Along with estate planning, insurance planning is likely another wealth planning topic that most people would rather not talk about. I believe that there are a few reasons for this;
- People do not like to discuss death,
- Insurance salespeople have been known to put their interests above yours,
- There are so many types of insurance that people do not understand what they mean or what they should be used for.
If you can find an advisor to work with that you trust and who places your interest before theirs, I think that most people can get past the first two points. In this piece, I want to provide you with the knowledge to understand the who, what, when, where, and how of life insurance products so that you can make the best decision for you and your family when integrating insurance planning into your wealth management plan.
There are six main reasons for having Life Insurance:
- It provides cash that replaces your current income for living expenses to support your dependents now, instead of your family having to sell the family home, the business, or other property they might want to keep in the family.
- It protects against the loss of future income and savings that would have paid for future expenses such as college, weddings, etc.
- It pays off your debts (mortgages, credit cards, personal or business loans).
- Life insurance proceeds can help pay estate taxes, thus protecting your other assets.
- If your significant other is the stay at home child caretaker, and you are the sole income provider, getting life insurance on the caretaker could be wise. This allows you to continue to work, and their death benefit payout can pay for a nanny or other childcare, so you can keep working without undue hardship on your family.
- The death benefit can provide a lump sum, a tax-free donation to one or more designated charities that depend on your on-going contributions.
How Much Life Insurance is Enough?
There are two primary approaches to determining the amount of life insurance that an individual or a family might need.
- Human Life Value
- Determines the present value of a life which is involved projecting the income of an individual through their remaining work-life expectancy, including raises and using a discount rate such as the risk-free rate or the expected investment return rate.
- Needs Approach
- Examines all the needs both recurring and nonrecurring, of dependent survivors such as but not limited to the following; loans, debts and mortgages, income to the survivors, final expenses such as medical and funeral expenses, emergency fund, education needs, and any other special needs
I use and prefer the needs approach. I have found that trying to value human life is somewhat tricky and not as straightforward as it may seem. Also, this method usually tends to require more life insurance, which is costlier than what you may need. By building a base case from what you may need, it helps to open up what goals should be planned for which previously may not have been thought about or discussed.
Types of Life Insurance
At its root level, there are only two types of insurance, temporary and permanent. As you will see, term insurance has immense flexibility with the length of a policy or need while there are various forms of permanent policies as well.
Term life insurance provides death benefit coverage over a fixed term of time such as 10, 20, or 30 years or any year in between. You should think of term similarity to your homeowners or renter’s insurance. It is there when you need it, but you still pay for it even when you do not. It has no cash value except at death. If you die after the term expires, your beneficiaries get no payout.
Term premiums are much less than permanent life insurance because you are only seeking coverage for a specific amount of time vs. your entire life. However, most term policies can be converted to a permanent policy at a later date. The owner of the policy can cancel the policy at any time, but your policy cannot be canceled due to poor health.
Most term policies are fixed policies in which case the annual cost of your policy is the same each year over the life of your policy. Your premiums will never go up, which is another reason to lock in your insurance policy when you are young. Additionally, your policy automatically renews annually.
If your term life insurance is purchased through an employer, your insurance coverage will most likely end when your employment ends. This is one reason why I encourage you to consider owning your own term policy. Like any life insurance policy, term insurance gets more expensive as you age. For example, if you have insurance through your employer and ten years later you change companies and need insurance, that insurance just got a whole lot more expensive. Also, most employee insurance plans can cap the dollar amount of coverage, which may be less than you need.
Overall, term insurance is best used when you have a known specified length of time and a significant amount of insurance need. For example, a young family with multiple financial priorities would find it difficult to get adequate coverage for their needs which could include income replace, paying off debts/mortgage, and funding future college education expense. Term insurance would allow them an affordable option during the years that their children are growing up.
Permanent life Insurance provides continuing coverage for the insured’s entire lifetime (if the premiums are paid), rather than for a set number of years as with term insurance. The annual premiums stay fixed, and at death, it pays out a lump sum death benefit.
Premiums on permanent policies are much higher than term, because the policy is designed to last a lifetime, and it builds up cash value on a tax-deferred basis. If you cancel the contract, you will get paid your cash surrender value, but if you have any gains, they will be taxed as ordinary income.
As I mentioned previously, there are several variations on Permanent Life Insurance:
- Whole Life
- Whole life premiums remain fixed and are guaranteed. Part of the premium payments goes towards a cash value savings build-up, which grows tax-deferred.
- You can take out a loan against the cash value. If you die before you pay the loan back, the amount borrowed is deducted from the death benefit payout.
- Annual dividend payouts if made by the company issuing your policy, may be sufficient over time to fund the annual premium payments.
- The insurance company bears the risk of maintaining the death benefit. Typically, your death benefit will grow over time in a traditional whole life policy.
- Universal Life (UL)
- UL offers flexible premiums, which can be adjusted up and down and are not guaranteed. The death benefit can also be adjusted annually over your lifetime.
- UL does not pay dividends.
- A percentage of the premium paid is applied to your policy’s cash value. Cash values are interest-sensitive, based on market interest rates and financial indices pegged by the insurer. They fluctuate accordingly.
- Some of the risks are shifted to the insured for maintaining the death benefit payout if the cash value or premium payments dip too low to cover the cost of the insurance. UL allows two death benefit options:
- Option A: the death benefit stays the same, and the cash value is part of the death benefit (cost of insurance is less, so your cash value will be higher.)
- Option B: pays the death benefit stated in the contract, plus any cash values built-up (cost of insurance is more, so your cash value will be lower).
- Variable Universal Life (VUL)
- VUL allows you to direct a part of your premium dollars to a separate account comprised of a variety of equity, bond, and money market funds in the insurance company’s portfolio.
- The death benefit and the cash value will fluctuate based on the performance of the funds you have chosen. VUL does not pay dividends.
- Most VUL policies will guarantee the death benefit to not fall below a certain point. However, a cash value minimum is rarely guaranteed. You can withdraw from the cash value during your lifetime via a loan.
- You bear the investment risk. If the funds perform poorly, less money is possibly available for premiums, cash value, and death benefit.
Overall, permanent insurance can be a useful planning tool for legacy and gifting planning in addition to the previous reasons we discussed as to why most people need life insurance. Permanent insurance can also be utilized for tax and retirement planning purposes given their current tax advantages.
In summary, I would like to make a few final points when it comes to life insurance;
- The death benefits are income tax-free.
- The cost of life insurance is based on your age, your gender, and your health. The younger and healthier you are, the less expensive. All things equal, men generally have higher premiums than women, because their life expectancy is shorter.
- Life insurance death benefits increase the size of your estate upon death by the amount of the death benefit.
- You should review your policies at least every five years to make sure they have not lapsed, and all assumptions are still applicable.
- If your contingent beneficiary predeceases you and you have not removed them as beneficiary and named someone else, the death benefit could go unclaimed.
Consider this an introduction into the world of life insurance planning. Given the uniqueness of any one particular wealth planning case, there could be various solutions utilizing the different forms of life insurance that were covered. However, understanding the essential features of these potential tools can have a lasting impact on both your financial and lifestyle goals.
For questions about any wealth planning and asset management topics, do not hesitate to contact me to find out what options may be best for your situation.