LIFE: Harder Than It Needs to Be - PLANNING FOR THE UNEXPECTED - Simple Money: A No-Nonsense Guide to Personal Finance - Tim Maurer

Simple Money: A No-Nonsense Guide to Personal Finance - Tim Maurer (2016)

Part IV. PLANNING FOR THE UNEXPECTED

Chapter 15. LIFE: Harder Than It Needs to Be

WHY do I need to read this chapter?

The probability that you will die in this lifetime is high. Really high. The probability that you will die prior to retirement age is, however, quite low. As a non-smoking male at age 40, for example, I have only a 6 percent chance of dying prior to age 65.1

This low probability—in addition to our preference for generally avoiding the subject of our own demise—has a way of lulling us into inaction when it comes to life insurance, much as with estate planning (chap. 13). But, although the probability is low, the financial impact of death during your working years would likely be so significant that the topic deserves serious consideration. Estate documents can tell the money where to go, but life insurance creates the money where it is lacking.

Unless you are independently wealthy, if anyone relies on you financially, you likely need life insurance. The key is discerning what kind, how much, and how to buy it. Unfortunately, determining what’s appropriate has been made much harder than it needs to be. But why?

Few financial planning topics are so strewn with information—information that often conflicts—as life insurance. This is, in large part, because of the myriad differences among life insurance products. And these differences are often driven by the compensation structure of insurance salespeople.

The good news, however, is that the coverage you likely need is simple and relatively inexpensive.

The Purpose of Life Insurance

Part of the reason life insurance is so confounding is that its purpose has been muddled. So let’s simplify:

Life insurance helps compensate for the financial loss accompanying the loss of life.

This is not its primary purpose—it’s the sole purpose.

Life insurance is not—I repeat, not—an investment. Some life insurance policies do have investment components, which we’ll address, but there is almost always a better location for your investing dollars than in a life insurance policy. As Aaron Vickar, director of BAM Risk Management, said, “If you need insurance, buy insurance. If you want to invest, buy investments. Comingling the two is typically not in your best interest.”

It’s also important to note that the process we’ll undertake to discern how much life insurance is appropriate for you is not an attempt to put a value on a human life. Instead, it is an attempt to arrive at the proper level of compensation for a household’s economic loss due to the death of a loved one. This will be made clear especially when we’re discussing how to accommodate for the passing of a stay-at-home spouse.

Few things in life are as difficult to endure as losing a loved one. The purpose of life insurance is to allow healing without the stress of financial strain.

I’d love to have a conversation about life insurance without industry jargon, but it’s unavoidable, so I’ll translate instead. First, individuals play three basic roles in a life insurance policy:

Simple Definitions

1. The owner—the person who pays the policy premiums.

2. The insured—the person on whose life the policy is based.

3. The beneficiary—the person who receives the death benefit.

The owner makes a contract with the insurance company—called a policy. As long as the owner continues to pay the policy premiums, the insurance company pledges to pay the beneficiary the death benefit if the insured passes away. So, when someone you know refers to having purchased a $1 million life insurance policy, the million bucks represents the death benefit.

Different Types of Life Insurance

Today there are two broad categories of life insurance: term and permanent. The fundamental difference is that term is constructed to shield policyholders from the financial risk of death for a stated period of time, while permanent is designed to go on interminably.

Although permanent insurance preceded term, it helps to explain the latter first. Term life insurance is, effectively, pure insurance. For a set period of time, as short as one year and typically no longer than thirty, an individual transfers the financial risk of death to the insurance company in exchange for the payment of a premium reflecting the probability of that individual’s premature passing. Premature, or perhaps catastrophic, may be the operative word here, because neither term policies nor premiums are designed to protect one from naturally expected death.

Because permanent life insurance must be actuarially designed to be viable to the literal end—as opposed to term policies, which are intended to pay out only in unexpected catastrophic scenarios—the premiums must also be higher. And by higher, I mean substantially higher. Depending on the type of permanent insurance and the age and health of the insured, premiums for a policy with an identical death benefit could be five, ten, or even twenty times larger than a comparable term policy.

