Should you insure your retirement income?

Retirees and pre-retirees considering the various types of insurance they need should include on their checklist insuring part of their retirement income. But how much of your retirement income do you really need to insure?

To help you answer this question, it's important to first consider when it's a good idea to buy any type of insurance. In short, it makes sense to buy insurance when there's a possible future event that's very unpredictable but if it happens to you, the outcome can be financially catastrophic. Following this logic, it's obvious that it's a good idea to buy fire insurance, auto insurance, medical insurance and life insurance if you're the parent of young children.

If an unpredictable event wouldn't result in a financial catastrophe, then insurance may not be necessary because you might have the financial resources to recover. For example, although losing a cell phone may be annoying and inconvenient, most people can survive it. That's why it's usually a waste of money to buy cell phone insurance.

Similarly, multimillionaires may not need much life insurance because their survivors would presumably inherit a financial legacy if these wealthy individuals pass away unexpectedly. Whenever you have enough financial resources to recover from a setback, you can "self-insure."

The case for insurance is more complicated when you're considering your retirement income. In this scenario, you should consider several possible unpredictable future events:

  • How long you'll live. Even if you formally calculate your life expectancy, it's just an estimate. You can easily live many years beyond your predicted life expectancy -- or fall well short.
  • The investment return you'll realize on your retirement savings. Even just one or two stock market crashes have the potential to dramatically reduce the retirement income your savings can generate.
  • Future inflation that increases your living expenses.
  • Being susceptible to making investment mistakes. Or the possibility of financial fraud as you age into your 80s and beyond, with less ability or interest to manage your financial affairs.
  • Your financial discipline. Can you resist the temptation to tap into the savings that's generating your retirement income? Do you have the stomach not to panic and sell your investments during a market downturn?

The financial consequences of any of these events are that you might outlive your money, experience an unacceptable reduction in your retirement income or find that your retirement income no longer covers your living expenses.

Insuring your retirement income means having sources of income that:

  • last the rest of your life, no matter how long you live
  • enable you to survive stock market crashes
  • still cover your living expenses even if inflation pushes them higher
  • are paid automatically without any effort or actions on your part

Only three sources of retirement income meet most or all of these criteria:

  • Social Security. It meets all the criteria and is one reason why it's a good idea to maximize your Social Security income by delaying the start of benefits as long as possible but not past age 70.
  • Employer-provided pensions. Some people still have old-fashioned pension plans that provides a monthly check for the rest of their lives, although most pensions don't increase for inflation. Still, pensions are one way to insure your retirement income. Plus, they offer a good reason to reject a lump sum buyout -- an action that's equivalent to passing up free retirement income insurance.
  • Annuities. You can buy an annuity from an insurance company that automatically pays you a monthly paycheck for the rest of your life and won't be affected by stock market crashes. Some annuities are fixed and still vulnerable to inflation, while others increase for inflation or increase at a fixed rate, such as 3 percent per year. Some types of annuities provide upside potential if the stock market does well and protection from downside risk, though they come with additional insurance charges.

Still, many people don't need to insure all or most of their retirement income. Here are circumstances when you don't need to do so:

  • You have enough financial resources to self-insure your retirement, which usually means your investments earn sufficient interest and dividends to cover your living expenses without having to dip into the principal.
  • You can survive a stock market crash, meaning you can still cover your living expenses if your savings depreciate or the amount of interest and dividends drop during a recession.
  • You have the financial skill and discipline to devise and implement retirement income strategies, or you can hire a trusted and skilled professional to help you with these tasks.

Here's one strategy to help you figure out how much retirement income insurance you need: Estimate your bare minimum living expenses for housing, food, insurance, utilities and so on during your retirement years. Then determine if you have enough savings to self-insure this amount of income together with your Social Security and a pension, if you have one.

If you can't self-insure your retirement income, buy enough of a low-cost annuity such that you can cover most, if not all, of your basic living expenses together with Social Security and a pension if you have one. Then take the rest of your savings and invest it for growth potential to fund your discretionary living expenses such as hobbies, gifts and travel.

The basic purpose of any type of insurance is to buy peace of mind. Having the right type and amount of retirement income insurance gives you that peace of mind in your later years. And that will help you enjoy your retirement.

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.