Retirement. Life Insurance in a Goals-Based Framework

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1 GLOBAL INVESTMENT COMMITTEE JUNE 2016 Retirement LISA SHALETT Head of Investment & Portfolio Strategies Morgan Stanley Wealth Management DANIEL HUNT, CFA Senior Asset Allocation Strategist Morgan Stanley Wealth Management JOE LAETSCH Market Strategist Morgan Stanley Wealth Management Life Insurance in a Goals-Based Framework While most people think of life insurance as a way to provide for dependents and pay for final expenses upon death, it can also play an important role in your portfolio during your lifetime. Especially in a world of low expected returns on risk assets, many life insurance policies have features that can help individuals meet their financial goals. Some of the most common uses of life insurance are protection, wealth accumulation and wealth transfer. An investor s decision to purchase insurance remains closely related to their goals, especially retirement goals. To put some context around these decisions, we therefore draw on the insights furnished by our analytical framework for retirement (see Introducing the Morgan Stanley Wealth Management Retirement Framework, November 2015). Core to our approach is the concept of an individual s funding ratio, which is a measure of retirement preparedness. The funding ratio the ratio of the present value of current and future savings to the present value of the income needs those savings have to fund can help us to understand how different types of insurance might play a role. Please refer to important information, disclosures and qualifications at the end of this material.

2 RETIREMENT Protection The traditional use of insurance is to protect one s finances against unforeseen events that can have detrimental effects on a family s ability to meet financial obligations. For example, when an investor is a breadwinner, whether by her wages or in retirement through a traditional pension or an individual annuity, the risk of her passing away prematurely is a liability for the entire family. A life insurance policy can hedge this risk. The benefit it pays upon her death to her beneficiaries ideally is an amount that offsets the financial loss to them of such an event. Term insurance, which provides life coverage for a certain period of time, is a cost-effective way to protect surviving beneficiaries, although other more expensive forms of life insurance combine protective benefits with other features that can further other client objectives. Two other types of risks can impede an investor s ability to meet their goals. One is not being able to work for an extended period of time due to illness or accident; to hedge that risk, there s disability insurance. The risk of needing long-term care during retirement due to a medical condition can similarly be hedged with long-term care insurance (Exhibit 1). To illustrate the implications associated with a decision of whether to purchase an insurance policy to protect against this type of risk, consider Exhibit 2 (see page 3). The analysis depicts what happens to an individual s financial position under four scenarios. In the first two, the investor has elected not to purchase long-term care insurance and thus the funding ratio is more than 100%. But if that investor needs long-term care and has to pay for it out of pocket, the funding ratio drops by more than a third to a seriously deficient 67%. Simply put, the present value of your assets to your liabilities is only about twothirds of what it should be. By purchasing the insurance, the funding ratio drops to 99% in the case that it s not needed and importantly, 96% if it is. The effect of the protection is to trade a somewhat reduced level of funding, from 105% to 99%, for a significant reduction in the impact of these contingent expenses. 1 Wealth Accumulation While the primary function of insurance is to provide protection against unknown events, the special features of some insurance policies can broaden their uses. Foremost among these features is the ability to grow what might otherwise be taxable investments on a tax-deferred basis and potentially, in an intergenerational context, even in a tax-exempt way. Of course, many types of retirement savings accounts confer tax benefits relative to standard savings vehicles like brokerage accounts, e.g., a tax exemption on contributions and deferred taxes on gains such as through 401(k)s and Individual Retirement Accounts. However, these vehicles are subject to contribution caps that can limit their usefulness for more affluent investors, and in certain circumstances can actually be less tax efficient. Life insurance, in particular cash value life insurance rather, also confers tax benefits on investments held in the policy, and therefore can also be used to aid a client s wealth accumulation objectives (see Exhibit 3, page 3). This is because monies contributed to a cash value policy can be accessed during the life of the insured up to the cash surrender value (though, of course, this will affect the cash value and death benefit of the policy 2 ). The portion that is the premiums paid typically does not create tax liability when withdrawn. The insured can also borrow against the cash value of a permanent policy, often on