A Life Insurance Primer
Life insurance can be important tool in financial and estate planning. It can be used to ensure that your loved ones have an inheritance if you pass away at an early age or, in the alternative, if you live a long life and run through your savings. In the context of special needs planning, life insurance can vital to funding a trust for a child or grandchild with special needs and being fair to your other children. Before the threshold for federal estate taxes began its rise from $600,000 to $11.58 million today, life insurance and life insurance trusts were often used to reduce estate taxes or to have funds available to pay the tax, or both. They are still used for this purpose today by those few fortunate or successful enough to be subject to federal estate taxes.
For everyone else, life insurance should be used to take care of the people you currently care for in case you were to die. Here’s a basic framework for understanding the different types of life insurance available on the market:
Term Life Insurance Policies
Term life insurance is similar in structure to homeowners or auto insurance. You’re insured only as long as you continue to pay premiums. The premiums are based on your age, health, and gender and are often quite low, increasing with age as your likelihood of dying within a year increases. In order to keep the premiums the same from year to year, you have the option of purchasing a term policy with level premiums for a period of time, often 10 or 20 years. This means that you’ll pay a bit more during the first few years, but you’ll know what the cost is for the period of the level term. Premiums generally increase substantially afterwards and most people then drop the policies unless they have a medical condition that would preclude them from purchasing a new term policy.
If you were to purchase a 20-year level premium term policy when your children (and presumably you) are young, this should get them through college even if you were to pass away unexpectedly.
Whole Life Insurance Policies
Whole life policies are often referred to as permanent because the intent is for you to hold the policy for the rest of your life. This means that the insurance company will have to pay out on most policies, even if that event is likely to occur long in the future. Whole life policies build up a cash reserve over time which the insurance company invests. Often, the earnings on the cash reserve fund are sufficient in later years to cover the annual premium. The policy owner may also borrow funds in the reserve if he needs cash in the future. The amount borrowed plus interest will then be deducted from the future death benefit. Because of the permanent nature of whole life policies and the cash reserve, the premiums are much higher than those for term policies.
Insurance brokers often sell whole life policies in part as investments since the growth of the reserve fund is not taxed unless the owner liquidates the policy and pockets the cash reserve. In addition, the value of the cash reserve grows income tax free, similar to an IRA. In addition, the death benefit grows over time. I don’t know whether investment professionals would agree with this claim, but I do have a whole life policy that should serve as an example of how this works.
I purchased the $500,000 policy when I was 53. The premium is about $16,000 a year, including the cost of a disability waiver. There are minimum cash surrender values, but the company also provides estimates of what they will be based on projected returns of the company’s investments. Using its midpoint projection provided in 2016, here’s how the numbers look:
When I am 70, after paying in about $270,000, the cash reserve will be just over $240,000 and the death benefit will be just under $590,000.
When I am 80, after paying in about $430,000, the cash reserve will be $440,00 and the death benefit about $675,000.
If I outlive my actuarial life expectancy and make it to 90, at that time the cash reserve is expected to be $680,000 and the death benefit $815,000, after paying in about $590,000.
After age 100, they waive the premiums.
I have no idea whether I (or rather, my heirs) would be better or worse off if, instead of purchasing this policy, I were to invest the premiums in the stock market or a balance portfolio. At least this has the benefit of a forced savings plan since I have to pay in each year or risk losing the policy.
Universal or Variable Life
Universal or variable life policies are similar to whole life policies in structure—the main difference being the treatment of the cash reserve. While the cash reserve in the whole life policy grows at a rate based on the insurance company’s investments, with a guaranteed minimum that is determined when the policy is purchased, universal life reserves are invested in a bucket of securities growing when the market goes up and declining if the market drops. The owner can choose from a variety of investment options. The hope with universal life policies is that the investments will do better than the return in a whole life policy. Universal life policies were more popular in the past when the market seemed stronger. But many owners were “burned” when the investments failed to perform as expected. They found that their policies were “under water” and they had to put additional funds in to maintain them.
In some instances, it makes sense for a husband and wife to purchase life insurance that doesn’t pay out until the second spouse passes away, especially if the purpose of the policy is to leave an inheritance for the next generation rather than for the surviving spouse. They’re often used to fund special needs trusts. Depending on the spouses’ ages and health, the premiums can be substantially less since statistically, there’s a greater chance that one of the two spouses will live longer than her actuarial life expectancy. But work with an insurance agent to make sure that the savings are sufficient to justify giving up funds for the surviving spouse. For instance, are you better off buying one second-to-die policy for $500,000 or insuring each spouse for $250,000? The larger policy will likely be cheaper than the two individual policies, but will the surviving spouse need the extra $250,000?
If you already have an insurance policy, have it reviewed. An insurance agent can have the insurance company provide a statement of the policy’s terms and if it’s a universal policy, whether your current premium payments are sufficient to support the policy. You may need to change your premiums or your benefit level. The agent will also be able to advise whether there may be a better policy available to you at the same price. While low interest rates have been pushing premiums up, greater longevity has been pushing them down. It may be that you can get the same coverage at a lower premium or more coverage at the same premium. Even if no better alternative is available, it can’t hurt to take a look.
And while you’re at it, review your beneficiary designations and make sure that they are what you want and are consistent with the rest of your estate plan.