Rebalancing for Life
I recently became an uncle. Meeting my nephew was a great experience. After I held the little guy for as long as he would let me, his parents put him to bed and we talked about newborn things – how he was eating and sleeping, where daycare costs and college savings fit in the budget, etc. I asked my brother if he had increased his life insurance coverage with the new dependent. I was happy to hear that yes, he took care of this a while ago and hadn’t thought much about it since. That’s how it should go. The sooner you set it and forget it, the lower the cost to you. But it’s important to periodically review your life insurance policy as your life progresses.
Life insurance is not the kind of thing we think about every day. There are no news programs dedicated to daily moves in policy rates or conversion options. For most people, life insurance serves to replace income when one passes away. The risk of losing your life in any particular year is low, but the financial severity of the loss is high, larger than the accidental loss of your home or automobile. For risks with those characteristics it’s smart to transfer the risk to a third party. Customers pay the life insurance company a premium to assume that risk.
Insurance companies offer two types of life insurance – temporary and permanent. Temporary, also known as term, insures a policyowner for a limited period of time. These terms range from 5-30 years and often involve level premiums throughout the term. Permanent insurance, on the other hand, insures the policyowner throughout their life until death. Because it’s impossible to outlive your coverage, permanent premiums are usually higher than term insurance where outliving the coverage is a common outcome. Along with a death benefit, permanent policies have a cash value feature. There are many types of permanent life insurance that accommodate different risk tolerances, income levels, and the policyowner’s intended use of the policy. Here are a few reasons you may favor one type over the other.
As we accumulate assets over time, term life insurance is useful to cover the accumulation period through the point of being “self-insured”, having enough set aside to cover the goals and expenses of your family. Term insurance supports tactical construction of coverage, layering multiple insurance contracts to meet your needs. Terms can be laddered to expire when dependents are no longer expected to need support. Additional coverage can also be added as the policyowner’s income or asset values change materially. It is most beneficial to establish term insurance early in life when age and health work to your advantage, resulting in lower premiums. That said, term insurance is still relatively affordable in your 40s and 50s these days. Those who prefer to retain control of excess cash for investment would be well served to cover insurance needs using term life insurance and invest the rest at your own discretion.
Permanent insurance includes whole life and universal life policies, among others. These plans offer additional features that may be desirable to some, including a cash value. Each premium payment includes a contribution to both the death benefit and the cash value. This cash value grows tax-deferred and can be borrowed against or withdrawn. Consult your tax professional prior to taking loans or withdrawals as these may result in taxable events.
Permanent life insurance comes in a variety of structures that offer flexibility in premium amount and timing. Payment options range from a one-time lump sum payment to premiums that rise with time, which benefits a policyowner with very little discretionary income at the beginning of the contract. Permanent life insurance can also be incorporated into an estate or business succession plan, making a large sum of cash available upon the policyowner’s death. This can be used by business owners to transfer ownership or to cover estate taxes on larger estates with a high proportion of illiquid assets.
If you are looking at whole and universal policies, it is very important you read all the fine print to understand their cost. When clients ask us to evaluate these policies, we often find their fees expensive, and terms can be inflexible. For example, for policies that incorporate equity investments we have seen annual management fees and investment fees over 2% and sometimes more. Another example is surrender charges that are lengthy, effectively locking you into the contract, or expensive if you do decide to terminate.
After choosing the appropriate type of insurance, or combination thereof, there are a few ways to calculate the appropriate level of insurance. The simplest is to insure the present value of future earnings of the insured. Some industry experts recommend ten times your annual income. Another option is to estimate the needs of surviving dependents. Compare this with expected assets available at the time of death then fund the difference. For this method, be sure to consider all current and potential dependents, and other expenses like funeral expenses, child education expenses, outstanding debt, and an emergency fund for the family.
Here are a few other considerations. Many people are offered life insurance through their employers, but this is often not enough and may be subject to your continued employment. Stay at home parents may also have a life insurance need, as childcare would need to be provided if something were to happen to them.
Periodic monitoring of your life insurance coverage is essential to the financial security of those who depend on you. Your income will change over time, as will the value of your assets. So, too, could the number and needs of your dependents, or your desire to leave something to your heirs. If you find a deficiency in your current coverage, think about supplementing it with a new plan. If you find your current coverage sufficient, you may be able to lower your premiums by improving your health and shopping for a new policy. Work to lose weight, stop smoking, and seek treatment for conditions you may have neglected during your first rating. Then, shop the marketplace for multiple offers. If you go this route, be sure to fully add new coverage before cancelling other coverage. As always, be sure to stay current on premiums for all insurance you carry.
We do not recommend using your life insurance policy to invest in the market. The control and flexibility of separately managed accounts is more favorable to long term wealth creation. While we at Provident Investment Management are not insurance brokers, we welcome your life insurance questions and will do our best to answer them.
Eric Pozolo, CFP®