Unlocking Client Benefits Based on the Size of Whole Life Insurance

Conclusions

• A 35-year-old client allocating 4% to 8% of gross income to WL premiums accrues accumulated value that accounts for between 5% and 10% of their total retirement assets at age 65. This optimal range of accumulated value unlocks client benefits in the face of retirement risks. This amount is equivalent to two to five years of initial retirement income.
• This amount of WL can lead to better outcomes than those experienced with an investment-only approach. For the 35-year-old client with optimal accumulated value in this 5% to 10% range: retirement income increases by 2% to 5% over an investment-only strategy; legacy³ at age 95 increases by 10% to 13% over an investment-only strategy.
• Clients are better equipped to withstand common retirement risks, including experiencing an unexpected long-term care event, living longer than expected, and uncertainty about future taxes. For a 35-year-old client with optimal accumulated value in this 5% to 10% range, the median legacy relative to the investment-only strategy is: 8% to 18% higher after an unexpected three-year long-term care event for the client; 14% to 21% higher if the client lives to 100 instead of 95; 13% to 20% (13% to 21%) higher after experiencing a 5% (10%) tax increase throughout retirement.

Ensuring human capital

For younger clients, the largest asset they have is their earnings potential, also called human capital. While an investor’s financial capital, such as investments and property, typically passes to beneficiaries following death, human capital does not. In the event of premature death, an individual’s loved ones are deprived of the future income that person would have provided. Life insurance is uniquely suited to protect human capital, ensuring an individual can provide loved ones with a legacy upon death to help maintain quality of life. The primary purpose of life insurance is to provide a death benefit, which can help protect clients against the risk of losing human capital. The amount of human capital that needs to be replaced by life insurance often ebbs and flows throughout a client’s life, as will the financial ability to use different types of insurance options.

Reasons other than human capital protection can also drive the need for additional protection (e.g., business or estate planning), and it is important to consider those reasons separately when determining the right amount of overall death benefit needed for life insurance coverage. Clients can consider two main types of life insurance to cover their death benefit need: term and permanent (e.g., WL). While term can cover a large amount of need at a lower initial cost, permanent life insurance is best when there is a long-term need. A client’s death benefit need changes over time as life events occur and financial goals evolve. Their budget changes over time, too, potentially shifting the mix of term and WL that may be used to cover that death benefit need.

Optimizing the use of WL

Not only does WL provide a lifelong death benefit; it also generates accumulated value that grows over time. In addition to the financial protection that life insurance affords, the accumulated value can be accessed during life, in an emergency, or even to supplement retirement income. The accumulated value also has the potential to help optimize the portfolio by increasing expected returns while lowering risk when viewed as an alternative to fixed-income investments.⁴

A 2021 EY paper, “Benefits of integrating insurance products into a retirement plan”,⁵ found that combining investment and insurance solutions can lead to better client outcomes, including higher retirement income and higher legacy values, which include the total value of assets that can be distributed upon death. Benefits from life insurance products include greater financial security in the form of flexibility to address premature death and uncertainties like down markets.

At a minimum, a living benefit of accumulated value is that it can be used during retirement as an asset of last resort. Beyond that, accumulated value can supplement income following a down market; this strategy prevents liquidating other invested assets with depressed values before those assets have a chance to rebound. Even greater synergies from including accumulated value within a portfolio of assets can be realized by considering accumulated value a fixed-income alternative and allocating the entire portfolio based on this approach.

This research focuses on the optimal amount of accumulated value needed to unlock a range of client benefits, as shown in Figure 1, including protection against retirement risks, and the resulting improvement in client outcomes. The WL strategies and results are described further in this paper.

Beyond the death benefit, a WL 2% strategy (with WL premiums of 2% of initial gross income to cover the death benefit need) provides the benefit of accumulated value being accessible as an asset of last resort. This may help the client pay for unexpected expenses later in life. It does not make a significant improvement to retirement income or legacy.

