When we sit down to plan our retirement, we often contemplate beautiful sceneries, times with our family, and perhaps even a new business or career. However, it is just as important to consider the risks associated with growing older, especially the biggest one: Death.
Let’s face it. Life insurance can be a pretty depressing subject. Basically, we are planning for our death, which is something that we don’t usually care to focus on during our living years! This planning also forces us to consider the state of our family after we pass on. Of course, taking care of our family is an important subject regardless of our age. And thus, the potential to make an investment in the future of our family is of utmost importance.
Before we can start to compare prices of insurance policies and determine our insurability, we first need to understand which type of life insurance is appropriate for us. In general, there are three main types of life insurance: Term, Universal and Variable Universal. Each type of insurance is unique and appropriate for a specialized set of circumstances.
The type of insurance that we often see advertised on television and online is called Term Life. Term life is very inexpensive as it will provide coverage for a certain number (a term) of years. For example, usually when a couple has a baby, they buy Term20. That means that they have life insurance for a period of 20 years as long as they continue to pay the annual premiums. In this case, the insurance would provide an asset to the surviving parent to make-up for the loss of income if one parent were to pass away during the growing years of the child. Also, the premium, or the cost, is the same for the entire term.
When the term of the insurance is completed, many policies give owners the option to continue coverage as an Annual Renewable Term where the premium would increase annually. This premium will get larger and larger as we grow older since, statistically the chance of our death increases. Many people who have term insurance may choose to buy a new policy at the end of the term and will have to re-qualify through additional medical exams. In theory, a Term Life policy is very cheap because if the insurance company reviews my health and approves me for the policy, they feel that the chance is relatively low that I will die over the term of the policy. In the past, if you the insured didn’t pass away, the insurance company would “win” outright. However, today, many companies offer a Return of Premium rider on the policy that will rebate the owner the premiums (sometimes with interest!) if the insured survives the period of the term.
If we want to assure that our beneficiaries will receive a death benefit regardless of when we die, we will want to invest our annual premiums into an an instrument called Permanent Insurance. As the name implies, the purpose of these policies is to stay in force until the policy endows, or pays out the death benefit. Under this category there are two main product lines: Universal Life and Variable Universal Life. In general, these policies are also called Cash Value Life Insurance.
Permanent insurance policies are like a motorcycle with a side car and there is more that just the death benefit in these policies. During the life of the policy, both Permanent Life products involve the owner paying a premium that goes into a “bucket.” At the bottom of the bucket is the cost of insurance, so that gets paid first, and of course, the next place the money goes is for administrative costs. The excess premium paid into the policy (that over just the cost of insurance + administrative costs) goes into the bucket as well as earns interest in a tax sheltered environment. Most cash value life insurance policies also have a loan provision allowing the owner to borrow the Cash Value of the policy, usually in a tax free, zero-interest environment.
The simple version of a cash value policy is called Universal Life. Universal Life insurance is for persons who simply want to have a death benefit go to their beneficiary when the insured passes away. In a Universal Life Insurance policy, the excess premiums (that over the cost of insurance and the administrative cost) earn a certain level of interest, usually calculated quarterly by the insurance company. At the time of purchase, the insurance company will state a guaranteed minimum interest rate for this money, usually around three percent. The theory with this policy is that we will pay one flat premium during our entire life. When we are younger and we pay this premium, the excess money will go into the savings account and earn interest. When we are older, we pay the same amount into the premium and the deficit on the cost of insurance and the administrative costs will be funded via a sweep of funds from the cash value account.
There is a risk that the percentage that the excess money is earning in the policy might drop in times of low interest rates and therefore, there would not be enough money in the cash account to cover the cost of insurance when we are older. For example, many persons who purchased Universal Life policies during the high interest rate times of the 1980’s did not take into account the possibility that the interest yield on the cash value account would go down as low for as long as we see in current times. As a result, many of these policies required significant additional premiums to stay in-force or simply imploded in the mid-2000s. If the policy implodes, the money from the cash account what was used in the past to pay the premiums is taxable to the owner since they received the benefit of the insurance over a period of time. Many persons have ended up with no insurance and a tax bill – that did not make many happy customers! To address the consumer concerns about such events reoccurring in the future, many insurance companies recently introduced a No Lapse Guarantee rider. This rider is a guarantee from the Insurance Company that as long as one pays a certain premium (usually referred to as the No Lapse Guarantee Premium) the policy will stay in force until it endows or pays out the benefit.
Variable Universal Life Insurance works in a similar way to Universal Life; however in Variable Life Insurance, the risk associated with the growth of the money in the cash account is transferred from the insurance company to the policy owner. Many persons like this type of policy because they can invest in the market in a tax free environment and they may earn returns in significant excess of those the simple interest instrument in a universal life policy. Most Variable Life insurance policies offer a vast portfolio of investment options for policy owners. The investment options usually include a range of choices including the large, midsize and small company stocks, international investment options as well as fixed income options such as bonds and real estate. These funds are called separate accounts and look and feel similar to mutual funds; however they are not traded on the open market. In most cases, the money in this account grows in a tax free environment and may be loaned to the policy owner in a zero interest non-taxable environment. For example, one use of a variable insurance policy is to fund a private executive pension plan.
A variable life insurance policy is not for everyone. It may seem like a great way to participate in the market in a tax free environment, but there is more to it than meets the eye. Unless the owner of the policy plans on paying a premium significantly over the base of the cost of insurance + administrative costs, the alleged value of the “tax free earnings” will be eaten up by policy fees. Since these policies pay the highest commission to agents, many sales of variable policies are unsuitable. Additionally, the Security and Exchange Commission and state insurance commissioners are working on specific guidelines to protect consumers.
Life insurance is an instrument to protect those who depend on us in case of our death. When we are younger, we might be insuring our “untimely death” using Term Insurance. However, as we grow older, many of us will include Permanent Insurance in our portfolio. In most cases, life insurance will provide tax free money to our beneficiary when we pass away, and this money may be used to fill the void our income once held, pay off a large debt, such as a mortgage, or fund a specific financial goal such as estate planning or business continuation. Most of all, it is important to understand the variety of options in a general sense so that when we look specific policies offered by companies, we have a general understanding of what we are looking for, what department we are shopping in. This piece of our retirement planning process may not be fun for us today; however, it is something that will help preserve our families’ standard of living once we pass away. And for that peace of mind, there is no price.
