I refer to it as the “desert island dilemma” — a metaphorical situation where one finds themselves stranded with only a single barrel of water, contemplating how long it might sustain them and how much they can afford to drink each day.
In the realm of personal finance, instead of water, envision that barrel filled with the savings you’ve diligently accumulated for your retirement. The challenge lies in assessing how long you can rely on those funds and determining the sustainable withdrawal rate that will allow you to enjoy your retirement without financial stress.
The responses to this dilemma undoubtedly differ from person to person; however, they have given rise to a universally applied guideline known as the 4% rule. This traditional principle suggests that retirees can safely withdraw 4% of their savings annually, along with a little extra to account for inflation, allowing them to maintain their lifestyle for up to 30 years of retirement without depleting their funds.
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However, there are significant concerns associated with this approach. A notable issue is that many aspiring retirees have not managed to build a substantial enough nest egg to withdraw 4% — even with the addition of Social Security income — to cover their living expenses. For instance, following the 4% rule, if you wish to withdraw $50,000 each year in retirement, you would need to have saved over $1.25 million. This figure is approximately double the average savings of around $600,000 that current retirees possess, as reported by the Federal Reserve.
The hefty savings requirement is one of the primary reasons to explore alternative retirement strategies that hark back to an era when pensions, rather than 401(k) plans, provided the foundation for retirement security. As a retirement planner, I refer to this alternative as Pension 2.0. While this method may contradict the advice of certain retirement experts, it could offer a path to a less stressful and more fulfilling retirement for many individuals.
Implementing a Pension-Like Strategy for Retirement Security
Historically, a greater number of employees had access to pensions that guaranteed them a consistent and reliable income throughout retirement. Couples typically faced two choices: they could opt for a reduced pension that would continue to support a surviving spouse or select a higher payout that would cease entirely upon the death of the pension holder.
Pension 2.0 reimagines the role of pensions by introducing the concept of purchasing an annuity — specifically, a single premium immediate annuity (SPIA). This one-time purchase, often made at the point of retirement, guarantees a significantly higher lifetime payout due to the life-only option, which forgoes survivor benefits, thus maximizing the income provided. Nowadays, SPIAs can yield annual payouts ranging from 7% to 8%, which is nearly double the amount most individuals withdraw from their retirement accounts using the 4% rule.
In practical terms, to generate an annual income of $50,000, you would only require an SPIA with an initial investment of approximately $625,000. While this is still a considerable amount, it is about half of what would be necessary in a traditional retirement account to achieve the same income under the 4% rule. Moreover, if a couple secures an SPIA to ensure a steady income stream, any leftover funds can be allocated for additional investments or expenses, allowing for a potentially more aggressive investment strategy compared to the conservative approach often taken with the 4% rule. However, it is crucial to note that when the annuitant passes away, the annuity payments cease, which is where the second element of Pension 2.0 — life insurance — becomes vital.
Utilizing Life Insurance as a Safety Net for Retirement
To safeguard the surviving spouse and ensure that the funds used for the SPIA can eventually be returned to the family, Pension 2.0 integrates a permanent life insurance policy. This policy can take various forms, including whole life, indexed life, or variable life insurance.
Unlike term life insurance, which may expire before the annuitant’s death, a well-maintained permanent policy guarantees a death benefit whenever the insured annuitant passes away. This feature ensures that the SPIA amount is refunded for the benefit of the surviving spouse or children, effectively closing the financial loop for the family.
Additionally, permanent life insurance policies often include a cash accumulation aspect. The cash value can grow over time, providing an additional resource that can either increase the policy’s death benefit or be utilized to cover the policy’s premiums. This dual function enhances the overall financial security of the policyholder.
Understanding the Drawbacks of the Pension 2.0 Approach
It’s important to recognize that no retirement strategy is without its flaws. While the permanent life insurance component of Pension 2.0 offers security to the surviving spouse, it necessitates a solid understanding of its benefits and a comfort level with the typically higher costs associated with such policies compared to term insurance. For instance, the average monthly premium for a $500,000 whole life policy can start at around $400, as per Policygenius.
Purchasing life insurance later in life can be both costly and risky, as individuals may face denial of coverage due to health issues. Therefore, it is advisable to secure a policy early on and ensure it is fully funded prior to retirement.
Furthermore, permanent life insurance tends to be a more conservative investment vehicle, with returns that are more aligned with bonds rather than the stock market. Nevertheless, incorporating less risky investments is beneficial for any retirement portfolio, and the insurance policy can contribute to achieving that desired balance.
Another reason some retirement advisors may advise against annuities is that once you have purchased one, it cannot be undone; it is already set to provide monthly income for the remainder of your life. However, you can choose a more flexible annuity option, but these typically offer lower payouts than the life-only SPIA variant. It’s crucial to thoroughly evaluate your annuity options, potentially with the guidance of a financial advisor.
Maximizing the Benefits of Pension 2.0 for a Secure Retirement
While Pension 2.0 may not be suitable for everyone, it can provide substantial benefits, particularly for those who may lack sufficient savings to navigate retirement comfortably. Its appeal may be especially pronounced for retirees who otherwise struggle to generate a reliable income from a modest retirement nest egg.
However, this approach also offers advantages for those who are relatively well-prepared for retirement. By merging the stability of an SPIA with the predictability of permanent life insurance, this strategy alleviates much of the anxiety associated with the fluctuations and uncertainties of the stock market.
Depending on individual risk tolerance and financial objectives, the funds remaining post-annuity and insurance purchase may be invested more aggressively in the stock market through Pension 2.0. Importantly, this strategy is not designed to be one-size-fits-all. Instead, it presents an additional avenue for families aiming to establish a secure retirement. Collaborating with a financial planner or professional is essential to assess your specific needs and ensure that this strategy aligns with your retirement aspirations.
This hybrid solution may not suit every retiree, but for those in pursuit of security and simplicity, it has the potential to transform their experience of financial freedom in retirement.
Walter C. Young, MBA and RICP, is a Seattle-based financial planner and the author of The 5th Option: Why Your Retirement Plan Won’t Work the Way You Think It Will. Advice from guest contributors like Walter does not necessarily reflect that of Money and its staff.
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