Glad you asked: The 5 most important things to know about life insurance
We often learn about money and finances from our parents, but absent a formal education on how the economy works and how to find our place in that economy, a person’s financial knowledge is largely hit-or-miss. This is especially true when it comes to assessing life's risks.
We start out absorbing the financial consequences of some of those risks, such as a tire blowout and the out-of-pocket cost of replacement. We call that “self-insuring” and we typically self-insure many of the risks we know about—and obviously all the risks we don’t know about.
We’re probably not overly concerned about the risk of replacing a tire, but which risks should people pay attention to? Which can be mitigated? And which have such great financial consequences that self-insuring could be a disastrous strategy?
So consider this typical scenario: we acquire a car—and then an apartment or condo or house. Our responsibilities increase with respect to a spouse and children—even parents—and possibly second families. The risks of loss—from fire, theft, sickness, accident, disability, and premature death—become a threat to our financial security. We readily make decisions about auto and homeowner’s insurance; it’s required if we want to own that home and drive the car.
But consider life insurance: It is not required. For most of us it’s about our love and feelings of responsibility for a family that needs to keep on going financially even if the breadwinner isn’t there. Life insurance responds to a calamitous loss, but no matter how much it might grieve us to leave our families destitute, we also would rather not think about what causes it to be paid out! Responsibility usually wins out, and when my clients ask, “What do I need to know about life insurance?” I take their questions seriously and try to share the five most important things I think they should know:
1. You don’t have enough.
Perhaps the biggest deterrent to maintaining enough life insurance is that we quantify it as a large lump sum that—if invested wisely—could produce sufficient income to maintain our families in the lifestyle to which we had become accustomed. But a consumer’s calculated need for $2 million or more to replace the income she would no longer be able to earn is a daunting number. We’re likely to subjectively think, “my spouse/my family doesn’t need that much.” So, most people don’t have enough.
Think of it this way: if you’re 35 and will work another 40 years or so (75 being the new 65), how much will you earn in total over that period of time? Currently earning $100,000 a year with three percent annual salary growth amounts to a lifetime $7.5 million; five percent annual increases raise that lifetime income to $12 million. You may not need to insure all of that, but you should probably consider a significant amount of that.
Whatever your number, it’s likely to be your biggest asset and most of us would want a significant portion of that asset to be “inherited” by our loved ones, to continue making mortgage payments and providing for allowances, braces, scouting, college, weddings – and retirement. The way to help your clients and prospects get over the enormity of the lump sum number is to focus on what it’s going to take to replace the economic engine. If we need to replace $100,000 a year in lost earnings, it gets us back to the $2 million, the death benefit from a life insurance policy payable to the survivor.
2. It’s not your father’s (or mother’s!) life insurance.
When I was growing up in the 1950s, my dad had, at most, $35,000 of life insurance in addition to a nominal amount of group term insurance through work. A good salary was $12,000 a year, and a typical home mortgage payment might have been $125 a month. College tuition at a public university was $100 a year.
What a difference 50 years makes! Not only were the money magnitudes so different than today, but the number of policy types from which my dad might have chosen boiled down to just whole life and five-year term. He had a pension to look forward to that would cover a substantial amount of family expenses in retirement, so perhaps he opted for term, thinking he had no need for a savings element. On the other hand, it was quite common to own whole life insurance as a simple form of diversification. The ultimate “dad” on TV—“Father Knows Best’s” Jim Anderson—was a life insurance salesman in that popular series.
Today’s dads and moms have much greater complexity to work through when considering not just the amount (as described in important thing #1) but the types of life insurance. Term? Whole life? That’s just where we start! Traditional universal, variable universal, adjustable life, guaranteed death benefit universal, index universal, and all the optional riders and funding options on those policy types. From the standpoint of large numbers and an array of some pretty complex financial instruments, we have a variety of important decisions to make.
To simplify the choices: unless there is the luxury of current resources to immediately deploy cash value-type policies, many of your clients and prospects may need to use affordable term insurance for an appropriate duration to provide as much financial protection to the family as possible. Consider the likely longer-term, lifetime needs and plan on gradual conversion of term insurance to the various forms of a permanent life insurance as income and resources can allow.
In choosing what kind, clients will want to consider whether their risk tolerance is relatively conservative, and for which guarantees would be most important. In that case they should consider participating whole life (usually from mutual insurers). Universal, variable universal, and indexed universal require not only a tolerance for risk but a willingness to manage such policies throughout your insured lifetime. The good news, of course is that there’s a style of insurance to fit everyone’s risk tolerance and resources, and even opportunities to synergize different levels of risk tolerance in one policy. For example, The Guardian Life Insurance Company of America offers a unique option with its Index Participation Feature (IPF),1 allowing dividends2 to be credited with indexed earnings while providing substantial minimum guarantees.3
3. It’s not as expensive as you think.
It is natural to consider price as a critical part of buying decisions involving a car—a big screen TV—and a life insurance policy. In common with these three purchases is that cars and digital TVs and insurance are complicated in design and difficult to discern quality differences based on their technology. As a result, we often defer to price as a key criterion for making our ultimate buying decision.
It’s ironic that while term insurance has the lowest initial price of all the available life insurance policy options, term potentially adds up to the highest long-term outlay for a lifetime need. Typically, when measured to average life expectancy, total lifetime term insurance premiums can add up to as much as 70% of the death benefit!
More practical for lifetime needs are policies designed for that purpose and which usually develop substantial cash value over the life of the policy, allowing for a focus on financial protection for our beneficiaries in the early years while the policy gradually becomes a substantial cash resource with competitive internal rates of return for its asset class and substantial income tax benefits.4
These benefits include a deferral of tax on cash value earnings and the forgiveness of those deferred taxes in the form of an income tax-free death benefit if the policy is in force at the time of death.
The cost of life insurance can also be appraised the way banks and businesses account for their substantial ownership of life insurance on key personnel: premiums are expensed as non-deductible outlays from cash while simultaneously crediting back onto the balance sheet the increase in cash value and any declared dividends when paying the current premium. As a long-term asset, such policies can “pay for themselves,” at least on a balance sheet basis, in as few as 10 years.
This view of the true value of life insurance is uncommon knowledge, but a lesson well learned by those with lifetime needs for life insurance and the desire to make a smart decision about the appropriate styles of life insurance compatible with their resources, risk tolerance, management skills, and investment acumen.
Next page: Insurance is foundational; Understand your policy and its value
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