Discuss the pros and cons of retirement funding by consuming principal and living off of principal and interest. |
An alternative strategy is to Consume Principle. With this alternative, you recognize that the only reason you accumulated your nest egg in the first place was to generate an income during your retirement years. The permanent life insurance policy provides the other two functions of guaranteeing that you don’t run out of money as well as providing a legacy to your heirs. The cash-value provides the “safety net” to keep you from running out of money, and the death benefit is the legacy that passes to your heirs. Now, if you knew that at your life expectancy that your heirs would receive the death benefit, and you had the cash value of the policy to fall back on as a “safety net” if things went wrong, what would you be able to do with your nest egg during your retirement years? That’s right, you would be free to consume or spend down the principle. Consuming the principle not only potentially gives you more spendable income during your retirement years, but it also helps to mitigate or minimize the effects of those five major risks we discussed before: 1)Inflation: when you have the ability to consume your principle, you can mitigate inflation by taking out less money in the early years of retirement and then increasing your distribution each year to keep up with inflation. The effect is that you can level your purchasing power. 2)Tax Rate: depending on the percentage of your nest egg that is invested in taxable accounts, by spending some of your principle every year you are reducing the size of your nest egg which means there is less principle to earn interest on in the succeeding years. As you earn less interest, you pay less taxes. So, even if the tax rate increases in the future, there is less interest being earned so it mitigates the impact of the tax increase. 3)Interest Rate: when you are consuming your own principle, a decrease in interest rate has less effect on your income than if you were trying to live on the interest alone. 4)Loss of Capital: you are already consuming your own capital so, again, while it would impact your spendable income, you would still have more spendable income than if you were trying to live only on the interest. 5)Market Risk: you could actually eliminate market risk from this alternative because you could construct a portfolio that would earn 2-3% return without exposing any of the assets to the market and, because of your ability to consume your principle, you would still have more income than living off interest alone. |
Presentation Math: First Year Gross Income = TVM Payment Calculation with the following inputs: Rate = Interest Rate, Periods = # Years in projection, PV = Initial Total Assets, FV = 0, Mode = Payments at End of Period. First Year Taxes = Annual Return * Tax Rate First Year Net Income = First Year Gross Income - Taxes
Documentation Worksheet: Gross Withdrawal = TVM Payment Calculation with the following inputs: Rate = Interest Rate, Periods = # Years in projection, PV = Initial Total Assets, FV = 0, Mode = Payments at End of Period. Tax Rate = Annual Taxes Paid / Annual Gross Withdrawal (Percentage of tax will reduce because of the changing ratio between taxable growth and return of principal). Taxes Paid = Annual Taxable Growth * Tax Rate Purchasing Power = TVM Present Value Calculation with the following inputs: Rate = Inflation Rate, Periods = Year - 1, Pmt = 0, FV = Gross Withdrawal - Taxes Paid. Documentation Summary Line: Gross Withdrawal = Sum of all Gross Withdrawals in projection. Tax Rate = Sum of Tax Rates / number of years in projection. Taxes Paid = Sum of all Taxes Paid in projection. Purchasing Power = Sum of all Purchasing Power results in projection. |