Retirement Investing Part 2: Life Insurance and How Much Do I Need to Save?

In Part 1 of my series on retirement investing, I discussed how to calculate your annual spending need at retirement and how much private savings you will need to accumulate at retirement to meet this spending need at a sustainable 4% annual withdrawal rate. 

How Much Do I Need to Save Now?

Determining the end game – what lump sum you need at retirement – is only part of the problem. A vital question that remains is how to determine how much you need to periodically save NOW in order to achieve that needed lump sum.

Unfortunately, the more vital a question, the more difficult it usually is to answer. An accurate calculation a current savings requirement involves many different variables. Some inputs are easy (e.g., current savings and expected retirement date) but all the rest are difficult to estimate accurately:

1. Inflation rate (3% or 6%?)
2. Lifespan (80 or 95?)
3. Annual income from sources other than private savings (e.g., will my pension and social security still be around in 30 years and will they have cost-of-living adjustments?)
4. Tax rate (20% or 35%?) (for IRA withdrawals and earnings on savings in non-retirement taxable accounts)
5. Compound annual return on investment (5% or 9%?)

Retirement Calculator is a Must

Even if you are confident in all of these variables, the calculation cannot be done in your head but requires a calculator.  One of the better ones on the web is the modestly-named “Ultimate Retirement Calculator.” The most important number it calculates is the “Additional Monthly Contribution Needed to Fully Fund Plan.” This number assumes that you are making your contributions to a tax-free retirement account. You’ll find that the savings requirement is much less if you don’t feel a need to bequeath any estate to your heirs. My advice: save yourself a lot of stress, live comfortably, and let the kids fend for themselves!

Tax Rate on the Earnings of Savings in a Non-Retirement Account

If you are a buy-and-hold investor who owns ten blue-chip growth stocks like Coke (NYSE: KO) and Johnson & Johnson (NYSE: JNJ), then you don’t have to worry about taxes (except on the dividend income).  Capital appreciation on stocks is non-taxable until the stocks are sold. If you don’t sell … no taxes.

But most people don’t invest this way. Rather, they invest in mutual funds and actively-managed mutual funds have turnover (i.e., they buy and sell stocks during year). If you are a mutual fund investor, you must take into account the taxes these funds’ capital gains distributions hit you with when calculating investment growth. These tax costs are not included in the annual performance numbers that mutual funds are required to disclose.

For example, Fidelity Large Cap Value (FSLVX) has a one-year return of 2.83%, but the after-tax return experienced by investors is only 2.35%, which is 17% lower. So, for taxable accounts full of mutual funds, if you are modeling a 6% annual return it makes sense to be conservative and reduce the expected return by 20% to 5%.

Another option is to dump actively-managed funds and switch over to ETFs. As Ben Shepherd, editor of Global ETF Profits has written:

ETFs are very tax efficient. They generally generate relatively low capital gains, because they typically have low turnover of their portfolio securities. While this is an advantage they share with other index funds, their tax efficiency is further enhanced because they do not have to sell securities to meet investor redemptions.

Life Insurance

Retirement calculators assume that you have several years to generate the savings needed to fund your retirement. But what if you drop dead and don’t have a future? Depressing to contemplate, but even more depressing is the thought that your spouse and children will be left in the lurch without any income.  This is where life insurance plays a role. To calculate the insurable need, add together four things:

1. Lump sum required by surviving spouse to live comfortably. See Part 1. Deduct out the current after-tax annual salary (if any) of the spouse and any expected pension and social security payments the spouse will be entitled to at retirement.

2. Lump sum required for child-care costs needed until children turn 18. A rough estimate is $1,000 per month per child.

3. Lump sum required for children’s college education, minus any existing 529 tuition savings plans (keep in mind that education inflation is typically double general consumer inflation).

4. Lump sum required to pay off the home mortgage.

Once you have the insurable need, subtract out four things:

1. The face amount of any existing whole, variable, or universal life insurance (proceeds are tax-free)

2. Current retirement plan assets. For pensions, traditional IRAs, 401K plans, and fixed and variable annuities, reduce by the ordinary income tax rate charged on withdrawals.

3. Current taxable assets. Reduce the amount by the federal and state capital gains tax rate due on any unrealized capital gains.

4. Non-insurance tax-free assets such as Roth IRAs and municipal bonds.

Insurance Company Ratings

The insurable need minus the after-tax value of current assets is the amount of life insurance you need.  Insurance is only as good as the financial strength of the insurance company providing it, so be sure to buy it only from strong companies with a high credit rating (click on the hypertext link and select “Top 50 Report” and sort by largest to smallest Comdex rating).

Stay Tuned

Next week, my retirement series continues with a look at what types of investments you should consider to generate the returns needed to fund your retirement and which accounts you should use for each type of investment.

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