A WL 4% strategy allows the accumulated value to grow to around two years of the initial retirement income need determined at 90% probability of success for that strategy. It improves retirement income and legacy, and it is large enough to act as a volatility hedge in down markets. It also enjoys the benefits experienced by the WL 2% strategy.

WL 6% and WL 8% strategies optimize retirement income and legacy. Accumulated value grows to over three years and around five years of initial retirement income for these strategies, respectively. These strategies provide greater protection against common retirement risks beyond the WL 2% to 4% strategies. The benefits are additive in that these strategies still provide a reserve for down markets, the ability to use the accumulated value as an asset of last resort, and a death benefit.

While a WL 10% strategy might not be considered optimal, it also provides all these benefits. When directing this much percentage of current income into WL premiums, only income or legacy tend to increase beyond a WL 8% strategy, but not both.

Goal

The goal of this research is to examine to what extent retirees experience benefits from having WL accumulated value as part of their portfolio of assets in retirement as well as the optimal size of accumulated value necessary to experience those benefits. The potential benefits investigated include having access to funds to cover emergency expenditures (e.g., from a long-term care event), being able to fund longer life expectancies, and withstanding unexpected tax increases. Does having accumulated value support these benefits and provide better outcomes than an investment-only strategy? How much accumulated value is needed to achieve these benefits?

Monte Carlo analysis (used in this research) generates 1,000 scenarios, each of which contains a time series of interest rates, inflation rates, equity returns, and fixed-income returns across the planning horizon. Monte Carlo is a method used to simulate randomness in variables whose behavior is uncertain to obtain a range of possible outcomes. The outcomes within the range are then used to make predictions regarding the likelihood that a particular outcome (or set of outcomes) will occur. Two outcome metrics generated through these simulations are then analyzed: (1) after-tax retirement income that can be sustained with 90% probability of success (a trial was deemed successful if the portfolio could maintain the inflation-adjusted level of income until the client’s death) and (2) median legacy value (calculated by averaging the legacy values of the two middle trials [500 and 501] when ranked by legacy).

Investment returns are based on Northwestern Mutual 2022 Capital Market Assumptions (CMAs). The CMAs forecast asset class rates of return over the next 80 years and provide expectations of risk-return profiles for the asset classes. The WL dividend interest rate (DIR) is modeled using a formula that is a weighted average of the prior year’s DIR and 10-year Treasury return to simulate the impact of different economic scenarios.⁶

This research analyzes three hypothetical 25-, 35-, and 45-year-old married couples and highlights results for the 35-year-old. The appendices include results for the other couples. Appendix 1 includes key assumptions. Retirement is assumed at age 65. A 30-year retirement is modeled except in the test of extended longevity. Asset allocation follows a moderately aggressive glide path beginning at 70% stocks and 30% fixed income (80/20 for the 25-year-old) and transitioning to 60% stocks and 40% fixed income by retirement.

The clients put 20% of their annual gross income toward their retirement goals and receive a 3% qualified employer match. For the 35-year-old couple initially earning $150,000 combined gross income and following the investment-only strategy, their $30,000 annual savings is split into a $19,000 qualified contribution, a $9,000 taxable contribution, and $2,000 savings to cash.

Figure 2 shows the initial allocation of the 20% budget (of gross income) that is devoted to the retirement goal by strategy. The five WL strategies redirect a portion of the overall 20% savings to WL premiums. A hypothetical WL policy insuring the male client is purchased immediately (e.g., at age 35 for the 35-year-old). The WL strategies allocate between 2% and 10% of initial gross income (in 2% increments) to WL premiums until retirement, when the policies are “reduced paid up,” and no further premiums are paid.

Figure 3 shows the amount dedicated to premiums and how it changes over time for the 35-year-old couple by strategy. The percentage of income going to WL premiums decreases over time because premiums are constant, while income grows over the accumulation period. For example, the WL 10% strategy starts with $15,000 going toward WL premiums. Ten years later, when the clients are 45 years old, they continue to pay premiums of $15,000 annually, yet their income has grown. Now, those WL premiums account for only approximately 8% of their total gross income. Immediately before retirement, their last WL premiums make up less than 5% of their gross income.