Another hallmark of permanent insurance is cash value, a savings mechanism that helps support a policy’s performance over time and hopefully supplements a policy owner’s other savings initiatives. A portion of each premium payment goes to support the insurance costs, while the balance is “invested” in the savings vehicle.

The differences among permanent policies, therefore, typically appear in the variations of savings mechanism. Here’s a quick rundown.

Whole life insurance, the oldest surviving brand of life insurance, is, as you might anticipate, expected to last for one’s whole life. The investing mechanism inside of a whole life policy is similar to that of a conservative fixed income vehicle, like US Treasuries or certificates of deposit (CDs). However, they are backed by the “full faith and credit” of the insurance company, not the federal government or the FDIC.

Typically the most costly of any life insurance product, whole life offers a policyholder the peace of mind that their policy will be there forever—as long as premiums are paid—and the savings mechanism will not be subject to stock market volatility.

Speaking of stock market volatility, the defining characteristic of variable life insurance is that policyholders may invest in the market through vehicles known as sub-accounts, the insurance world’s answer to mutual funds.

Although the additional expected rate of return of such investment vehicles, relative to those found in whole life, should help reduce premium payments over the years, there are, of course, no guarantees that it will do so. It makes this particular type of life insurance, in my opinion, the least useful. If it is market investment you desire, I recommend you invest in the market, not in an insurance policy with an ancillary investment component.

The last variety of permanent life insurance you should be familiar with is universal life. Designed to be a less costly variety of permanent insurance, universal life is effectively a term/whole life hybrid. It is intended to last for a lifetime, but to do so in the most cost effective way possible. Therefore, it rarely amasses a significant amount of cash value. One quirky element found in universal life policies is that they can be very interest rate sensitive. Older policies created in high interest rate environments are notorious for requiring policyholders to actually increase their premiums if they want to keep the policy, now that interest rates are lower.

A Simple Money tenet is to avoid unnecessary complications in creating a financial plan. In most cases, that means avoiding permanent life insurance. The benefits rarely outweigh the complexity. Now, let’s get out of the informational weeds and work our way toward the Simple Money Life Insurance Guide. In order to help make sense of our motivation behind buying life insurance, let’s separate that motivation into two categories: needs and wants.

Life Insurance Needs

Life Insurance Needs answer the question, “What would need to be covered in the case of a death in the family?” Satisfying these needs would help ensure that a household continues to function financially even after the loss of someone who makes an economic contribution to it.

There are five primary life insurance needs:

1. Payment of final expenses

2. Repayment of debts and mortgages

3. Pre-funding expected educational expenses

4. Funding replacement of household duties

5. Replacement of lost income

Some of these needs are immediate, like the requirement to pay final expenses, such as those for a funeral and burial. No one wants to be thinking about money immediately following the loss of a loved one, so covering these expenses in advance provides a sliver of peace in the midst of personal upheaval.

Other life insurance needs are of a mid-term variety, like paying off debts and pre-funding the cost of education. Typically, these needs were funded, at least in part, by the decedent. Debts, mortgages, and the cost of education for minor children frequently represent the largest present and future financial household obligations. Relieving a surviving spouse of covering these responsibilities alone will help him or her get reestablished financially without the fear of looming bills.

Take note, business owners.

There is one life insurance need that applies only to you. In a case where there are two or more owners of a business, it is highly recommended that they have a “buy-sell” agreement. The purpose of this agreement is to lay out the plan for the company in the case that one of the owners dies. The agreement is then “funded” by life insurance, meaning it’s used to create the available funds for the deceased partner to be bought out. If the venture is short term in nature, it could make sense to use a term policy. But if the business partners are lifers, it may make sense to use a permanent life insurance policy.

Still others are long-term needs, like re-creating a stream of income or compensating for the economic loss of someone who helped manage the household.

