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Pre-Retiree Retirement Planning – Managing Volatility, Taxes & Future Needs

The wealth accumulation phase during an individual’s working years is relatively simple: leverage the power of compounding, and, when available, tax deferral to grow your assets over a period of 40 or so years. While diversification/reallocation does not ensure profit or protect against lose in a declining market, as your asset base grows, many advisors recommend diversifying among assets classes and vehicles.

If there’s a prolonged market downturn – the S&P 500 dropped 57% between October 9, 2007 and March 9, 2009 - grit your teeth and know that (historically), over time a bull market follows the bear – the S&P gained 271% between that March 9, 2009 trough and December 31, 2018. When you have a 30-year time horizon, the ups and downs of the market roller coaster are points on a graph - merely paper gains and paper losses.

As clients get within the 10/15-year window of retirement, market corrections change from a bad quarterly statement to a true risk for retirement income needs. In an environment with low yields in fixed income instruments and prolonged retirement years as people live longer, the traditional de-risking through a simple reallocation to a more conservative portfolio may not be sufficient to support a retirement lifestyle (with several segments therein of different needs) that may last an additional 30+ years. (Asset Allocation is a method used to help manage investment risk, driven by complex, mathematical models and should not be confused with a simpler concept of diversification nor does it guarantee to protect against investment loss in declining markets.)

The landscape for new retirees and pre-retirees has shifted both in terms of the type of retirement assets and the quality of life requirements from previous generations. The movement away from the traditional pension or defined benefit plan towards a more employee-focused 401(k) world – this puts more of an onus on the individual and their advisors to develop a plan to maximize the flexibility provided through individual retirement assets.

As market-based retirement assets have become the primary source for retirement income, the impact of income tax rates has become an important factor in developing a strategy to maximize the various “buckets” of tax. The conventional wisdom has been that clients will have a higher federal income tax rates during their working years, and they will be in a lower tax bracket once they retire – with more taxable dollars being used to support retirement (bumping up the brackets) and potential higher rates after the sunset of the Tax Cut and Jobs Act (TCJA), it may be prudent for pre-retirees to consider and plan for higher tax rates in retirement. Changes in legislation will also impact the efficiency of leaving behind tax-qualified dollars to the next generation; in both the proposed Setting Every Community Up for Retirement Enhancement Act (SECURE) and the Retirement Enhancement Securities Act (RESA) will put limits on the ability to “stretch” inherited IRA’s over an extended period of time. In short, that sizeable IRA nest egg is a giant future income tax liability.

For the pre-retiree, retirement income and tax planning are about more than just replacing cash flow from the working years. As clients transition through the different phases of retirement, various new considerations are necessary, namely the potential need for long term care. People are living longer, medical advancements and the ability to prolong life are progressing every day.

There are over 51 million Americans over the age of 651, and 70% of people over the age of 65 will require long terms care services and support at some point in their lives2. The 2018 monthly cost of care in the Philadelphia area was approximately $12,0003. Over the past 15 years, the annual average annual increase (nationally) to the cost of a private room has been 3.16% (54% total)3. For clients with a meaningful asset base, government sponsored programs aren’t available until the portfolio has been essentially depleted.

Below is a brief sample of the some of the strategies pre-retirees are employing in preparation for their retirement years.

1. Risk and Tax Diversification through Life Insurance

The tax properties of life insurance make it an attractive vehicle to accumulate cash value and distribute income to supplement retirement planning for high net worth individuals.

Funded with after-tax dollars, the cash value grows income tax deferred and can be distributed tax-free in the form of a withdrawal (return of premium) and loan (gain).Though the tax characteristics are similar to a ROTH IRA, there are no contribution limits (premium payments), subject to policy limitations.

The crediting mechanisms within the insurance policy can provide an alternative asset class to an equities-based portfolio.

When comparing the IUL crediting mechanism to the “uncapped” price return of the S&P 500 over the past 20 years (1999-2018), the compound annual growth rate – the rate of return that would be required for an investment to grow from its beginning balance to its ending balance, assuming the profits were reinvested at the end of each year of the investment’s lifespan – for the IUL’s return is 6.16% where the uncapped market return is 3.63%.