Figure 4 shows how median accumulated value grows for the 35-year-olds. At age 65, the percentage of accumulated value as a portion of retirement assets at the median is shown for each of the WL strategies.

In this research, annual rebalancing considers accumulated value an alternative to fixed income when WL is included in the portfolio of retirement assets, so the overall 60/40 allocation has 40% in a combination of fixed income and accumulated value.

Figure 5 shows the allocation breakdown of total assets at retirement—age 65—by strategy for the 35-year-olds. The resulting accumulated value as a percentage of total assets at retirement is based on the median trial and is impacted by initial asset assumptions and the distribution of savings.

Income and legacy lift from WL accumulated value

For the 35-year-olds, Table 1 reports the retirement income achievable at 90% probability of success⁸ along with the corresponding median legacy value at age 95.⁹ All income and legacy values are shown in future dollars. In all cases, income and legacy are higher for the WL strategies. These results confirm the EY study and show that integrating insurance and investments leads to better client outcomes in these examples.

For the 35-year-olds, both retirement income and legacy increase with higher levels of WL funding. Retirement income and legacy increase by 6% and 13%, respectively, for the WL 10% strategy in comparison to the investment-only strategy. Legacy is comparable for the WL 8% and 10% strategies, meaning the WL 10% strategy comes with additional income lift beyond WL 8% but no significant legacy lift in this case.

The results for the 25- and 45-year-olds are available in Appendix 2 and are similar. One difference is that retirement income peaks with the WL 8% strategy in both of those cases. However, those cases see higher legacy in the WL 10% strategy over the WL 8% strategy. In all cases, the WL 10% strategy comes with either additional legacy or income lift beyond WL 8% but not both.

Change in impact of retirement risks with WL accumulated value

This research also seeks to quantify client benefits through a series of tests subjecting the hypothetical retirees to various retirement risks. These risks include long-term care expenses, tax increases, and extended longevity.

Rather than solving for the retirement income achievable at 90% probability of success, here the initial retirement income is set at the baseline investment-only retirement income reported above for each couple (e.g., $92,813 for the 35-year-old). Then, an “event” occurs, and the resulting effects are analyzed. The baseline retirement income is used because the couple would not have known that they would experience one of these events beforehand.

The retirement risks are modeled as follows:

• Long-term care (LTC) expenses of $75,000 (in today’s dollars) are added for three years (age 84-86).
• Couples live until age 100 rather than 95.
• Federal income tax increases of both 5% and 10% start at age 65 and last throughout retirement.

The results of these tests for the 35-year-olds are shown below in Tables 2 through 4 and summarized in Table 5. Similar summary results for the 25- and 45-year-olds are shown in Appendix 3.

Table 2 shows the impact of the LTC event on median legacy. All strategies reflect the same retirement income ($92,813) and LTC costs. When LTC expenses of $75,000 (in today’s dollars) are included as an additional income need for three years (assuming the absence of any LTC coverage), the median legacy declines by 29% (from $7,546,883 to $5,369,409), and the probability of success falls from 90% to 78%. However, having WL accumulated value lessens these drops.

For a 35-year-old who has purchased a WL policy with, for example, premiums equivalent to 6% of income at age 35, the legacy declines by only 20% due to the LTC event, and the probability of success falls from 90% to 80%. The WL 6% strategy does 13% better than the investment-only strategy ($6,053,979 versus $5,369,409) when both experience the LTC event.

Table 3 shows the impact of living longer on median legacy and compares the investment-only strategy when the client lives to age 100 with the WL strategies to age 100. Using the example of the WL 6% strategy again, the median legacy is 19% higher for the WL 6% strategy than the investment-only strategy when both experience extended longevity.

