Let me start off by telling you what our financial planner told us years ago. Before you start talking about investing, you need to set up a will, an advance directive, and purchase life insurance. If you have children, this is even more important.
At the time, my wife had just given birth to our first child. We were making good incomes and were ready to start investing. We did have life insurance already in place, but before she allowed us to set up our investments, we did go ahead and get a will and an advance directive drawn up by an attorney.
Life insurance is one of those topics that nobody really wants to spend much time thinking about. But if you have children, a spouse, or debt, it is a necessity so you don’t leave your loved ones bearing a financial burden in the event of your untimely demise.
Now many years later, as we get to the end of each year (and the beginning of a new year), one of the items on my year-end financial checklist is to review my life insurance.
Before we address the two big questions most of us have – How much life insurance do I need? And, what type of life insurance product is best? – let’s ask an even more fundamental question, Do I really need life insurance?
But even before we start discussing these questions, let me start off by saying, I am not an expert in life insurance. I don’t have a license to sell life insurance (or any insurance). And as such, my comments are based on my own experiences and should not be taken as professional advice. If you are interested in buying life insurance, I recommend getting in contact with a reputable agent.
That said, let’s get started.
How Much Life Insurance Do I Need If I’m Single?
I remember getting my first job and seeing that one of the benefits was company-paid life insurance in some multiple of my salary. There was also an added benefit for accidental death and disability which would add another multiple or two of my salary in the event that my death was an accident. This was all well and good, but as a healthy, single, 24 year-old with a used car and almost negligible living expenses, my need for life insurance was pretty low.
At the time, my significant other (now my wife) was working for an individual who had a chronic health condition (we’ll discuss why this is important a little later). He was something of a mentor to my wife and he recommended that we meet with his life insurance agent.
When we finally did sit down to discuss our needs, I began to see life insurance not just as another insurance product like what you might buy for your car, but instead, I saw how a properly constructed life insurance portfolio will grow with you as your needs grow and will provide a cushion to some of your other investments.
So back to the question of whether you need life insurance. Start by reviewing your balance sheet. What is the value of your assets relative to the cost of your liabilities? Simply put, if the liquidation of your assets does not adequately cover the cost of your current and long-term liabilities, you need life insurance to fill the gap.
And don’t forget to include living expenses in long-term liabilities. These could easily be the most significant need if you are no longer around to earn an income. Whether you are the primary earner in your household, or you contribute to a dual income household, or even if your spouse earns everything and you stay-at-home, your contributions (in both dollars and/or time) will need to be replaced if you die. If your net worth is not large enough to cover these costs, you will want to have adequate insurance to provide living expenses for a period of time after your death.
Uses of Life Insurance Proceeds
Once you decide you do require life insurance, the next step is to forecast your needs. I suggest looking at any debt and any large expenditures and focus on paying those off first. And again, make sure you have adequate insurance proceeds to cover living expenses after paying off the debt and large expenditures. I came up with the following categories:
- Home mortgage
- Private school
- Living expenses
For the most part, the first four are pretty easy to determine. College gets a little difficult to predict as my kids are still 6 or 7 years away and I have no idea if they will be going to a public in-state university or a private college. Make an assumption about what college will cost today and inflate that number by 4% to 5% per year. You can also reduce the amount of life insurance you will need by any college savings you may already have.
In your living expenses, be sure to include items such as property taxes and insurance. Although you will use life insurance proceeds to pay off the mortgage, there can still be substantial expenses maintaining a house depending on where you live. Don’t be too aggressive in assuming you will cut out expenses in this analysis. Essentially, if you spend $200K per year and $50K of that is private school and your mortgage, you should assume $150K in living expenses going forward.
For how long you will need those living expenses depends. If you have children, I would assume keeping living expenses at that level until the kids are through school. If you want to be even more conservative, assume you’ll need to provide living expenses until retirement – hopefully you will have enough retirement funds to live on by that time.
Once you have determined your uses above, now you need to take a look at your sources of funds. For my analysis, I considered three scenarios:
- I die but my spouse survives
- My spouse dies but I survive
- Both my spouse and I die
These three scenarios pretty much cover all outcomes that I will plan for.
Take a look at each scenario and determine how much life insurance you will need in each. In my case, both my spouse and I need about equal amounts of life insurance as we both contribute to household earnings. As such, the third scenario in which both of us die takes care of itself. As long as we have enough insurance to meet the needs in scenarios one and two, the third will provide twice as much insurance proceeds for my children.
Term Life Insurance or Whole Life Insurance?
There are a number of different types of life insurance products available, but because life insurance as an investment is beyond the scope of this article, we are going to limit ourselves to the two most common types – term life and whole life.
