In this post we’ll be analyzing a showdown: LIRP vs Annuities for retirement income. I’ll be comparing the income from a Life Insurance Retirement Plan to the income from an Annuity. This is important because most people don’t think of Life Insurance when it comes to retirement income planning.
Goal
The goal of this post is to show you how a life insurance retirement plan (LIRP) can provide more after-tax income than an Annuity.
If this sounds interesting to you, keep reading.
Annuity Basics
Annuities are fairly simple financial products. They are intended to provide income for a lifetime or some defined period. They provide peace of mind for retirees who are concerned about running out of money before they pass away.
The best way to understand an annuity is to think of it as a loan to the insurance company. You are giving them money and then they are paying you back with interest over time. In the case of a lifetime annuity, the payments are simply spread over your life expectancy. Annuities provide tax-free growth of principal. And because annuity income includes a return of principal, you are not taxed on the principal component of the income. You are only taxed on the interest.
Annuities are highly customizable. You can fund an annuity with a single lump sum premium or a series of recurring premiums up until retirement. This is known as the “Accumulation Phase”. After the accumulation phase, you can spread the income out over a lifetime or a defined period. The latter is known as a “Period Certain” annuity. They may or may not have a death benefit component. They may also include riders that pay extra in the event of critical or chronic illness.
Life Insurance Basics
A LIRP is made possible by state statutes that require that insurance companies make loans to policy owners.[1] Policy loans are secured by the cash value of the policy.[2] More importantly, any unpaid interest is tacked on to the loan balance so that the borrower doesn’t have to make payments on loans. This means that 100 percent of the cash value continues to earn dividends and interest because it never leaves the policy.[3] It may not seem like much at first glance, but these two paragraphs have created an incredibly powerful financial product:
This is an except of the Florida Statutes regarding policy loans. It is written in legalese, but if you read just the underlined parts, it makes much more sense. Just imagine if you could ask your bank to loan you the money to pay them interest because your house is appreciating in value. They would laugh you out of the bank. But that is exactly what happens in a LIRP.
Comparison
Tax-free Income
It is important to understand that income from a life insurance policy is tax-free. This is because it is a loan and not a withdrawal. On the other hand, income from an Annuity IS taxable. One thing I should point out, though, is that because the income from an annuity includes principal repayment, only the interest component is taxed.
Tax-free Growth
Both a LIRP and an Annuity offer tax-free growth. In the case of a life insurance policy, it is just important to point out that the cash value is actually part of the life insurance contract. Its not a separate investment. Likewise, an Annuity is a guaranteed contract with the life insurance company. It is not treated like a security.
Leverage
This is the most important difference. It is very important to understand that income from a life insurance policy is in the form of loans secured by the cash value. This means that the cash value itself never leaves the policy. The policy’s cash value will continue to grow and compound even while you are taking loans for income.
You should be aware that Annuity income is essentially the insurance company returning your money to you over your life expectancy. Each payment includes a return of the original principal. This means that the Cash Value that is being credited with interest is shrinking with every passing payment.
It is important to realize that this difference has a major impact on the amount of income that can be taken from a life insurance policy. “The 4%-Rule” is a rule of thumb used by financial advisors to estimate the safe withdrawal rate from retirement savings. If you just google that term, you’ll find lots of articles explaining it.
It’s important to point out that the similar rule for Life Insurance is more like 8%! That is twice the income due to the way income is taken.[4]
Death Benefit
It shouldn’t be a surprise that Life Insurance provides a death benefit, but you should realize that you can get a death benefit with an annuity as well. These products are very flexible and can be set up so that any additional funds still held by the insurance company at the time of death will pass to a beneficiary.
LIRP vs Annuity Income Comparison
This table clearly shows that life insurance will provide more retirement income. The assumption is that the retiree is going into retirement with $1,000,000 in an annuity or $1,000,000 in cash value in a life insurance policy. Rather than run illustrations, I’m simply using an amortization calculator to estimate payments based on life expectancy.
In this case, I am using 24 years which is the life expectancy of a healthy, non-smoking 65 year old male.[5] I am also showing payouts based on 3%, 4%, 5%, 6%, and 7%. Annuity rates are dependent upon the interest rates in the debt markets. These rates are always changing. With the low rates over the last 10 years, annuity rates were right around 3-4%. They are trending up now with the recent inflation (Nov 2022)
You can see that even before tax, the life insurance policy will clearly provide more income. I am not including taxes because there are too many factors that impact taxes for annuities.
Taxation of Annuities
Only the interest income of an annuity is taxed. So, in my example above, it makes a big difference whether that $1 million came from a single premium at Age 65 or from a smaller premium, or series of premiums, many years earlier. Every case is going to be different.
Conclusion
While annuities are much more well-known and simpler to understand, a LIRP can provide more retirement income.
[1] Florida Statutes for example: http://www.leg.state.fl.us/Statutes/index.cfm?App_mode=Display_Statute&Search_String=&URL=0600-0699/0627/Sections/0627.458.html
[2] For a good Life Insurance 101 that explains cash value, download this free ebook: https://innovativeretirementstrategies.com/product/free-download-life-insurance-101/
[3] Not all companies continue to credit interest/dividends on cash value serving as collateral for a loan. But you wouldn’t use those companies for a LIRP.
[4] This presumes at least 1% of positive interest rate arbitrage: the difference between the earning rate on the cash value and the loan rate for policy loans. Historically, this arbitrage has been greater than 1%. Especially in an Indexed Universal Life where the goal of hedging is to capture a premium over the debt market rate of return.
[5] If you are curious, the life expectancy of a 65 year old healthy, non-smoking female is 28 years.