a tax-free basis. This means that in addition to providing a death benefit to a beneficiary, cash value life insurance can be employed to fund normal retirement expenses, or as a legacy plan that also functions as a backstop against emergency retirement expenses. The wealth-accumulation benefit of some cash value life insurance policies may include a guaranteed minimum interest crediting rate. In many cases, the Exhibit 1: Types of Protective Insurance Policy Type Who Rationale Term Insurance provides coverage for a certain period of time (a specified term of years) at a guaranteed premium rate This is most appropriate for people who need insurance for a limited period of time and are more focused on liability management (income replacement and debt coverage) than wealth accumulation Can help protect dependents or beneficiaries from potential loss of wages and large responsibilities such as mortgages and college education in the event of the insured s death. Also frequently used to cover outstanding debt Long-Term Care Insurance helps provide for the cost of long-term care such as home care and assisted living for someone with a chronic disease or disability This is most appropriate for people who are concerned with protecting savings from the future cost of medical care or nursing facilities Can help protect retirement savings from unexpected and often high medical expenses Disability Insurance helps protect income in the event of becoming unable to work due to an injury or disability This is most appropriate for people who want to protect against the possibility of lost wages and do not have the ability to sustain a prolonged loss of income Can help protect retirement savings and offset lost wages if one becomes unable to work Please refer to important information, disclosures and qualifications at the end of this material. June

3 Exhibit 2: Protection Reduces Risk to Retirement Plans 120% % No Contingent Expenses 67% Contingent Expenses Without Insurance With Insurance Note: For the assumptions used in these calculations, see footnote 1 on page 7. Source: US Department of Health and Human Services, FactSet, Morgan Stanley Wealth Management GIC guaranteed rate can be more attractive than those available in the fixed income market on an after-tax basis. It is locked in for the duration of the policy which is typically substantially longer than the tenor of most bonds. These potentially higher rates can help a client meet their growth hurdles without using riskier portfolio strategies. What s more, guaranteed rates reduce downside risk exposure, which is especially desirable when the individual is close to or in retirement. Wealth Transfer These same features also mean that, in certain circumstances, life insurance can also be used as a vehicle to transfer wealth to other generations on a tax-efficient basis (see Exhibit 4, see page 4). Guaranteed universal life, variable universal life, indexed universal life and whole life insurance can be used for this purpose, as with these policies the death benefit is generally passed to the beneficiary free of income taxes (see Exhibit 5, see page 4). In some cases, the death benefit may be 99% 96% No Contingent Expenses guaranteed. Combined with estate planning or, if the beneficiary is a charitable organization, the tax advantages of these policies for use in intergenerational wealth transfer can be magnified. As shown in Exhibit 4, one such strategy is to use life insurance in conjunction with an irrevocable life insurance trust. In this situation, the grantor contributes cash to the irrevocable life insurance trust. The trust purchases a policy from a life insurance carrier using the cash contributed to pay the premiums. When the insured passes away, the death benefit passes to the trust and, in turn, onto the beneficiaries of the trust free of both income and estate taxes. Of course, all estate planning strategies have drawbacks, and need to be considered in consultation with qualified professionals. 4 Drawbacks Life insurance comes with several drawbacks that potential buyers should consider, including limitations and conditions on access to cash values and the Exhibit 3: Benefits of Cash Value Life Insurance Contingent Expenses potential for policy lapse, with associated tax consequences. We highlight the following in depth: liquidity risk, credit risk, health risk and expense. Liquidity risk stems from an investment that cannot be bought or sold quickly without substantial, in some cases prohibitive, transaction costs. While many permanent life insurance policies allow clients to access their policy s cash value through policy loans, a life insurance policy cannot be liquidated in the same way as stocks, bonds and mutual funds. This means a client may not be able to access this cash to satisfy an immediate need. Accordingly, investors should consider their liquidity profile, and generally incorporate life insurance as part of a strategy that includes liquid savings. Another risk associated with life insurance is credit risk, or the risk that the selected insurance carrier becomes insolvent. As policies are subject to the claims-paying abilities of their issuers, there s some risk claims may not be paid. The exposure of life insurance to credit risk can, however, be mitigated through diversification of coverage across different insurance companies. This is effectively the same as mitigating the potential for losses in any one investment in a portfolio by holding smaller concentrations of a greater number of investments. On that basis, depending on the level of concentration and the size of the policies, it sometimes makes sense for investors to consider holding insurance policies with more than one company. 