Understanding Life Insurance
You’ve worked hard, built a career, bought your dream home, and started a family. Your income covers your expenses (with some left), you’re maxing out your 401(k) contributions, saving for college and even putting something aside in an investment portfolio. You’re in great shape to retire in 20 years or so, with your mortgage paid off and enough to see you through a comfortable retirement.
What’s missing from this picture? A comprehensive risk management plan. Not investment risk: The assumption is that you have that covered with effective portfolio management. This is life risk – the risk that something can happen to derail your carefully built plans.
Another word for risk management? Life insurance. No one likes to think about it because it’s.... (A) complicated and (B) far more interesting as the motive in classic movie plots. But when you have a lifestyle that is dependent on your salary, it’s critical.
There are essentially two types of insurance, term and permanent life. Term life may be preferable because it covers you only for the period you really need it, and because it is much less expensive, it leaves you more to invest in instruments with a potentially higher rate of return.
Key concepts covered: Term Life Insurance and Permanent Life Insurance
Term Life Insurance – Coverage During Your Working Life
This type of life insurance is quite simple – it provides coverage for a specific period of time (a “term”) and then ends. If you die during the term, the policy pays your named survivor, called your “beneficiary”. The whole point of this insurance is to provide for your family during the years when you are earning – to replace your salary and keep their lives on track.
It’s very inexpensive, because insurance companies have people called actuaries. These individuals create very specific predictive models based on data they’ve carefully collected for decades. Since insurance companies know that they are only going to pay off in fairly rare circumstances (most people outlive their term), they keep rates low enough to make them affordable (think hundreds or less, depending on your health and your age).
How much coverage do you need? The rule of thumb is 10-15 times your salary on a breadwinning income, and also depends on how much debt you have. It's also critical to think through how long you need death benefit coverage? Consider coverage that lasts long enough for you to pay off major debt and big expenses (like college). Say you have a 20-year mortgage and your kids are currently ages 6 and 4... A 20-year term policy sounds just about right.
Permanent Life Insurance – Coverage for A Lifetime
Permanent life insurance is coverage specifically designed to last your lifetime and comes in several shapes and forms. Many people will often associate permanent life insurance synonymously with “whole life” insurance, which is a type of permanent life insurance in its own right. However, there are many types of permanent life insurance beyond just whole life insurance. In addition to whole life, you have other types of permanent life insurance policies such as variable universal life, indexed universal life, and traditional universal life, among others.
In general, most permanent life policies will include an investment component called a “cash value”. Think of it as a tax-deferred bucket of money designed to support policy costs through a person’s lifetime, and that cash value can grow or fluctuate depending on the underlying investments it’s tied to.
Once you accumulate a cash value, you can also borrow against it. The loan provision in many of these policies can be attractive because it provides a benefit to the policyholder while they are alive and carries certain tax advantages. Furthermore, you do not have to pay taxes on loans distributed from your own policy, but you do have to repay policy loan interest. While the word "loan" might not sound too appealing, most life insurance carriers design these policies to account for loan interest, and any debt not repaid will count against your death benefit.
This is why some individuals will fund some version of a permanent life insurance policy and make large premium payments, because they'll use it as a supplemental retirement plan as a way of taking advantage of some tax and estate planning benefits.
Some policies are designed with fixed premiums and guarantees where as long as you keep paying the premium, death benefit coverage will last a lifetime. Other types of policies have flexible premiums that feed into the policies cash value, and death benefit coverage will last as long as there is sufficient cash value built-up to keep the policy in force.
These policies are not without cost though and can come with hefty surrender penalties. A surrender penalty is a penalty fee if you decide to get out of (cancel) the policy within the penalty period, which is normally 10-15 years. Further, if you surrender the policy, your coverage ends.
As discussed above, actuaries at insurance companies who determine the risk of permanent life insurance policies have a little bit of a harder time pricing the cost of these policies. The death benefit term can be variable and premium payments on policies may differ, so companies often need to build in a fairly big cushion to ensure the insurance company makes money. This makes the internal costs for a permanent life insurance very expensive (think thousands annually) compared to term insurance.
What Do You Need?
Based on the information above, you should be able to answer this question: What is the purpose of life insurance?
- If you said, “To replace my income and protect my family if something happens to me," then term insurance is likely the best option for you.
- If you said, "To plan for my estate and leave behind a legacy gift for my relatives," then some form of permanent life insurance specifically designed for your circumstances could be appropriate.
However, it's important to keep in mind that while any form of permanent life insurance will accumulate a cash value, and of course there is a pay-out at the end, the underlying investments within a life insurance policy will generally not replace the long-term returns you should be able to produce within a diversified investment portfolio and solid savings plan. It’s worthwhile thinking about whether you need to be purchasing more expensive permanent life insurance for very specific policy benefits, and whether those benefits are worth the costs in your situation.
We find the vast majority of people only need term insurance – but there are limited instances for estate planning purposes and for higher net worth individuals where permanent life insurance may be appropriate and beneficial.
The Bottom Line
Everyone’s different. We find it’s best to determine how much death benefit coverage you need and then design a life insurance plan suitable to your circumstances. If you need assistance with this, please feel free to give our office a call at (209) 857-5207 and we can help you evaluate what type of insurance plan is most appropriate for you and your family.
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