Table 4 shows the impact of a tax increase on median legacy. A 5% increase in federal income tax rates during retirement negatively impacts legacy compared to a situation without an increase in tax rates. Legacy drops 9% for the investment-only strategy. By contrast, for the WL 6% strategy, for example, legacy increases by 7%. When both experience a 5% increase in taxes, legacy is 17% higher for the WL 6% strategy than it is for investment-only.

A 10% increase in federal income tax rates during retirement more severely impacts legacy. Legacy declines 16% for the investment-only strategy. Continuing with the WL 6% strategy as an example, legacy declines by 1%. Although legacy declines in both cases, when both are subjected to a 10% increase in taxes, legacy is 18% higher for the WL 6% strategy than it is for investment-only.

Table 5 summarizes the relative impact of the retirement risks on median legacy—as already shown in Tables 2 through 4—for comparison across the events. The increases were similar for either the 5% or 10% tax increase, so the table shows the 5% tax increase.

All WL strategies in these examples improve outcomes when the client is subjected to a retirement risk. The WL 2% strategy offers the least improvement. The WL 4% strategy provides about twice as much improvement in legacy as the WL 2% strategy. Comparing WL premiums from the 4% to 8% strategy provides more than twice as much improvement with the LTC event, yet the relative improvements are smaller for the other risks.

These patterns are consistent with the outcomes for the 25- and 45-year-old couples, shown in Appendix 3. Moreover, improvements increase the earlier WL is incorporated. In other words, the 25-year-old clients see the greatest improvements from having WL when subjected to retirement risks, whereas the 45-year-old clients see less improvement than the other couples. For the WL 6% strategy example, the 25-year-olds have 21%, 18%, and 19% higher legacy than the investment-only strategy when both experience an LTC event, extended longevity, or a 5% federal tax increase, respectively. The same situation for the 45-year-olds results in increases of 8%, 14%, and 7% higher legacy.

Optimal WL accumulated value levels to unlock client benefits

Next, the research aims to determine the optimal level of accumulated value to unlock client benefits in retirement.

Figure 6 shows the income and legacy lift from having WL accumulated value versus an investment-only strategy. The dark blue dots correspond to the 35-year-old couple. The size of the dots corresponds to the strategy, with larger dots indicating a higher amount of WL premiums. The income lift is greatest (4%+) for the WL 6% to 10% strategies, and the legacy lift is greatest (10%+) for the WL 4% to 10% strategies.

There is a similar story with the 25-year-old couple, shown by the light blue dots. For the WL 4% to 10% strategies, both income and legacy lifts are over 5% and 9%, respectively. Notice that the WL 10% strategy achieves the greatest lift in legacy, but there is no further income lift from the WL 8% strategy.

The 45-year-old couple is shown by the green dots and has similar findings, yet they experience more income lift rather than legacy lift. The income lift is 4% or more for the WL 4% to 10% strategies, and it is equal for the WL 8% to 10% strategies. As with the 25-year-olds, the WL 10% strategy shows a slightly higher legacy than the WL 8% strategy, but there is no additional income lift beyond the WL 8% strategy.

The 45-year-olds’ income lift is slightly greater than that of the 35-year-olds for each corresponding strategy from WL 4% to 10%. For example, the WL 4% strategy has a 2% income lift for the 35-year-olds and a 4% income lift for the 45-year-olds. This larger income lift combined with a shorter runway to retirement helps to explain why the legacy lift is not higher for the 45-year-olds. An additional test in Appendix 2 shows that when income is held constant for all strategies at the investment-only income at 90% probability of success, legacy increases up to 11% for the WL 10% strategy.

Overall, the results from all three age groups suggest that allocating between 4% and 8% of initial gross income to WL results in better outcomes. The WL 2% strategy results in a small amount of accumulated value at retirement, and it does not provide much income or legacy lift in relation to the other WL strategies within each age group. The WL 10% strategy comes with additional legacy or income lift beyond WL 8% but not both.

Is whole life insurance valuable only for the death benefit?