5 Another drawback to consider is the health of the insured. The cost of the client s death benefit is a function of the insurance company s evaluation of that individual s risk of early mortality. To conduct that evaluation, an insurance company will examine the insured s health Cash value of account grows tax deferred Withdrawals or loans against the life insurance policy can generally be taken free of income tax 2 Unlike traditional retirement vehicles in which contribution amounts are capped (401(k)s and IRAs), insurance products allow clients to contribute additional dollars into a tax-advantaged structure with greater flexibility up to certain limits 3 Death benefit can pass to heirs income tax-free upon death Please refer to important information, disclosures and qualifications at the end of this material. June

4 Exhibit 4: Life Insurance Can Enhance Estate Planning Grantor Premiums history as well as the insured s family history. Underwriters will also look at the insured s occupation, hobbies, driving record and other relevant factors. The insurance company then determines, based on the risk they assess, the price at which it can offer the insurance. In cases of poor health or high risk factors, the price can be very high, even prohibitively so. This is part of the reason why it makes sense to evaluate the need for life insurance at a younger age. Clients can often obtain Life Insurance Carrier Premiums Death Benefit Irrevocable Life Insurance Trust Death Benefit Beneficiaries insurance even if they have health impairments; however, there are associated costs. Finally, while life insurance expenses pay for its many features, these costs can be significant relative to traditional investment vehicles, particularly in a permanent or variable universal life insurance policy. In certain situations, the tax efficiency benefits can outweigh the additional costs, but when returns are lower, expenses can reduce the potential upside or magnify the downside relative to an investment-only strategy. Solving for Your Retirement Needs Weighing both its advantages and drawbacks, there are many instances where insurance can play an important role within a retirement plan be it to provide protection, assist with wealth accumulation or transfer wealth to the next generation. As with traditional investments and types of annuities that we have analyzed in the past, the applicability of different types of insurance to any particular investor and the nature of the goals most pertinent to them will vary by investor. Morgan Stanley Wealth Management s Retirement Framework outlines analytical tools we can employ to help us diagnose investor needs and the applicability of various insurance solutions in a more transparent way than does complex planning analysis. Specifically, an individual s funding ratio can help us identify which types of insurance policies Exhibit 5: Types of Life Insurance Best Suited for Wealth Accumulation and Transfer As with any financial or insurance product, life insurance comes with benefits and drawbacks. This table communicates the rationale for these policy types for different types of individuals in the context of wealth accumulation and transfer. For a discussion of associated drawbacks, see the drawbacks section on page 3. Policy Type Who Rationale Guaranteed Universal Life Insurance is a form of permanent insurance with the flexibility to choose a designated guaranteed premium and death benefit, and the age to which the death benefit will be guaranteed, whether it s 100, 105, 115 or 120 Variable Universal Life Insurance is a form of permanent insurance designed for cash accumulation tied to market performance. Multiple investment options are available to suit the client s risk tolerance Indexed Universal Life Insurance is a form of permanent insurance that allows the owner to allocate cash value amounts between fixed rate and indexed subaccounts, such as the S&P 500. Indexed account returns are typically capped and the downside limited Whole Life Insurance is a form of permanent insurance designed to last a lifetime. The premiums, death benefit and cash value are all guaranteed by the insurance carrier This is most appropriate for people who want life insurance s protective and wealth transfer properties with reduced uncertainty about their insurance coverage This is most appropriate for people who want life insurance s protective properties but also want to be able to build and access the cash value and have a higher risk tolerance This is most appropriate for people who want life insurance s protective properties but also to be able to build and access the cash value and have a lower risk tolerance This is most appropriate for people who want life insurance s protective and accumulation properties with minimal uncertainty about their insurance coverage Guaranteed value as long