Whole Life (WL) insurance builds cash value through guaranteed increases to cash value along with participation in non-guaranteed dividends. Non-guaranteed dividends rates are determined by the issuing company and are generally a reflection of the company’s profit based on investment income and mortality. Dividends tend to be uncorrelated to equity markets.

For the pre-retiree, directing excess cash flow or reallocating a portion of the taxable portfolio to a permanent insurance product may achieve the dual benefit of tax-deferred growth and tax-free income while removing some equity market risk. Since an individual must medically qualify for an insurance product and these income-generating strategies are most efficient after the 15th policy year, clients should consider incorporating the use of life insurance as an asset class within the portfolio several years prior to retirement.

Accessing cash values may result in surrender fees and charges, may require additional premium payments to maintain coverage, and will reduce the death benefit and policy values. Policy must not be a modified endowment contract (MEC) and withdrawals must not exceed cost basis. Partial withdrawals during the first 15 policy years are subject to additional rules and may be taxable. Policy must not be surrendered, lapsed or otherwise terminated during the insured's lifetime. Ongoing policy administration is essential to the strategies effectiveness.

2. Guaranteed Income through Annuities (the “A” word)

Few financial products are as controversial as annuities.As with any type of insurance product or asset class, there are favorable and unfavorable characteristics.Because of the high fees associated with the guaranteed income riders and lack of liquidity, these strategies are most often recommended as a small portion of the overall plan with the function of providing a baseline of guaranteed monthly or annual income.

Deferred annuities are generally structured to include a guaranteed growth and income rider.The concept is to create an accounting mechanism separate from the actual cash value to determine the lifetime benefit; hence we call this account the “Benefit Base”.During the accumulation phase, each year the benefit grows and resets to the greater of a) the cash value or b) the stated simple or compound interest factor (guaranteed growth and income) / an increase in an inflation factor (inflation protection).There may be a limit on the number of years the annuity will provide increases to the benefit base under the rider, such as 10 years.

When the owner is ready to monetize the asset, the annuity will payout a percentage of the benefit base for life based upon the age of first withdrawal.At this point, the guaranteed growth and income will cease increasing the benefit base whereas some inflation protection riders will continue to increase the base or payout amount as determined by increases in inflation.

Traditionally, non-qualified dollars were used as the funding source to capture the benefit of tax-deferred growth, however, the marketplace has shifted to using IRA funds as the primary seed for deferred annuities.The reason for this is twofold: First, any gain from the annuity is taxed at normal income rates.By using taxable dollars, while we achieve tax-deferred growth, we are transforming the income portion from primarily capital gains to normal income tax.By using IRA dollars, we are not taking advantage of the already achieved tax deferred growth, but are not negatively altering the ultimate tax impact on future income.Second, due to the desire to let the initial deposit grow over a period of time, using IRA money during accumulation phase has less of a liquidity impact for clients younger than 59 ½.

The shifting a portion of IRA dollars to an annuity is a consideration best evaluated in the pre-retirement years.For the client who is 50 years old, they can achieve the 10-year deferral period to maximize the guaranteed growth rider and initiate income once they are beyond the IRA distribution penalty age.More advisors are planning to turn on income from annuities as early as possible to improve the chances of maximizing the return on the initial deposit.

For example, a $100,000 initial deposit that grows at 8% simple for 10 year and payouts at 4.35% (Age 60) will generate $7,830 guaranteed income per year.Therefore, it will take almost 13 years (now Age 73) for the annuitant to be “in the money” after income is greater than the initial deposit.If the annuitant lives to Age 85, the total income from the annuity would be $203,580, which represents a 3.35% internal rate of return on the deposit.The client and advisor should evaluate if this risk-free (subject to claims paying ability of the issuing company) return is viable in the current interest rate environment.

3. Accumulation Annuities

With the prolonged low interest rate environment, fixed deferred annuities have become less of a viable product for accumulation with downside protection.Recent years have seen an emergence of structured variable annuity products that feature a specified holding period (usually 5 or 6 years) during which growth is based off a widely held index with floors and caps.