Just as the name implies, term life provides life insurance coverage over a specific time period. It can be for 5, 10, or 20 years; or it can be through a specific age (i.e., 65, 75, etc.). Premiums for term insurance can be level over the coverage period or they can escalate.
Alternatively, a whole life policy, which is also described as permanent life insurance, is designed to provide coverage over a significant portion of your life. The big difference between whole life and term life is that term only provides a death benefit. If you don’t use it, you lose it. Whole life builds a cash value such that if you don’t use it, you can surrender the policy for cash at some point in the future. This is why whole life is often considered to be a portion of your investment portfolio, essentially performing similar to a bond.
Most life insurance agents will advise that you get a base of whole life that you will keep in place until age 70, 80, or 90 and to supplement that base with lower cost term insurance. The cost of whole life is significantly greater than the cost of term – as much as ten times more. Thus, it is usually not practical to provide for all your life insurance needs with a whole life policy.
Investment Value of Life Insurance Products
I mentioned above that whole life policies, in addition to providing a death benefit similar to a term policy, also provide for a cash value. This essentially makes them an investment. Whole policies also pay dividends similar to the interest on a bond. Most of the time, you will simply reinvest the dividend back into the policy, but there is a point where the dividend value actually equals or exceeds the premium cost of the policy. At this point, you can essentially use the dividend to pay the premium and not pay anything additional out-of-pocket on the policy. The policy will still provide a death benefit and will still provide a cash value. The cash value will simply not grow any more as you are taking the dividends as cash payments.
In order to determine the investment value of a whole policy, simply take the cost of the whole life premiums and subtract out the premiums of a comparable term policy. What you are left with is the money you are paying for the future cash value of the policy as well as the cost for any additional add-ons such as additional purchase options (discussed below) and disability premium waivers (these allow for the premiums to be waived in the event you become disabled and cannot work).
Once you know how much you are paying for the investment portion, and you know how much the cash value will be in the future, use your calculator to do some simple math to determine the implied interest rate.
In my experience, the implied interest rate on the cash value of a whole life policy runs around 4.5% to 5.0%. If this is an acceptable return for the bond portion of your portfolio, you should consider adding a whole life policy for the investment value.
Additional Purchase Options
Another benefit of whole life policies is a feature allowing the policy holder to buy additional life insurance at the best available rate without having to qualify medically. As we age, we become susceptible to a variety of ailments which may make purchasing life insurance difficult or impossible (or really expensive).
When you buy a whole life policy, you have the option to also buy these additional purchase options. These options provide you the ability to buy additional life insurance in set increments at the same rate level that you purchased the original policy. So if you bought a policy when you were young and healthy, but then you started to age and get unhealthy, you can still buy life insurance at the young and healthy rate.
I mentioned early on that my wife’s boss had directed us to his life insurance agent and that he had a chronic condition. He was the perfect example of someone who was healthy and didn’t show any signs of disease when he was young. But as he aged, he developed a condition that would have prevented him from purchasing additional life insurance. Instead, because he had additional purchase options attached to his policy, he was able to increase his insurance coverage to meet his increased needs. This was all the motivation we needed at the time to add the additional purchase options to our whole policies.
How Much Life Insurance Do I Need for My Child?
Another consideration is whether to buy a policy for your child. A $75K whole life policy for an 11 year-old will run about $60 per month. Now obviously an 11 year-old probably doesn’t need $75K in life insurance; however, there are two benefits to buying a whole policy for a child. First, the premium cost is locked and will remain level until the policy pays out at age 65 and that cost is significantly less than what you will pay if you take the policy out later in life.
The other benefit is that you can include the additional purchase options. As discussed above, these purchase options allow the insured to purchase an additional $150K in life insurance at the best available rates without any medical questions. No one plans to have medical problems, but it’s nice to know that even if your child does develop a problem which might make life insurance impossible to get or very expensive to get, that they still have these purchase options to rely on.
It should also be noted that the policy that I looked at had the projected divided growing such that by age 24, the divided would cover half of the premium cost.
If you opt to continue paying the full premium, the economics are such that at age 60, the policy will have an insurance value of $227K and a cash surrender value of $105K. Based on paying $737 per year from age 11 through age 60, that implies a 3.9% rate of return.
To be honest, I have always found the appropriate level of life insurance tricky. Typically, I get hung up on how much in living expense I want to cover and for how long. I have also felt the returns to be too low for the investment value. That said, as I have aged and watched the 10-year Treasury hover at a little over 2%, the idea of a 4%+ return seems more appealing.
I welcome feedback from others who have experience in this area.