as you maintain contract terms and premium payments, ability to grow at a guaranteed minimum rate tax deferred or in some cases tax exempt Ability to grow what might otherwise be taxable investments tax deferred or in some cases tax exempt, ability to access cash value via loans or withdrawals, cash accumulation tied to market performance Ability to grow fixed rate and indexed subaccounts that might otherwise be taxable, tax deferred or in some cases tax exempt, ability to access cash value via loans or withdrawals Guaranteed death benefit and cash value, ability to grow what might otherwise be taxable investments tax deferred and or in some cases tax exempt, ability to access cash value via loans or withdrawals Please refer to important information, disclosures and qualifications at the end of this material. June

5 Exhibit 6: The Funding Ratio Illuminates Progress and Potential Solutions With a 97% Funding Ratio an Investor Is on Track to Meet Retirement Goals Present Value of Needed Income $2.5 Million Present Value of Current and Planned Savings Age $2.2 $2.1 On Track (%) At Risk (%) Note: On Track means an investor is likely to achieve his goals; At Risk implies a material risk that an investor may not achieve his goals; Off Track means it is unlikely an investor will meet his goals without modifying savings or spending plans. might make sense to a specific investor, and even give an estimate of how much coverage may apply. To see how that works, go back to the funding ratio, a measure of a person s retirement preparedness that can be used to track the progress of an investor toward their goals in real time. It is based, not on return forecasts and a complex statistical framework, but on the objective criteria of prevailing interest rates and actuarial estimates of the present day cost of retirement liabilities. In the example illustrated in Exhibit 6, the extent to which a funding ratio resembles an individual s balance sheet is laid bare: their accumulated and planned savings plus resources like Social Security and pension benefits relative to their spending plans. A funding ratio can tell us whether an investor is on track to fulfilling their objectives. It can also be used to help assess the need for as well as the appropriate size of a suitable insurance policy in the context of specified risks, wealth transfer objectives or to determine investment strategy. For example, a marginally funded investor would likely be able to afford insurance associated with disability, long-term care and early mortality, but would not likely be able to manage if those unforeseen expenses Off Track (%) occurred. For such an investor, protective insurance would be very appealing given the potential for increased retirement spending plans, reduced retirement savings and increased risk of outliving their resources. By contrast, such protection might be much less appealing for very underfunded or very overfunded investors. An investor who is quite underfunded is unable to lower the risk of high contingent expenses without increasing other risks to their retirement while a quite overfunded investor can self insure those risks and use the funds for other purposes. One such use of funds for well-funded investors is to further wealth accumulation and transfer through enhanced tax efficiency. In the case of wealth transfer, a funding ratio can very quickly help an investor identify the surplus funds available for gifting. While a funding ratio helps to understand the potential usefulness of insurance for an investor, a more detailed examination and analysis is often needed. What is clear is that there are multiple sets of circumstances under which investors benefit from using insurance. That makes sense both intuitively and with respect to established practice. Moreover, our framework supports it. In the following pages, we provide more detail about the various types of insurance in this report The Bottom Line While the primary rationale for life insurance is the death benefit, its other attractive features make it useful beyond the need to protect loved ones. In an age when investors are required to take the risks associated with preparing for retirement during an extended period of financial repression and potentially lower returns, the tax advantages and competitive guaranteed appreciation of many life insurance products represent an opportunity many investors should consider. Furthermore, during this period of high tax rates amid a massive transfer of wealth from the baby boomer generation to younger generations, the need to consider smarter strategies for more efficient wealth transfer is as great as it has ever been. Using life insurance as part of an overall investment strategy can help improve the likelihood an investor will be able to meet their objectives while also potentially allaying concerns with respect to market and life contingencies. The funding ratio, together with more detailed financial planning, can help investors and their Financial Advisors understand how and where those potential advantages can be accessed given their circumstances. Please refer to important information, disclosures and qualifications at the end of this material. June

