Life insurance is one of the pillars of personal finance, deserving of consideration by every household. I’d even go so far as to say it’s vital for most. Yet, despite its nearly worldwide applicability, there remains a great deal of confusion, and even skepticism, regarding life insurance.
Perhaps this is due to life insurance’s complexness, the good posture of those who sell it or merely our preference for avoiding the topic of our own ruin. But armed with the proper information, you can make simpler the decision-making process and arrive at the right choice for you and your family. To help, here are 10 things you absolutely need to know about life insurance:
1. If anyone relies upon you financially, you need life insurance. It’s virtually obligatory if you are a spouse or the parent of dependent children. But you may also require life insurance if you are someone’s ex-spouse, life partner, a child of dependent parents, the sister of a dependent adult, an employee, an employer or a business partner. If you are stably retired or financially independent, and no one would suffer financially if you were to be no more, then you don’t need life insurance. You may, however, consider using life insurance as a strategic financial tool.
2. Life insurance does not simply apply a monetary value to someone’s life. Instead, it helps compensate for the inevitable financial consequences that accompany the losing of life. Strategically, it helps those left behind cover the costs of final expenses, outstanding debts and mortgages, planned educational expenses and lost income. But most importantly, in the aftermath of an unexpected death, life insurance can lessen financial trouble at a time when enduring family members are dealing with the losing of a loved one. In addition, life insurance can provide valuable peace of mind for the policy holder. That is why life insurance is significant for the bread winner of a single-income household, but still important for a stay-at-home spouse.
3. Life insurance is a risk management tool, not an investment. While some life insurance policies have an investment feature that can give a degree of tax freedom, insurance is rarely an optimal investment. There’s usually a better, more effective tool for the financial task you’re trying to accomplish. If you haven’t yet filled up your emergency cash reserves, paid all non-mortgage debt, maxed out your 401(k) or Roth IRA, contributed to an education savings plan (where appropriate) and set money aside for large purchases you expect in the next decade, then you likely need not stress about types of life insurance that include an investment component. (You’ll see why in #7. )
4. There are two broad varieties of life insurance about which you should become aware—term and permanent. Term life is the simplest, the most affordable and the most widely applicable. With term life, a life insurance company bases the policy premium on the probability that the insured will die within a stated term—typically 10, 20 or 30 years. The premiums are guaranteed for the length of the term, after which the policy becomes cost-prohibitive to maintain or you determine to allow it to go lapse. Yes, this means that you may very well pay premiums for decades and “get nothing out of it. ” But that’s good news, because it means you’re winning at the game of life.
5. Permanent life insurance includes this same probability-of-death calculus, but also includes a savings mechanism. This mechanism, which is often referred to as “cash value, ” is designed to help the policy exist into perpetuity. Whole life—the original—has an investment component much like bonds or Dvds (but backed by the insurance company). Variable life offers investment options more like mutual funds. Worldwide life was designed as a less expensive permanent life insurance alternative with added flexibility, but increased rate risk for the owner. Although they are more complex and expensive, there are financial dilemmas—often related to business planning and/or high-net-worth residence planning—for which permanent life insurance may be the only solution. There are a few select instances where permanent policies are engineered to maximize the tax-privileged growth of cash value. They are, however, only befitting a small number of people and still dependent on numerous other factors to work the way they’re intended.
6. Life insurance can be extremely expensive, but it can also be surprisingly inexpensive. If you apply for a bells-and whistles permanent policy, the size of the premiums alone might cause you to have to have a life insurance benefit right then and there. But most people are happily surprised when they see the relatively low premiums of a plain-vanilla term policy. A healthy, non-smoking, 30-something male, for example, might pay less than $500 annually for a 20-year term policy with a million dollar death benefit. That same individual might be required to pay 10—or even 20—times as much for a variable or whole life insurance policy with a matching death benefit. No, a term/perm comparison is not apples-to-apples. I would hazard to guess, however, that a recent widower cares little for bells-and-whistles but a great deal for the death benefit. Of course, a smoker will likely pay twice as much for any of the above. Someone with health problems could pay three times or more (or simply be declined for coverage).
7. Determining the optimal life insurance policy for you doesn’t have to be complicated. While we could get really granular with a detailed life insurance needs analysis, it’s more important to get set up with something you can comprehend than it is to push off an important decision due to life insurance’s overwhelming complexness. In the vast majority of situations, a household would be well cared for simply by buying enough life insurance to replicate all or most of the insured’s income for a term as long as family members expects to need that income.
8. Therefore, picture this simple but effective strategy for determining how much life insurance your household needs. Multiply a wage earner’s income by 15 and buy cover with an equivalent death benefit for a term that lengthens before the person insured would presumably cease working. Why 15? Because it works. But it works because it results in a number which will re-create 75% of a wage earner’s income if the death benefit was conservatively invested to earn 5% (hopefully plus a bit more for inflation) annually. Here’s an example:
Gaga makes $100, 000.
$100, 000 x 15 = $1, 500, 000 of death benefit
$1, 500, 000 earning 5% annually produces $75, 000 of income.
9. Consider using a live person to help in your death planning. There are many online tools that can help give you an idea of the amount of money you should pay for the policy you need. But once you get to the period, I would recommend contacting a real, live agent who can walk you through the application and underwriting process. The premiums at a given insurance company are identical whether you apply online, via a toll-free number or with a person. Indeed, a well educated and dedicated insurance professional or agent may help you save money by choosing the best carrier for your particular situation. Underwriting, by the way, is the necessarily tedious process through which the insurance company classifies how much of a risk you are, based on your current health, past health, the health of your parents and littermates and enough other questions to make anyone blush. Answer truthfully—but succinctly.
10. Know your options when cancelling a preexisting life insurance policy so you don’t leave money, or coverage, on the table. If you have cover that isn’t befitting you—or you simply no longer need it—it’s important to proceed carefully. First, if you realize that you have overpaid for a policy that doesn’t meet your needs, but you still need life insurance, don’t cancel the wrong policy before the right policy is in place. Who knows, you could learn of a health consequence that might lead to you being declined for the new policy. Then you’d be left without any coverage. If you have a preexisting term policy you no longer need, you can simply cease premium payments and it can be away. If you have an unnecessary permanent policy with a cash value, however, you should analyze its present and expected future investment value, as well as any prospective tax complications, before cashing it in. You can do so by requesting an “in-force illustration” and a “cost basis report” from your agent.
I suspect we don’t love talking about life insurance because we don’t like talking about death. No shocker there. But open and honest discussions about planning for a critical death can be surprisingly life-giving. And even if you don’t buy that, the chances are good that purchasing life insurance is still an important part of your long-term and comprehensive financial plan.
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