Worried Your Retirement Savings Won't Last? Consider This Alternative

I call it the "desert island dilemma” — a reference to being stranded alone with a single barrel of water, having to decide how long it might last and how much you can afford to drink every day.

In personal finance terms, rather than water, imagine the barrel is filled with the savings you’ve accumulated to live on in retirement, and you must determine how long you can survive on those proceeds and at what rate you can afford to spend them.

The answers vary by individual, of course, but they have led to the creation of a one-size-fits-all solution known as the 4% rule. It’s the traditional idea that you can safely withdraw that percentage — plus a little extra for inflation — of your savings each year and still make it through up to 30 years of retirement without running out of money.

But there are issues to this approach. Notably, many would-be retirees haven’t accumulated a large-enough nest egg for 4% of it — even with Social Security income added in — to be enough to live on. With the 4% rule, withdrawing $50,000 annually in retirement means you’d need to have saved more than $1.25 million. That’s roughly twice the average savings of about $600,000 that retirees now have, according to the Federal Reserve.

The sizable requirement is among the reasons to consider a retirement alternative that’s rooted in the era when pensions, rather than 401(k)s, were the cornerstone of retirement security. As a retirement planner, I call the approach Pension 2.0. While it flies in the face of what some other retirement experts advise, this strategy might be the ticket to a less stressful, more bountiful retirement for some people.

A pension-like strategy

Once upon a time, more workers had access to pensions that offered retirees steady, reliable life long income. Couples often had two options: opt for a reduced pension that continued for a surviving spouse or choose a higher payout that ceased upon the pensioner’s death.

Pension 2.0 starts by replacing what a pension used to do with the purchase of an annuity — specifically a single premium immediate annuity (SPIA). This one-time purchase (usually at retirement) provides a high guaranteed lifetime payout because the life-only option does not offer survivor benefits – and so delivers more in income. Today, SPIAs can provide payouts of 7–8% annually, which is double, or nearly so, the amount that people draw from their retirement accounts under the 4% rule.

For $50,000 in annual income, you’d need an SPIA with just $625,000 — still a hefty sum, but about half what you’d need in a retirement account to yield that same income if following the 4% rule.

If a couple secures an SPIA to guarantee a certain income, any remaining funds can be allocated for other purposes, and perhaps with a willingness to be a little less conservative with investments than people tend to be under the 4% rule. But upon the death of the annuitant, the annuity income stops. That’s where the second component of Pension 2.0 — life insurance — comes into play.

Life insurance as a backstop

To protect the surviving spouse and ensure that the funds used to purchase the SPIA are eventually returned to the family, Pension 2.0 incorporates a permanent life insurance policy, which can come in several forms – whole life, indexed life or variable.

Unlike term life insurance, which risks expiring before the annuitant’s death, a properly maintained permanent policy is guaranteed to provide a death benefit whenever the insured annuitant passes away. This ensures the refunding of the SPIA amount for the benefit of the survivor or children — closing the loop elegantly for the family.

There’s also a cash accumulation component to permanent life insurance policies. That cash value can accumulate over time, eventually delivering an additional cash value that can increase the policy’s death benefit or be used to pay the policy’s premiums.

The cons to the approach

No retirement strategy is perfect. While the permanent life insurance required under Pension 2.0 delivers security to the surviving spouse, it requires understanding the benefit and being comfortable with the higher cost of such a policy compared with term coverage; for example, the average monthly premium for a $500,000 policy of the whole life type can be at least $400 a month, according to Policygenius.

Buying life insurance later in life is costly and risky because you could be denied coverage due to health issues. So it’s ideal to secure a policy early and have it fully funded before retirement.

Additionally, permanent life insurance is a conservative growth vehicle, with returns that are closer to those of bonds than of a typical retirement account based on stock market returns. That said, any retirement portfolio usefully contains less risky investments, and the insurance policy can contribute to creating that balance.

Another reason some retirement advisors steer clients away from annuities is that, once you’ve purchased one, it can’t be reversed; it’s already destined to deliver monthly income to you for as long as you live. (You can, however, opt for a more flexible annuity, but these have smaller payouts than the life-only SPIA type. It’s important to review your annuity options, perhaps with an advisor)

How this strategy can work

It's not for everyone, but Pension 2.0 can deliver well, and not only to those who lack the savings to weather retirement in good financial shape. Admittedly, its appeal might be greatest to retirees who might otherwise be unable to create a viable income from their modest retirement nest egg.

But the approach has advantages even for those who are comparatively well-prepared for their retirements. By combining the stability of an SPIA with the certainty of permanent life insurance, this strategy all but relieves retirees of having to worry about the unpredictabilities and inherent volatility of the stock market.

Depending on your risk tolerance and financial goals, the funds remaining after purchasing an annuity and insurance policy could be invested a little more aggressively in the market through Pension 2.0.

Pension 2.0 is not a one-size-fits-all strategy. Rather, it provides an additional option as families work to create a secure retirement. Work with a financial planner or professional to evaluate your unique needs to ensure that this strategy aligns with your retirement goals.

This hybrid solution might not fit every retiree, but for those seeking security and simplicity, it could redefine 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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