When you turn on the news, you often see talking heads pounding the table and saying “buy term insurance! The only life insurance you will ever need is term insurance!”
Well, that’s not true, by a long shot. Most of these folks can barely spell “insurance.”
Here’s a little secret: The best kind of insurance to own is the kind that is in place when the insured dies.
And here’s the corollary to that law: The best amount of life insurance to buy is the amount you can easily afford.
Both policies – term insurance, and cash value policies, have their place. Don’t trust anyone who’s a zealot for one kind of policy over another: That’s like someone who waxes rhapsodic over the benefits of hammers when you’ve handed him a screw! Use the policy that 1.) you can afford, that 2.) best fits your need, and 3.) most likely to be in force when the insured dies.
Do these three things, and it’s tough to go wrong.
Two Kinds of Needs
Sure, you can get fancy with things like cash values and non-direct recognition accumulation of dividends and the so-called “be your own banker” or “infinite banking” ideas (more on those in a future column). But when you get down to brass tacks, life insurance is all about providing a tax-free death benefit to whoever will have a desperate need for immediate cash when the insured dies. That’s it. All the cash values, and all the gee-whiz tax benefits of life insurance are in the death benefits, and only there because of the death benefits.
Now, there are two kinds of death benefit needs: Temporary and permanent. Temporary needs will go away after a certain period of time. Permanent needs will never go away. They will still be there no matter how long you live. The best way to do life insurance planning is to make sure the right kind of insurance is covering the right kind of needs.
Here are some common examples of temporary needs. Think term insurance for these:
- Providing for a college fund for children.
- Pay off your mortgage.
- Pay off a debt your estate will owe if you die.
- Provide money to raise your children for as long as they live at home.
- Any needs that might be permanent, but you can’t afford permanent insurance premiums yet.
- Lock in coverage at a favorable rate when you’re young and healthy.
For these kinds of needs, term insurance is usually the most cost-effective way to provide large amounts of coverage for a finite period of time.
Here are some permanent needs. These are the kinds of things you would match up with permanent insurance policies, such as whole life or universal life (again, more detail on these kinds of policies later).
- Provide for a final expense or funeral fund
- Pay off possible medical expenses
- Pay anticipated estate taxes (so your family won’t have to hold a fire sale on illiquid property or small business interests to raise cash quickly
- Provide enough cash to tide your heirs over until other assets make it through probate
- Pay off mortgages taken later in life, when term insurance premiums will no longer be economical.
- Equalize an illiquid estate. For example, one child may have a desire to take over the family business. Another child may have no desire or aptitude for it, and may want cash instead. A cash death benefit may allow one heir to buy out your other heir’s interest in a business, farm or other property.
- Fund a buy-sell agreement for a business
- Create a non-qualified executive compensation plan, or “golden handcuffs” for a key employee.
For temporary needs, use term insurance. My preference is for “convertible” policies, that allow you to convert to a permanent policy if your needs change – preferably priced at the age at which you bought the original term policy. Some policies you can’t convert to permanent, even if you wanted to. The company may not even sell permanent, or the kind of permanent policy that you want.
Why term? It’s cheap in the short run, and most people can afford a lot of it – even early in their careers. You can always drop part of a large death benefit if you don’t want it later. But if your health goes south, or even if you get a DUI, it’s tough to buy more insurance later in life.
But permanent policies, such as whole life, and in some applications, universal life, serve an important role, too. The need for liquidity at your death won’t go away just because your 20-year term expires. And your “invest the difference” money could be stuck in probate for months, leaving your heirs in a tight spot.
Here’s the thing to keep in mind: Term policies are actuarially designed to lapse. Only about 2 to 5 percent of term policies ever pay a claim. That’s why they’re so affordable! Plus, if you buy a term policy at any age – and hang on to it to your actuarial life expectancy, you will pay more in premiums than your heirs will ever receive in a death benefit. In the short run, term is very affordable. In the long run, term is expensive. Very expensive.
With permanent policies, it’s quite the opposite: Whole life policies, in particular, require a pretty big commitment for the same amount of death benefit. Very few young families can afford permanent insurance for the total amount of death benefit they need. But in the long run, if you live to your actuarial life expectancy, you will get far more out of a whole life policy than you ever put into it – either via cash value or via the death benefit.
In the short run, whole life is very expensive. In the long run, it doesn’t cost anything. You just have to commit to it for an extended period of time.
A few rules of thumb to bear in mind:
George S. Patton, the great American WWII general, was fond of saying that “the best is the enemy of the good.” By the same token, the second best policy that you can afford to keep in place is much better than the perfect policy that you will lapse.
It is better to buy convertible term now, and figure out the best policy later, than to go uninsured while you make up your mind – and risk dying, or becoming uninsurable.
Permanent insurance is oversold to the people who can’t afford it, and undersold to the people who can. Stick with what you can easily afford.
Some insurance agents will try to sell you a cash value policy to supplement retirement plans, or college savings, or for tax or wealth protection purposes. When the right kind of policy is placed with the right kind of client, these can be excellent vehicles. But they are not a great fit for everyone. If you’ve got an agent proposing a plan like this, no worries filling out an app and getting into underwriting. It’s all theoretical until you get an offer, anyway. But give us a call before you accept delivery of the policy. Your agent should give you an illustration, which is a projection of the policy’s cash values, premiums and death benefits into the future. We’ll help walk you through it give you an impartial assessment of it, and help you determine if that particular policy is the best one for your needs. A small investment now could make a difference of tens of thousands down the road.