No. While the death benefit is an important part of whole life insurance, the accumulated value portion of the policy also offers advantages. That value can provide protection against living longer than expected, help cover unexpected expenses such as long-term care costs, and help mitigate the effects of higher taxes in retirement. The accumulated value can also provide an asset of last resort for covering necessary expenses in the event your household budget suffers a setback.

How much should I spend on whole life premiums?

The amount you spend on whole life insurance premiums should start with your need for a death benefit, which is how much coverage your loved ones would need to maintain their quality of life if you were to pass away. Once that death benefit need is established, you can consider what percentage of your income to direct toward premiums. Research has shown that targeting a premium between 4% and 8% of your gross income at the time of purchase can provide an optimal value to help mitigate many retirement risks you might face, including living longer than expected and incurring unexpected long-term care costs. Targeting a premium that is lower than 4% will still provide a death benefit and some flexibility in covering expenses, but it is unlikely to have a meaningful effect on income in retirement or legacy balances.

Do the benefits of whole life insurance accrue only if you buy a policy in your 20s or 30s?

No. Whole life insurance still provides a valuable death benefit when purchased by couples in their 40s or older. However, age is a factor in the cost of your premiums, and the older you are, the less time the assets in your policy will have to grow. While couples in their 40s can still experience a meaningful increase in their retirement income from the accumulated value of a whole life policy, the expected increase in legacy balances is generally smaller for those in their 40s than it is for couples who purchase their policies in their 20s and 30s.

In addition to the death benefit coverage, clients can experience several benefits in retirement from having WL in their portfolio of assets. Optimally sizing WL leads to better client outcomes of higher income and greater legacy when accumulated value is included in rebalancing and treated as an alternative to fixed income in the overall portfolio allocation.

To realize client benefits under the stated assumptions, the optimal size of WL to unlock the living benefits from accumulated value is found to be between 4% and 8% of income at the time of purchase, which results in 5% to 10% of retirement assets being composed of accumulated value at age 65 for the 35-year-old couple. This is equivalent to two to five years of initial retirement income, which unlocks both a down-markets reserve benefit as well as protection against retirement risks, including long-term care expenses, extended longevity, and unexpected changes in taxes.

Appendix 1

Capital market assumptions used in the research

CMAs, including standard deviations and correlations, are from Northwestern Mutual’s Investment Risk & Operations. The CMAs are based on forecasts of asset class returns over the next 80 years, and the table below includes both expected geometric mean returns and expected arithmetic mean returns.

CMAs are based on the averages derived from 1,000 trials over an 80-year time period. For purposes of performing any probability analysis, CMAs are calculated for each year and vary over time. The model for simulating asset class returns assumes that risk factors in the economy (such as nominal and real interest rates, investment-grade corporate spreads, and equity factors) are the drivers of asset class returns. By studying the historical correlation between these risk factors and the prices and performance of asset classes, a statistical model is constructed that could explain the prices of asset classes over time based on the risk factors. The current valuation levels of asset classes are also considered.

In each of the 1,000 trials, the economic risk factors are randomized to create a possible future path of the economy, and each year calculates the asset prices and returns based on the randomized risk factors. For example, if the risk factors show the economy in a recession, higher corporate spreads correspond to lower equity returns. The risk factors are randomized using a time series model with mean reversion, meaning that the values in one year are the starting point for determining the values in the next year and that over time risk factors revert to the economic assumptions that underlie the CMAs and not necessarily historical averages. NM CMAs are intended to put into perspective realistic expectations of investment risk/return profiles of various asset classes and to reflect the relative behavior of the asset classes over the long term. The development of the CMAs combines two forecasting approaches: (1) quantitative empirical modeling to capture historical data relationship and (2) forward-looking adjustments, which reflect judgment and insight from internal asset managers and third-party CMA providers.

The model considers present asset prices and current economic conditions as the starting point for simulations. The mean reversion within the model means that each year the average of risk factors changes, and the returns of asset classes are different and shift over time.

