From my earliest days in the insurance business, I’ve heard this refrain from skeptics: “Buy term and invest the difference.” That is, pay the lowest premium possible, and use the savings to pad your investment portfolio. Perhaps you’ve suggested this strategy to clients. Just know there are several problems with this advice.
First, all life insurance is term insurance. That’s because all insurance is based on similar mortality costs. The only difference between permanent and term insurance is how you pay the premiums. Second, while “investing the difference” might sound plausible, very few can do it successfully over the long haul. Finally, when the term runs out and the premiums start to skyrocket, most people can’t afford to replace the insurance, especially when they’re reaching an age at which health conditions become a factor. So, people who buy pure-term life insurance are almost certain to end up without coverage as they age. Is that the outcome you want for your clients?
I realize many people find life insurance complex. Most buyers (and some advisors) are mystified by how it’s structured, how the varied options in the contract work and how the pricing algorithms are calculated. Most people don’t enjoy discussing their own demise, and complexity makes the conversation even more off-putting. But protecting one’s family, business or employer is a subject too important to be ignored.
If you scour the web or cable business channels, you’ll find plenty of pundits opining about the pros and cons of life insurance, especially term insurance versus permanent insurance. But they rarely explain the distinction accurately.
Four Fundamental Questions
Let’s keep it simple. Whether someone is considering term insurance, whole life, universal life, indexed life or variable life, they have four fundamental questions:
- How much insurance should I buy?
- What’s the right policy for me to buy?
- What will it cost?
- How long should I keep it?
Let’s take them one at a time:
1. How much insurance should I buy?
There are five buckets to consider when answering this question:
a. Liquidity for emergencies.
b. Debts.
c. Mortgage.
d. Education for children.
e. Capital to produce income.
The amount of money a client puts into each bucket is a personal decision, and it depends on multiple factors. The first four buckets above are finite and measurable. But the fifth (capital to produce income) is a big mystery. It depends on investment prowess, inflation, taxes and other factors, such as economic conditions, risk tolerance and knowledge. Assuming your client can earn 5% consistently from their portfolio, then $1 million could produce an annual income of $50,000 a year—hardly enough to support your client’s family in the event of the client’s death. Using this method, it’s easy to argue for $2.5 to $3.0 million of capital, but families rarely agree to this method. As with any test you took in school, you never know the outcome until you see the final grade. Unfortunately, with life insurance, there’s no makeup exam or do-over.
2. What’s the right policy for me?
Since no one knows exactly how long they’re going to live, the answer depends on many variables:
- Income.
- Length of coverage.
- Propensity to save in a long-term contract.
- Age/premium.
- Insurability.
- Reason for the coverage.
A skilled advisor should be able to guide clients appropriately.
3. What will it cost?
Ultimately, insurance is based on three factors: (i) mortality costs (that is, the cost of insurance), (ii) administration expenses, and (iii) investment return. So, it’s not surprising that the cost of insurance is very similar across all carriers. They all use the same mortality tables (that is, “probability of death” table), and by law, every insurance company must use the Commissioners Standard Ordinary table for guaranteed mortality costs. They can adjust this cost with their own underwriting experience. But over time, these costs are nearly the same across carriers. Some insurers are more efficient than others. But practically speaking, the administration costs are a small part of the total cost of insurance. Regarding investment returns, even though insurers may invest their general account in bonds, real estate, mortgages and some stocks, the government is particular about how much you can put into each category. So, it’s difficult for one company to outperform another due to all the regulatory constraints over time. And when it comes to index universal life, the companies don’t control their returns.
Again, with term, your client must fund the premiums out of pocket with after-tax dollars. If they keep the term to life expectancy, the cost will be about 74% of the face amount adjusted for their tax bracket. If your client instead buys permanent insurance, assuming a 5% return, the cost will be paid by the tax-free compound interest inside the policy. At life expectancy, the cost is approximately 10% to 20% of the term cost. If your client needs life insurance at death, term insurance won’t be there because it will be too expensive to continue.
When you think about it, almost everyone owns or buys life insurance. It comes down to whether they purchase it from a commercial product or whether they self-insure. When a death in the family occurs, the bills keep coming, the mortgage must be paid, the children’s education must be funded, etc. Where does the money come from to meet those obligations when the family’s economic engine stops running? Does it come from savings, retirement plans or the sales of assets? If none of those options exist, the surviving spouse must often return to work. Granted, there are many combinations to the fact pattern, but when death occurs, some part of the family’s economic stability family ceases. New arrangements must be fashioned to fill the void. Life insurance is the best solution because money replaces the loss of income. The cost of that money is usually a fraction of the value delivered.
4. How long should I keep it? Because all life insurance is term insurance, the answer is simple: Tell me when you’ll die, and I’ll tell you how long to keep it. Sorry to be glib, but it’s true. If you knew exactly how long your client would need life insurance, it would be very easy to decide which type they should purchase. But since we don’t know, you must help your client look at contingencies, alternatives and cash flow.
Again, many insurance buyers (and their advisors) go with term insurance because it seems less costly, especially in the early years. They ignore the fact that term will cost 74% of the face amount if they reach normal life expectancy, that is, the age at which 50% of their cohort is dead, but 50% is still alive.) If your client is 65 and still wants coverage when their current term expires, they have some tough decisions to make. At their age, replacing term will require a physical exam and significantly higher premiums, among other challenges. So, they typically decide to self-insure. Unfortunately, when the economic engine dies, there’s no insurance to fill the gap. The family must liquidate assets to pay the bills and may end up in a financial spiral that’s impossible to escape. Confusion or frustration often cause buyers to make a less productive purchase or no purchase at all. That’s not a solution, is it?
Dr. Guy Baker, CFP, CEPA, MBA is the founder of Wealth Teams Alliance (Irvine, CA).