Understanding Life Insurance
A comprehensive risk management plan, developed with a fiduciary advisor, can help you identify when, what and how life insurance can play a role in ensuring your financial success.
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 whole 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 Whole 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, depending on how much debt you have. How long do you need coverage for? Only until your debt and big expenses (like college) are paid off. Have a 20-year mortgage and your kids are currently 6 and 4? A 20-year term sounds just right.
Whole Life Insurance – Coverage for A Lifetime
Whole life is an entirely different product. It’s called “whole” because once you buy it, as long as you keep paying the premium, it never ends. And your annual premium basically stays the same for the entire time.
As discussed above, the actuaries at insurance companies who determine the risk of these policies have a little bit of a harder time here. Because the term is variable and the price never increases, they need to build in a fairly big cushion to ensure that the insurance company makes money. This makes whole life very expensive (think thousands annually).
Whole life policies include an investment component called a “cash value”. This grows slowly at a guaranteed rate, and it is tax-deferred, so you don’t pay taxes on gains while they grow. This is why whole life policies are sometimes referred to as investments.
Once you accumulate a cash value, you can also borrow against it or surrender your policy for the cash. However, you have to repay any policy loans with interest, or they will count against your death benefit. Obviously, if you surrender the policy your coverage ends.
Why Term Life?
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”, good job, you’ve been paying attention.
While the whole life plan will accumulate a cash value, and of course there is a pay-out at the end, a life insurance policy is not an investment that can replace the long-term returns you should be able to produce with a diversified portfolio and solid savings plan. It’s worthwhile thinking about whether you need to be purchasing very expensive life insurance during the years when you are retired and your expenses are lower.
The Bottom Line
If you’ve set up a plan to become financially independent and take care of your retirement, you’ve already provided for your family and they shouldn’t need a big death benefit. And the option to invest the difference between the cost of the whole life policy and the term life – or just spend it on something else you value – is often more important than a lifetime of coverage.
By working with a fiduciary advisor and not a broker, you can be assured that you'll receive comprehensive advice as to which route is best for you, with your interests first.
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