The simulation considers present asset values as its starting point. Compared to historical averages, at the time these simulations were done equity asset classes were assumed to be richly valued. Thus, in the short term, equity asset classes have lower average returns as valuation levels return to historical averages. In the longer term, equity asset classes’ average returns increase as the importance of current valuation levels diminishes. The model also considers current interest rates, which are low by historical standards. The simulations assume that over time real interest rates will increase as they revert to historical averages. Cash and Fixed Income have lower short-term rates of return due to current interest rates, but average returns increase with the assumption that real interest rates will increase as well.

Limitations of this analysis

The results of this analysis are based on assumptions that may differ significantly from your own facts and circumstances. Results may vary based on differing assumptions regarding net worth, time horizon, salary, and other variables. This analysis also uses an assumed portfolio that may not be appropriate for you depending on your risk tolerance and investment objectives. Use of a different assumed portfolio may cause results to differ. This analysis does not project the results of any actual investments or holdings and should not be interpreted as a recommendation of any particular investment or investment strategy.

Appendix 2

For the 25-year-olds, retirement income and legacy increase by 9% and 14%, respectively, for the WL 10% strategy in comparison to the investment-only strategy. These are larger gains than the 35-year-olds experience, which is attributable to the longer time horizon for both saving and growth of the death benefit.

For the 45-year-olds, retirement income and legacy increase by 7% and 3%, respectively, for the WL 10% strategy in comparison to the investment-only strategy. The retirement income gain is slightly larger than for the 35-year-olds, with a smaller increase in legacy.

In the EY study, the 45-year-olds had smaller increases in retirement income than shown here. Their results show that retirement income for the WL 2% and WL 4% strategies was lower than the investment-only strategy. For the WL 6%, 8%, and 10% strategies, the increases were around 3%, 2%, and less than 1%, respectively. However, EY saw much higher increases in legacy, from 5% to nearly 30%.

To check these results versus the EY paper for the 45-year-olds, an additional test was conducted where income was held constant at the investment-only income at 90% probability of success for all strategies. This allowed better comparison of the legacy lifts since EY found negligible income lifts. Table A.7 shows the WL 10% strategy has an 11% legacy increase in comparison to the investment-only strategy.

Appendix 3

The authors are members of the Northwestern Mutual Financial Planning Excellence team.

Brandon Marcott, CFP^®, CPM, MBA

Alissa Fiorentino, MBA

Vickie Messman, Ph.D.

Andrew Weber, CFP^®, CLU^®, AEP^®, RICP^®, WMCP^®

Important Disclosures
All depicted WL policies are hypothetical products, reflect industry-average mortality and expenses and a dividend interest rate that correlates to but lags changes in bond rates. They do not represent or approximate any actual policies sold by Northwestern Mutual. Growth in the accumulated value and/or death benefit of any hypothetical WL policy is based on assumed policy guarantees and the payment of non-guaranteed dividends. WL insurance is not an investment or fixed income investment and is purchased to meet death benefit needs.
Utilizing the cash value through policy loans, surrenders, or cash withdrawals will reduce both the death benefit and surrender value of the policy, may necessitate a greater premium outlay than anticipated, and may result in an unintended policy lapse and/or an unexpected taxable event.
Generally, the death benefit of life insurance policies that have not been transferred for value is received free from ordinary income tax. Estate taxes may apply. Partial surrenders of life insurance policies are treated first as tax-free distributions of the investment in the contract up to the cost basis followed by taxable distributions of gain once all the cost basis has been distributed. Policy loans are not treated as taxable distributions at the time they are taken.
Unpaid loan interest is capitalized to the loan principal and the loan balance may grow large enough to cause the policy to lapse. If a policy lapses or is surrendered prior to the insured’s death, the loan will be repaid from the policy’s cash value and taxed as a distribution, subject to ordinary income taxation to the extent the loan exceeds the cost basis.
All investments carry some level of risk, including the loss of principal. No investment strategy can guarantee a profit or protect against a loss.