Simple Money Life Insurance Guide

Most forms of life insurance analysis involve high-effort attempts to capture every little detail about your life. The most common method is to apply an economic value to each of the life insurance needs, add them up, and then buy that much life insurance. But on my quest to simplify personal finance, a lingering question has persisted:

Why are we focusing on all these details when we could just use life insurance to replicate the income that a person brings into a household with a simple calculation? Is there an easier, simpler path that would apply to the vast majority of households?

Yes. Here it is:

Simple Money Life Insurance Guide

For income earners, multiply your annual income by 15. Then purchase a term life policy for as many years as you can conservatively expect to need the income.

Income x 15 = Life Insurance Need

For a stay-at-home spouse, purchase a policy with a death benefit of between $250,000 (if children are older) and $500,000 (if children are younger).

Why 15 times the individual’s income? Primarily because it works. But know that it works for a reason. Most households use income for two basic purposes: to pay current living expenses, like a mortgage, and to save for future expenses, like college and retirement. Therefore, it’s only logical that purchasing enough life insurance to reproduce the income lost would be sufficient.

It might even be superfluous to purchase enough insurance to pay off all debts, pre-fund education costs, and replace lost income. The only question remaining, then, is how much of a lump sum do we need, given that it’s conservatively invested, to reproduce the income?

If we divide the annual income—say $100,000—by the amount of interest we could reasonably assume earning—say 5 percent (or .05)—that tells us how much money we’d need sitting in an account while earning five percent to generate $100,000 per year of income.2 That brings us to $2 million, a multiple of 20. But, because life insurance is both science and art, we’re allowed to acknowledge a couple of things:

1. While we’re attempting to re-create a deceased person’s income stream, the reality is that most households will move on. For example, a family might downsize their house. Many people will eventually remarry, rendering a large portion of the life insurance proceeds superfluous.

2. As coarse as it sounds to acknowledge it, household expenses will be less with one fewer member of the household.

Therefore, we can save some money on life insurance, which we hope to never use, by reducing our multiple from 20 to 15. It’s the intersection of analysis and common sense.

In almost every life insurance need scenario, term life insurance would be the optimal risk transfer tool. Why? Because the need for life insurance should expire once the household is financially independent. Therefore, purchasing a life insurance policy with a death benefit that is 15 times the income of the person being insured for a term that lasts until the household will no longer need earned income should be sufficient.

Life Insurance Wants

Are there any other reasons for purchasing life insurance beyond these needs? Long ago, my sales manager at a large insurance company certainly thought so. He said, “Anyone who can fog a mirror is a life insurance prospect.” While I couldn’t disagree with him more, I’m happy to concede that there are valid reasons for wanting life insurance above and beyond one’s needs, if you’re willing to endure the inherent complication and cost:

1. Pre-insuring future needs

2. Creating an estate

3. Funding charitable bequests

4. Replacing an estate lost to taxes

5. Building cash value

Very few people make it into young adulthood without having a friend or acquaintance take up the trade of life insurance sales. But there aren’t many older prospects who will allow themselves to be persuaded by a youngster. So, guess who just became their target prospect? You, or at least a younger you. Do you remember that awkward conversation?

Since you didn’t have a spouse or children yet, there was very little evidence on which to base an argument for a life insurance need. But the newly minted agent said, “You’re gonna need it eventually, what with all your impressive personal and professional potential.” Plus, he says, “You’re young now, so the insurance is cheaper.”

While your potential was (and is) impressive, and while insurance is indeed cheaper when you’re younger (and healthier), I’m hesitant to recommend insuring a risk until it becomes one. This, remember, is a general risk management principle: Avoid, reduce, and assume the risk you can handle and transfer the risk that you can’t.

Perhaps you’re nearer to the end of your saving days than the beginning, and while you don’t have any dependents, you would like to leave an estate behind for heirs, loved ones, or a charity you supported during life. You may buy a life insurance policy for any of these purposes, thereby creating an estate that may not have otherwise existed. A noble want it may be, but it’s surely not a need.

