Typically when we discuss a topic in the episodes of Your Wealth Curve, I call in an expert in that field to lend their expertise. In this episode, I am calling on myself as the expert. Our topic is life insurance, which is something I have accumulated a wealth of knowledge on over the years in my financial planning practice.
I started off my career in the life insurance business in 1989, on a college contract with Principal Mutual between my junior and senior year. I spent a lot of time talking to people about why they should protect their families with life insurance. Back then, life insurance was this dirty word, not really considered a financial product, or any kind of useful tool that people wanted to discuss. It always seemed strange to me why no one wanted to discuss life insurance or how it can play a vital part in your financial plan. This is the purpose of this podcast – not only to discuss what life insurance is, and what the different kinds are, but to discuss the goal of life insurance, the role it plays in your plan, and how these two things change as we get closer to retirement.
The first type of life insurance I would like to discuss is term insurance. Very simply stated, term insurance is a rental of a death benefit for a particular time frame. Term insurance has a yearly renewable term, which means the premium goes up every year. There is a level term policy, which means the premium stays level for a period of 10 years, 15 years, etc. up to 30 years, and the premium may or may not be guaranteed for the length of that term.
Whole life insurance, which is a policy where you have ownership, has a series of guarantees – cash value, death benefit and premium. In a whole life policy, the cost of insurance, or the mortality expense, is the same throughout the life of the policy.
Universal life insurance falls somewhere in between term and whole, in essence a hybrid of them. A UL policy builds a cash value like a whole policy does, but is slightly different. It is similar to a term policy in that the mortality cost is going up every year inside the contract with the hope that the cash value you are building will offset the higher premium as you age. The universal life concept was developed in the late 70s and early 80s, where extremely high interest rates gave people the ability to accumulate money rapidly inside these UL policies. As interest rates fell, these policies got less popular due to rising premiums to accommodate the lower rates of return on the cash value portions of the policies. Core UL policies invest your money in the life insurance company itself, and guaranteed UL policies will guarantee premium and death benefit regardless of the cash value, as long as the premium is paid in a certain timeframe. There are also indexed UL policies and variable UL policies, which basically give policy holders alternative ways to invest the proceeds. These types of policies enable the cash proceeds to be invested in an index or mutual fund as opposed to being invested in the life insurance company itself.
There are two types of companies to offer life insurance policies. A mutual company is owned by the policy holders and the profits made from its “whole life insurance” contract policies are returned to the owners in the form of dividends. The other type of life insurance company is a stock company, which is a publically traded company.
For the purpose of our wealth plan, it is important to look at life insurance in terms of what we are trying to use it for in the various stages of life. During our lifetime, at various ages, there are different family dynamics and different economic circumstances. When you are in your accumulating phase, or the phase where you are earning your living and saving for the future, we use life insurance as a tool to protect your greatest asset, or your ability to work and earn future income. Life insurance insures the economic value of an individual, or the determination of what you are making and how long you will earn it for. When you purchase life insurance, the amount of coverage you are eligible for is calculated by using a multiple of your income plus assets. As we age, the multiple is going down. For example, of a 30-year-old person is earning $150,000 they are eligible for $3,750,000 worth of coverage, which is the salary times 25. At age 30, they use the multiple of 25 as the maximum amount of coverage you can purchase at that salary level. As this person gets older, that number keeps going down. The idea is when trying to figure out how much coverage to buy, you should ask yourself how much money you would need to get your family through to retirement age at their current standard of living. How much do you need to make sure your family can still pay the bills, attend schools, etc. from now on?
As you move into the retirement phase on your wealth curve, the role of life insurance changes. The policy’s role goes from protecting your future potential earnings to asset protection. As you start to live off of your assets, including social security or any pension you might have, and spend down what we have saved, life insurance can be used to replenish these funds after collection of the death benefit. Maybe it’s a down market when we retire, causing us to have to sell things off at pennies on the dollar, or we burn through a few hundred thousand dollars in healthcare costs in our old age – life insurance can replenish those assets upon death.
Life insurance policies have what we call a “conversion” or the ability to convert a term policy to a permanent life policy should changes in your health occur during the life of your policy. A conversion allows the policy owner to convert the policy at the same preferred rate for which they purchased it. By adding a conversion clause, you are in essence insuring your insurability. Policies can be converted to different things – universal life, indexed universal life, or whole life. When considering a conversion clause, make sure it is convertible in today’s environment and is convertible to something permanent with controlled premiums. Also, when buying a term policy, make sure you choose a term you are comfortable with. The way it works is that you pay a premium for the length of the term, then the premium jumps when the term expires. Another factor affecting your premium is what your “rate class” is. The rate class is how you are rated in terms of health, credit score, driving record and tobacco use. There are also different “riders” to a term policy, including one called a “waiver of premium” rider. This means that in case of a disability, the life insurance company would start paying the premium on your policy and then it would automatically convert to a permanent policy at the end of the term.
When trying to decide on the amount of coverage to own, it is important to thoroughly examine your current financial obligations to figure out much your will need in the future to support your family as is. We ask the types of questions like how much do I owe on my mortgage? What do I owe in debt? Do I owe back taxes? What kind of inheritance tax will I have to pay? Do any of my children have special needs that need to be considered? Once you have a firm grasp on your current financial picture, you can then determine what the maximum coverage you can buy is. Try to look into the future – what are the interest rates? What are the needs of my family? Err on the side of conservativeness here – remember you are trying to protect the assets at a minimum cost.
The role of life insurance in your wealth plan changes from protecting your ability to work and earn money to protecting your assets so you can free up money to spend in retirement while keeping intact the inheritance I wish to pass on after death. In order to make the best choice when deciding on what type of coverage is right for you, it is important to identify where on the wealth curve you are now and where you would like your family to end up in retirement.