6 Term Life Policy Type Long-Term Care Insurance Disability Insurance Insurance for Protection Description Term insurance provides coverage for a certain period of time, or a specified term of years. Once the policyholder stops making the payments, the insurance coverage ends. While term insurance is inexpensive at younger ages, costs rise dramatically at older ages particularly after 65. Many term products are convertible to permanent products. Because term insurance does not build internal cash value, it is usually not a good choice for long-term estate planning. This type of insurance is most appropriate for clients who: Are between the ages of 25 and 55 Have families that depend upon a wage earner s income to fulfill their financial goals Have a large need and low cash flow Need insurance for a limited period of time usually 10 to 30 years More focused on liability coverage than cash accumulation Long-term care insurance covers services provided to anyone with a chronic disease, disability or sudden illness who requires assistance with activities of daily living such as eating, bathing, dressing or moving from a bed to a chair. It also includes the supervision of persons with severe cognitive impairments, such as Alzheimer s disease or other mental illnesses that can limit a person s ability to think or reason. This type of insurance is most appropriate for clients who: Are between the ages of 45 and 75 Are concerned about future medical expenses or nursing facility expenses Would like to protect savings from major medical expenses Disability insurance provides income to help pay life s expenses even though you can't work due to a disability. A disabling illness or injury can stop income, impose additional costs and prevent saving for the future. This type of insurance is most appropriate for clients who: Are between the ages of 25 and 60 Are professionals or business owners Do not have resources that are adequate to sustain a prolonged loss of income Please refer to important information, disclosures and qualifications at the end of this material. June

7 Policy Type Guaranteed Universal Life Variable Universal Life Indexed Universal Life Whole Life Insurance Life Insurance for Accumulation and Wealth Transfer Description Guaranteed universal life insurance is a specific type of life insurance that provides the policyholder a guaranteed death benefit. This means that even if there is insufficient cash value within the contract to support the death benefit, it will still remain in force due to the coverage protection guarantee. The stipulation to this is that premium minimums must be met and paid on time. These policies may be appropriate for clients who: Are over age 25 Have a high and stable cash flow Are focused on wealth transfer strategies Have estate or business planning needs Have children or other dependents who rely on their income to maintain their lifestyle Have a conservative or moderate risk tolerance Variable universal life is a form of permanent insurance that allows the policy owner to invest the policy's cash value in a number of variable portfolios (also known as subaccounts). While these portfolios provide the opportunity to potentially improve the return on the policy's cash value, the value of these subaccounts is subject to investment risk, including the possible loss of premiums paid into the policy causing the policy to lapse. These policies are most appropriate for clients who: Are between the ages of 25 and 75 Have a high and stable cash flow Believe that long-term equity markets are likely to outperform bonds Want to protect their family and also accumulate assets Have an estate or business planning objective Have a higher risk tolerance Indexed universal life is similar to variable universal life in that it is also a form of permanent insurance linked to market performance and provides access to the policy s cash value. Where it differs is that in place of investing in subaccounts, the policy provides access to account value growth potential through a fixed interest account as well as an optional indexed account linked to the performance of an index, such as the S&P 500. There is normally a return floor of 0% and a cap which limits both the downside and upside potential of the policy; therefore, there is less upside potential and less downside risk than in a variable universal life policy. These policies are most appropriate for clients who: Are between the ages of 25 and 75 Have a high and stable cash flow Believe that long-term equity markets are likely to outperform bonds Want to protect their family and also accumulate assets Have an estate or business planning objective Have a moderate to high risk tolerance Whole life is a form of permanent insurance that builds cash value tax deferred. Clients can access their cash value via tax-free loans or through withdrawals (taxes will apply if the amount of the withdrawal or loan exceeds the basis). In whole life, the premiums, death benefit and cash value are all guaranteed by the insurance carrier. Accordingly, premiums may be higher than other forms of permanent insurance. These polices are most appropriate for clients who: Are over age 55 Are risk-averse, conservative investors Have a high and stable cash flow Have a long-term estate planning need Want to limit uncertainty about their insurance coverage Please refer to important information, disclosures and qualifications at the end of this material. June

