beyond this date, the longevity insurance then kicks in. So, you are in effect self-insuring your income needs up until the start date of the longevity insurance policy.


  3. Comment With longevity insurance, the two big risks are inflation and insurance company insolvency. Some products address the first risk. What about the second — we’ve learned that AAA ratings aren’t always reliable…who knows what the world will be like in 30 years when we’re supposed to be reaping the returns. Can we get insurance for our insurance?


  4. Jul – you certainly raise a very important point. It is precisely for this reason that I always suggest diversifying against this risk by purchasing several, smaller policies from different insurance companies. Just as you would never put too much of your investment portfolio into a single stock or a single type of bond, you should not purchase all of your longevity protection from a single insurance company. This is the best type of “insurance for insurance” that I am aware of.


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