In my opinion, the most sensible—but least likely to be utilized—life insurance want is that of estate replacement. Those blessed to amass a net worth in excess of $5 million may expect the federal government to become an unintended beneficiary of their estates. The IRS collects a tax notoriously known as the “Death Tax” on estates north of $5.43 million (in 2015, indexed for inflation), although couples can safely shield twice that amount.

Now, you might think this a most glorious dilemma and feel no sympathy for these well-to-do. But what if I told you the federal estate tax is as high as 40 percent? That it often represents a third layer of taxation on these assets? That family businesses and farms can be forced to sell when liquid cash is not available to pay the estate tax? That the federal estate tax is a moving target, and until recently was applied to estates that were over $1 million at rates up to 55 percent? And that many states also have estate or inheritance taxes levied at varying thresholds and rates?

Okay, wealth replacement still may not constitute a life insurance need, but it’s a valid want nonetheless. And it’s a worthy consideration for those of significant means.

Lastly, we discuss the most common life insurance want—cash value. Cash value is the savings component associated with permanent life insurance. It builds over time and is available for withdrawal or borrowing during life, as a complement to the policy’s death benefit. Sounds great, right? Yes, and it can be a useful financial tool. But it comes at a cost—five, ten, or even twenty times that of a comparable term policy.

Now, let’s address the elephant in the room (not to be confused with the Elephant in chapter 3).

How to Buy Life Insurance

Into the Lion’s Den

One of the oft-mentioned reasons I hear from folks balking at addressing their life insurance needs is that they don’t want to deal with life insurance agents. But while there are still a number of agents who’ve earned the stereotype now applied to the entire industry, there are also many knowledgeable insurance specialists who do well by their clients. And frankly, I more blame the insurance industry proper—and its antiquated compensation regime—than the agents whose decisions often set them at odds with the clientele they serve.

Virtually all insurance agents are compensated by commission, which means they get a cut of the premium you pay to the insurance company. Typically, the commission will be between 50 percent and 100 percent of your policy’s first-year premium.

It often surprises young, healthy, first-time life insurance shoppers to learn that a million-dollar term life insurance policy could be as inexpensive as $450 per year. Correspondingly, the agent’s commission is also pretty low. But would you believe that the annual premium on a $250,000 whole life policy for that same healthy young person could be $2,000 or more—for only a quarter of the coverage? Because the commission would also be significantly higher, this means the agent has a greater conflict of interest. He or she is incentivized to sell the insurance policy that would leave the client woefully underinsured.

I wish this was a mere hypothetical example, but I’ve seen this play out too many times. Dave and Jen had three kids when I met them. What they needed was a $1.25 million policy on Dave’s life and $500,000 on Jen, who worked part-time. What they owned was a single $250,000 whole life policy on Dave’s life alone—that cost more than the two term policies they needed combined.

Because the motivation for selling permanent insurance products over their term counterparts is so significant, many marketing systems have been designed to twist reality in a way that compels the prospective buyer to view permanent insurance as a “no-brainer.” One of the lines I’ve heard too many times is, “Buying term insurance is like renting—wouldn’t you rather own your policy?” No, thanks—I’d rather not develop an unnatural emotional connection with my insurance policy, as I might my house.

Another classic: “Only 2 percent of term life insurance policies even pay out!” That’s great news. I hope my term policy never pays out, because that means I’m still alive! Indeed, who would wish for their home to burn down so that they can receive the benefit from their homeowner’s insurance policy? The point of insurance isn’t to reap a payday but to transfer catastrophic risk that we cannot avoid, reduce, or self-insure until we are financially independent.

The best way to avoid getting caught in the middle of a gut-wrenching sales pitch that will make you question yourself is to know exactly how much and what kind of life insurance you want before interacting with an insurance agent. By all means, consider the agent’s suggestions for slight variations on your plan, but remember that it’s your plan, not theirs. If you’ve done the work ahead of time (the work you’re doing right now as you read this), you should be able to confidently move forward without falling prey to a sales pitch.