Like the Indexed Universal Life product discussed previously, these products feature a portion of protection on negative returns – generally absorbing the first segment of loss over the tracking period – while allowing for potential in upside return with a cap.The most popular versions of this type of product are either a year-to-year lock or over the entire 5 or 6-year segment.Unlike income generating annuities, structured accumulation products are low cost or even at no explicit cost.

As a planning tool, annuities used for accumulation are positioned to reduce some risk while still in the accumulation phase.Again, because of the liquidity restrictions, these can be employed on qualified assets and eventually rolled into an income generating annuity or reallocated back into the marketable security account.

4. Long Term Care Planning

Using an insurance product as a partial or total funding source for long term care costs can be viewed as providing insurance against the asset portfolio, which could be eroded under a self-insurance strategy.Over the past decade, there has been significant evolution in the design and pricing of long-term care insurance products as the marketplace has moved away from the previously available “stand alone” long term care insurance, which generally featured non-guaranteed premiums and no death benefit and/or cash value.

First made popular by Lincoln Financial, the asset-based hybrid product adopted a life insurance chassis that would provide tax-free distributions for long term care qualified insureds in excess of the death benefit.As a “long term care first” product design, these policies were funded at a minimum death benefit with minimal cash value growth, generally having a return of premium feature should the insurance no longer be needed.The premiums are guaranteed and are often funded in a single premium – a reallocation of cash or fixed income assets – or over a 10-year period from current cash flow.

In more recent years, more life insurance policies have adopted the ability to accelerate the death benefit to pay for qualified long-term care costs.Currently, there are two primary types of riders: 1) ‘true’ Long Term Care (LTC) rider and 2) a Chronic Illness Accelerated Benefit (CIAB) rider.The LTC rider is underwritten for morbidity prior to issue and may be declined while a life insurance risk class may be offered.The cost for the rider is explicitly added to the base life insurance premium cost; as a result, distributions under the rider are a dollar-for-dollar reduction in death benefit.Conversely, the CIAB rider does not require specific underwriting and is included automatically on most permanent insurance policies.There is no upfront charge or increase to schedule premium; the rider cost is applied on the back end when distributions take place, making the total pool of money available for long term care costs to be less than the full death benefit.The cost of the CIAB rider is based upon the age of the insured when distributions take place and determined on life expectancy tables from that point.

Like any life insurance product, the ability to purchase and cost of long-term care insurance is dependent upon the medical qualification of the insured.As a planning technique for pre-retiree clients, the determination of whether to utilize a hybrid or life insurance policy (if at all) is dependent upon the primary desire for coverage.

The hybrid asset-based based approach will most likely provide more long-term care benefit per premium dollar and less death benefit than a life insurance policy with an LTC or CIAB rider.If using a cash accumulation policy (Whole Life, Variable Universal Life, Indexed Universal Life, Universal Life), the life insurance also provides the ability to grow cash value on a tax-preferenced basis, adding flexibility for future needs.

Of course, all client situations have unique circumstances and needs. The techniques and products discussed in this article highlight only of a small sample of the strategies and planning devices advisors employ when working with the pre-retiree. The themes of shifting risk, evaluating the tax implications of retirement income, and anticipating new potential expenses are critical part of the planning process for clients that are approaching the decumulation phase.

1. U.S. Census Bureau (, July 1, 2018.

2. 2019 U.S Department of Health and Human Services (, 10/10/2017.

3. Genworth Cost of Care Survey 2018, conducted by CareScout®, June 2018

This material is for informational purposes only. The views expressed are of those of the author and does not necessarily represent the views of Hornor Townsend & Kent, LLC (HTK) or its affiliates. The information herein has been derived from sources believed to be accurate. Please note - investing involves risk, and past performance is no guarantee of future results. Investments will fluctuate and when redeemed may be worth more or less than when originally invested. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All market indices discussed are unmanaged and are not illustrative of any particular investment. Indices do not incur management fees, costs, or expenses. Investors cannot invest directly in indices. All economic and performance data is historical and not indicative of future results. HTK does not provide tax or legal services. Always consult a qualified advisor regarding your personal situation. 2727806AL_OCT21

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