The following is adapted from Keep It Simple, Make It Big.
If someone you love depends on you or your income, chances are you need life insurance.
From the start of your working years to the end of your life, life insurance serves an important purpose.
Early in life, when mortgages are large, children need to be educated, and retirement plans are in the building stage, life insurance funds these unfunded liabilities should something happen to a breadwinner. It allows a family to accomplish its goals.
Later in life, the focus shifts to protecting the assets one has acquired. Should a spouse die, life insurance can make up for the loss of a pension, reduced Social Security payment, the depletion of investments for long-term care services, and more.
We must protect that which we can least afford to lose. So no matter your age, you need life insurance to take care of your loved ones should you pass.
How Much Life Insurance Do You Need?
There are various rules of thumb about how much life insurance you need—such as two times, ten times, or twenty times salary—but everyone’s needs are unique. It’s best to do your own personal math.
There are two basic methods of calculating how much life insurance you need.
The first is referred to as the human life value. This straightforward method simply figures what a person would earn until retirement, subtracts out taxes and what the person would consume, and then figures out how much money that would be in current dollars.
The second approach is often called a basic needs analysis. This method examines the actual expenses that would be involved if one died, the things a family would want to take care of, such as education for the children, paying off mortgages and other debts, and income replacement. It then calculates a figure based on these basic needs.
If a family is living on 100 percent of their income, which is often the case, these two approaches will produce similar results. One difference is that expected future salary increases can be built into a human life calculation.
The value of one’s services must be protected as well. When a primary earner dies, income needs to be replaced but expenses will generally go down. When a homemaker dies, though, expenses will increase, due to the need for things like childcare.
For retirees, the focus is on replacing income that will be lost, such as Social Security and pension. Wealth replacement is also an issue. If a long-term care need strikes, assets earmarked for income may have to be expended. A prudent life insurance program can replace this wealth when a person passes away.
The Types of Life Insurance
Insurance comes with many features and many names, but there are two fundamental types: temporary and permanent.
Temporary Insurance
Temporary insurance is called term insurance. These contracts cover a person for a set number of years: one, ten, fifteen, twenty, and thirty. It can have adjustable premiums or level premiums over a period and then adjust. It is pure insurance, like auto and home. If you don’t get unlucky and use it, there is no residual value.
Over the last few decades, it has consistently gotten better and cheaper. If you are healthy, you can now purchase term that does not expire until you are in your eighties.
As with anything, term life has advantages and disadvantages. The primary advantage is price. Young healthy people can purchase big blocks of insurance for low premiums. It allows young families to cover temporary needs with temporary insurance.
The primary disadvantage is that premiums increase over time, which makes it unaffordable for older people. Each contract term has a level premium, but one will likely outlive this contract and then face higher prices. This means that very few policies pay a death benefit, roughly 1 percent. If a family has permanent needs, this will not provide the protection it needs.
If you obtain life insurance through your employer, it is most likely group term. The advantages are that it’s easy to get in open enrollment, and the premiums can be fairly inexpensive. However, the disadvantages are that an employer usually does not offer enough face amount to cover a person’s need, and the insurance is usually not portable at low prices. Changing jobs means changing insurance or losing insurance.
Permanent Insurance
Permanent insurance is designed to last a person’s lifetime and ultimately pay a death benefit. It combines term insurance with an investment account in which premiums grow on a tax-free basis.
These cash values are owned by the contract owner and can be accessed for use while the person is alive for such things as college funding, cash reserve, and retirement funding. Some policies allow the cash to be accessed as a withdrawal of premium. Others require the cash to be loaned.
Permanent policies differ based on how the cash value is invested, who controls the investment, whether the premiums are flexible or fixed, and whether the death benefit is flexible or fixed.
Whole life is the name for traditional permanent life insurance. The cash values are invested by the insurance company in its general account, which is comprised mostly of fixed-income investments. Premiums are fixed, as is the death benefit. Participating policies will pay dividends that can be used to offset premiums or purchase additional insurance.
Universal life policies are similar to whole life in that the cash value of this policy is invested conservatively by the insurance company. It differs from whole life in that it never pays dividends. Its premiums are flexible as is its death benefit. Modern contracts can offer lifetime guarantees for death benefit regardless of cash value.
Variable universal life is a contract in which the cash value is invested by the contract owner in variable subaccounts that provide access to professional money managers. These are generally equity, fixed income, and a guaranteed interest account. Premiums are flexible as is the death benefit. Some modern contracts offer guarantees for death benefit that are not dependent on cash values.
Survivorship policies, often called “joint life” or “second to die” policies, are single contracts that cover two lives and pay a single benefit upon the second death. They are permanent contracts and can be whole life, universal life, or variable universal life.
Choosing the Life Insurance Right for You
There is no “best” life insurance contract or type. The type that best fits a family’s needs will depend on many factors.
Start by calculating the amount of life insurance you need, and then look at your various options. It can be worth consulting a professional.
Everyone should think of life insurance as a necessary expense. There are some risks in life that simply can’t be invested for; they must be insured against.
It’s far better to have life insurance and not need it, than to need it and not have it. With life insurance, you can ensure that your loved ones are financially taken care of after you’re gone.
For more advice on life insurance, you can find Keep It Simple, Make It Big on Amazon.
Michael Lynch is a CERTIFIED FINANCIAL PLANNERTM professional with nearly twenty years of experience working with American families to craft plans that fund their dreams, educate their children, and finance their retirement. Michael has contributed to the Wall Street Journal and Investor’s Business Daily, and hosted Smart Money Radio for a decade. He’s served as an adjunct faculty member at Fairfield University and currently teaches financial planning to employees of corporations like Madison Square Garden and Yale New Haven Health Systems. Michael is a five-time Financial Planner of the Year for MetLife and a 2019 inductee to the Barnum Financial Group Hall of Fame. You can enjoy his latest articles and videos at www.michaelwlynch.com.
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