8 Footnotes 1 Assumptions used in calculation are: age: 65; marital status, single; working status, retired; nontaxable assets, $300,000; taxable assets, $600,000; Roth IRA assets, $25,000; annual Social Security, $25,000; annual other income, $10,000; annual savings, $0; annual expenses, $75,000; average annual longterm care insurance premiums, $2,207; average annual semiprivate room longterm care expenses, $74,820. In scenarios that contingent expenses occur, they begin at 85 and last for five years and the inflation rate is 2%. In case where there are contingent expenses with long-term care insurance, client pays 10% deductible. Discount rate is 2.7%. 2 Any withdrawal or unpaid loan balance and loan interest from a life insurance policy will reduce the policy s cash value and death benefit. A policy lapse or surrender while loans are outstanding may result in the recognition of taxable income. There may be penalties and fees associated with the use of loans and withdrawals. If the policy is a Modified Endowment Contract (MEC), distributions, including withdrawals, loans, unpaid loan interest and surrenders are subject to Federal income tax to the extent of the gain in the policy and if taken before age 59½ may be subject to an additional 10% tax penalty. 3 Contributions cannot exceed limits defined in Sec of the IRC. Also, note that if contributions exceed, the 7-pay test as defined in Sec 7702A of the IRC, policy will become a MEC. 4 An irrevocable life insurance trust (ILIT) is, by definition, irrevocable, meaning that once in place it cannot be reversed or amended, even if circumstances change, and the insured cannot be deemed as having incidents of ownership in order to not be subject to estate taxes. ILITs are complex legal instruments and there are legal fees and other costs associated not only with establishing the trust but also managing and maintaining it. 5 Multiple insurance policies require multiple premium payments and additional expenses versus a single policy. Index Definitions S&P 500 INDEX This capitalizationweighted index includes a representative sample of 500 leading companies in leading industries in the US economy. Please refer to important information, disclosures and qualifications at the end of this material. June

9 Risk Considerations Variable Life Insurance Morgan Stanley Smith Barney LLC offers insurance products in conjunction with its licensed insurance agency affiliates. Variable life insurance is sold by prospectus only. The prospectus contains the investment objectives, risks, fees, charges and expenses, and other information regarding the variable life insurance contract and the underlying investment options, which should be considered carefully before investing. Prospectuses for both the variable life insurance contract and the underlying investment options are available from your Financial Advisor. Please read the prospectuses carefully before you invest. All guarantees are backed by the claims-paying ability of the issuing company and do not apply to the underlying portfolio option. Hypothetical Performance General: Hypothetical performance should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. Hypothetical performance results have inherent limitations. The performance shown here is simulated performance, not investment results from an actual portfolio or actual trading. There can be large differences between hypothetical and actual performance results achieved by a particular asset allocation. Despite the limitations of hypothetical performance, these hypothetical performance results may allow clients and Financial Advisors to obtain a sense of the risk/return trade-off of using insurance as part of a retirement plan. Investing in the market entails the risk of market volatility. The value of all types of securities may increase or decrease over varying time periods. This analysis does not purport to recommend or implement an investment strategy. Financial forecasts, rates of return, risk, inflation, and other assumptions may be used as the basis for illustrations in this analysis. They should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. No analysis has the ability to accurately predict the future, eliminate risk or guarantee investment results. As investment returns, inflation, taxes, and other economic conditions vary from the assumptions used in this analysis, your actual results will vary (perhaps significantly) from those presented in this analysis. Disclosures Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. 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The appropriateness of a particular investment or strategy will depend on an investor s individual circumstances and objectives. Morgan Stanley Wealth Management recommends that investors independently evaluate specific investments and strategies, and encourages investors to seek the advice of a financial advisor. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or financial conditions of companies and other issuers or other factors. Estimates of future performance are based on assumptions that may not be realized. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. 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