Life Insurance in Retirement: Who Needs It?

The KISS principle--invented by the U.S. Navy in the 1960s--holds that most systems work best when they are kept simple.

And KISS is a great principle to apply to this question: When, if ever, does it make sense to own life insurance in retirement?

Keeping things simple, here's the answer: In most cases, never. The basic purpose of life insurance is to protect dependents against the loss of income--yours--in the event of premature death. But by the time retirement rolls around, that risk usually declines sharply. Children are out on their own, we hope. And life insurance is hardly the only way to provide for your surviving spouse; smart options include Social Security optimization, retirement savings, joint and survivor defined benefit pension features, and income annuities.

"The purpose of term insurance is to cover the loss of human capital, and you don't have much of that at retirement age," says Michael Finke, dean and chief academic officer at The American College of Financial Services.

Term life insurance is an easy target to eliminate in retirement--especially older policies with built-in large premium spikes for older policyholders. An exception to that rule: If you're in poor health at retirement age, that's a good reason to think twice about dropping an existing life insurance policy.

"If there's a health issue, the term policy may be a valuable asset for the beneficiaries, or you might be able to sell it to a third party in a life settlement," says Glenn Daily, a fee-only life insurance advisor. "So I always ask about health early on in discussions with clients."

But Finke and other researchers have been developing a theory of retirement income planning that suggests including insurance--annuities and cash value life insurance--in the mix alongside equities and bonds. They argue that insurance can play a role in mitigating longevity risk.

The risk of outliving your assets is a key consideration in any retirement plan. In fact, longevity may be a more important component in retirement planning than any other, as Morningstar's David Blanchett has noted.

Expected longevity for men and women at age 65 has jumped more than 10% since 2000, according to the Society of Actuaries. Men who reach age 65 can be expected to live to an average age of 86.6, and women to 88.8. But those figures are only averages. A 65-year-old man in good health has a 13% chance to live to 95, as do 21% of women, according to research by Vickie Bajtelsmit, a professor of finance at Colorado State University whose research focuses on retirement and financial planning. And there's a 31% chance that a surviving spouse will make it to 100, she calculates.

Those eye-popping numbers bolster the case for strategies such as working longer and saving more, optimizing Social Security and perhaps adding an income annuity to the mix to bolster lifetime guaranteed income.

How about life insurance?

Plenty of experts are skeptical about cash value insurance as an investment, due to its complexity and high costs. But Finke has made the case for holding cash value insurance, if purchased at an earlier age, as a bondlike portion of a broader portfolio that also includes equities and income annuities. (For the record, the research was sponsored by an insurance company, but the numbers are worth considering.) Finke's longevity-related whole life argument is that the tax-sheltered status of these policies can provide liquidity in later years, offer guaranteed and stable cash value, and provide tax-deferred growth.

Daily says holding an older permanent policy sometimes makes sense--compared with other fixed-income holdings--if it is being held for beneficiaries, considering only the growth of cash value.

"I've seen many whole life policies with an expected present value of death benefits that is 10% to 30% higher than the expected present value of premiums."

Estate planning may offer another exception to the KISS rule. Life insurance plays an important role in planning for families with special needs children, for example.

And protecting a surviving spouse with life insurance occasionally makes sense, notes Daily.

"You probably would think that it wouldn't be needed for survivor protection retirement, if enough retirement assets have been accumulated to provide the necessary retirement income," he says. "But I’ve seen some situations where there’s a gap."

Indeed, Bajtelsmit notes that income can fall as much as one third when one spouse dies. That results from elimination of one spouse's Social Security payment, and, in some cases, the end of payments from an annuity or defined benefit pension.

"Expenses like food, healthcare, and consumer goods also tend to fall, but housing probably does not," she adds.

Insurance also can be useful as a tool to provide estate tax liquidity, Daily notes.

"It's a defensible use in situations where the estate's assets are illiquid--let's say real estate or a business," he says. "You don’t want to sell the assets in a fire sale, and the estate tax comes due--insurance can be used to fund the tax liability."

Business ownership is another liquidity-related problem that life insurance can be used to address, he notes.

"Let's say a small-business owner has several children, and only one of them is interested in taking over the business, and is good at running it," he says. "The owner wants that child to inherit the business but doesn't want to disinherit the others. So, he buys a life insurance policy and names the other children as beneficiaries to treat everyone equally."

Life insurance also can be used to finance long-term care needs via a life-combination policy. The appeal is that heirs collect on the life insurance policy if you don't wind up needing nursing home care--but that's an appeal to emotion that misses the point of any insurance policy, which is to insure against a risk that might not actually occur.

Still, interest in these hybrid policies has been rising in concert with declining popularity of traditional standalone LTCI policies. Life-combination sales have risen fivefold over the past eight years, with 220,000 new policies sold in 2015, according to Limra, the industry research and consulting group. That's up from just 60,000 in 2010. By contrast, just 104,000 traditional policies were sold in 2015, down from 236,000 in 2010. Limra reports that most of the combination policies being sold (59%) are life insurance policies with chronic illness riders--an accelerated death-benefit rider that can pay out a small portion of a death benefit to fund care.

Hybrids do offer simplified underwriting, which can be a plus for buyers with pre-existing conditions who may not qualify for a traditional policy. But areas of coverage can be more limited, and so can payouts. Another appeal of hybrids is that they inoculate buyers from the risk of steep premium increases via a single upfront payment.

Michael Kitces, partner and director of research for Maryland-based Pinnacle Advisory Group, is skeptical of that argument. As he noted when I wrote about these hybrid policies in 2015, underwriters control the cash value and are under no obligation to pay a going rate of return in a rising-rate environment–instead, they can simply underpay on rates for your cash value.

"It's an emotional response," he told me. "I don't want to pay $3,000 a year in premiums for a traditional policy, but I'll give an insurance company $100,000 for a universal policy and forfeit any growth for the rest of my life."

Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work, and Living. The views expressed in this article do not necessarily reflect the views of Morningstar.com.