A good starting place is one of several online resources for life insurance quotes. These will give you some idea of a reasonable price range after putting in minimal information. But after you’ve done so, I do recommend working with a real, live agent to complete your application process—not an 800 number or a faceless website. You’re not likely to pay any more, and you’ll get help navigating through the last step of the insurance purchasing process—underwriting.

Underwriting

Underwriting is the process through which insurance companies determine how much of a risk you are. The insurance company will subject you to a battery of questions private enough to make anyone blush. They’ll ask about your personal health and habits, as well as that of your parents and siblings. If you’re a full-time smoker or excess drinker, you can be prepared to pay two to three times as much for your life insurance. But if you enjoy a few cigars each year or a glass of wine at dinner, most insurers won’t hold that against you.

The key is to answer these questions honestly but concisely. If telling the truth isn’t motivation enough, getting busted in a lie could put a black mark on your insurability for all time. Companies actually review your medical records and take blood and urine samples. But that doesn’t mean you should elaborate on all of your hopes and dreams. If they ask if you have plans to visit any dangerous foreign countries, don’t delve into your future vision for building a Swiss Family Robinson-style tree house on the Amazon. If you don’t have plane tickets, you don’t have plans.

Navigating the underwriting process is reason enough for using an insurance agent. A good one will earn his or her pay.

How to Get Out of a Policy

Perhaps through this analysis you’ve learned that you no longer need life insurance that you already own. There are two primary reasons you might want to get out of, or end, an insurance policy:

1. You don’t need it. Remember, once you’ve reached financial independence, you don’t need life insurance anymore. If you own a term policy, getting out is extremely easy—you just stop paying the premiums. Yup, that’s it. When your premium is due, and you don’t pay, you’ll get a notice from the carrier, who will typically give you a couple chances to get back in. You can forestall these attempts by simply letting them know that you no longer need the policy.

2. You don’t want it. Perhaps you are an example of the young parents who was sold $250,000 of whole life instead of the term insurance they needed? This family shouldn’t just dump their life insurance immediately. They should apply for the appropriate coverage first—to ensure they survive the underwriting process—and then look into options for ending the unnecessary policy. If it’s relatively new, the chances are good that you won’t be walking away with any money, but at least you won’t be paying exorbitant premiums anymore.
If, however, you own a permanent policy you’ve been paying premiums into for many years, you should have some cash value built up. Especially if it’s an older policy, the cash value may even be performing well as a supplementary investment. You can examine the policy’s expected future performance by requesting an “in-force illustration.” You may decide to keep the policy even if you don’t need it. But if you intend to cash it in, you should also ask for a “cost basis report.” If your cash value is higher than your cost basis, you may have a taxable gain to report.

Simple, but Not Easy

After you’ve done the work, financial planning for an unexpected death may be simple(r), but that doesn’t mean it’s easy. No, it’s not always easy to discuss the personal and financial implications of our inevitable departure from this earth. But I find that when they are entered into with an open heart and mind, these conversations can be surprisingly life-giving.

Simple Money Life Insurance Summary

1. If anyone relies on you financially—unless you are independently wealthy—you likely need life insurance.

2. The good news is that the coverage you likely need is simple and relatively inexpensive. The bad news is that there is a ton of misinformation out there, making your life insurance decisions more challenging.

3. The purpose of life insurance is to help compensate for the financial loss accompanying the loss of life. That’s it. Life insurance is not an investment.

4. Let’s not overcomplicate matters. The Simple Money Life Insurance Guide: Purchase a term life insurance policy with a death benefit of 15 times your income for a term as long as you can reasonably expect your survivor to need the income.

5. It’s not always easy to discuss the implications of our eventual demise, but healthy conversations on the topic can be surprisingly life-giving.