Discussions of life insurance require us to consider life and death issues which aren’t always easy to think about. Facing our own mortality forces us to answer questions and consider scenarios we’d rather pretend do not exist. While we’d rather believe life will go on for decades and we’ll be able to continue providing for loved ones, the reality is that we don’t always have that opportunity.
If you’ve ever spent time with a young parent who recently lost their spouse and is dealing with grief while also caring for and providing for their children, you will never forget the tears in their eyes and their concern for the future. Sitting together they wonder:
- Will I be able to provide for myself and my children?
- Can I keep our house?
- Do I need to work multiple jobs?
- If I have to work, who will take care of my children?
- What about the children’s education? Can they stay in their current school? Will they be able to go to college?
- My spouse always took care of our finances, where do I start?
While the grief and pain that comes from losing a loved one cannot be eliminated, the financial stressors that accompany such a loss can be alleviated with appropriate planning. The discussions around mortality are difficult, but having them can ensure your loved ones are protected.
The primary method of protecting your family against the financial hardships that arise from an untimely death is life insurance. This blog post will be the first of a two-part series on life insurance.
This first post will focus specifically on the importance of life insurance to protect against the loss of a loved one and how to make sure your family is adequately protected. The second post will focus on permanent life insurance policies that are often marketed more for their investment characteristics than their risk mitigation attributes.
Life insurance, as discussed in this first post, is a crucial financial tool that provides a safety net for your loved ones in the event of your passing. However, with various types and options available, understanding the fundamentals of life insurance and basic tips for purchasing the best policy is essential to making informed decisions that align with your financial goals.
Overview of Life Insurance:
Life insurance can be divided into two primary categories: permanent insurance and term insurance.
Term Life Insurance: Term insurance provides coverage for a specific period, usually ranging from 10 to 30 years. If the insured individual passes away during the term, the policy pays out a death benefit to the beneficiaries. Term life insurance does not have a cash value and does not include any investment component within the policy. Accordingly, it is pure insurance and is typically affordable and straightforward for individuals who are young and healthy.
Permanent Life Insurance: Unlike term insurance, permanent insurance is intended to provide coverage for the entire lifetime of the insured individual as long as sufficient premiums are paid. It also includes a cash value component which accumulates over time and can be cashed out or borrowed against in the future. There are various subtypes of permanent life insurance, including whole life, variable life, and universal life, each offering different features and benefits.
Key Takeaway:
Term life insurance is simple and more affordable than permanent insurance.
General Purpose of Life Insurance:
The most common need for life insurance is to safeguard a family’s financial well-being in the event of an individual’s death, especially if that individual plays a significant role in providing financial resources for the family. It can help replace lost income, cover mortgage payments, fund education expenses, and maintain the family’s standard of living.
Additionally, for some families, life insurance can play a vital role in estate planning by providing liquidity to pay estate taxes or funding buy/sell agreements for business owners.
Choosing the Right Type of Life Insurance:
When determining the type of policy to purchase, families must consider their financial objectives and current circumstances.
If the goal is to protect against the loss of income during specific years, such as until children are grown, the mortgage is paid off, or sufficient retirement assets are accumulated, term insurance is often the most suitable option due to its affordability and simplicity.
Permanent insurance may be necessary if coverage is required for an entire lifetime (even if the individual lives to a normal life expectancy) such as in cases where it is being used to fund a buy/sell agreement for a business or to provide estate liquidity for a taxable estate. However, it’s essential to weigh the costs and benefits carefully as permanent insurance tends to be more expensive and complex than term insurance.
Key Takeaway:
In most cases, term life insurance should be the default option for young and middle-aged individuals who are simply trying to protect against the loss of income from a primary wage earner.
Determining the Coverage Amount:
The amount of life insurance you need depends on various factors, including your income, assets, and future financial obligations. Additionally, families should consider factors like the earning potential of the surviving spouse and any existing savings or investments.
As a general rule, single individuals with no children typically have minimal life insurance needs. Without anyone relying on them financially, the loss of their income doesn’t have a substantial financial impact on others.
Married couples without children may need life insurance; although, their need typically isn’t as significant as it becomes once children enter the picture. If there are no children but one spouse provides a significant proportion of the income, life insurance may be necessary to supplement what the surviving spouse can earn in order to maintain the surviving spouse’s lifestyle and provide a sense of continuity by allowing them to pay off a mortgage or maintain a home that their own earnings would otherwise not support.
Once children enter the picture, the need for life insurance becomes much more important. Not only are there additional living expenses, but many families want to assist their children with education, weddings, first homes, and so on. In addition, childcare becomes important (and expensive) when the surviving spouse now has to fulfill the role of being the primary wage earner.
Accordingly, families should assess their specific facts and circumstances and consider purchasing sufficient insurance to eliminate the financial concerns that will arise if a loved one passes away.
Key Takeaway:
Life insurance is an important consideration for anyone who has loved ones who rely on their income for financial support.
Duration of Life Insurance Coverage:
For most families, a primary financial goal is to accumulate enough savings and investments over time that they are financially independent and no longer rely on their labor to produce the income they require. Once a family reaches that stage, the financial risks associated with the death of a loved one are typically much lower, and therefore, reduce or eliminate the need for life insurance.
With that goal in mind, the length or term of a life insurance policy should align with your financial timeline. For example, if a family expects that it will take 30 years before their children are out of the house, the mortgage is paid off, and sufficient retirement savings will be accumulated, a 30-year term policy may be the best option.
Key Takeaway:
Individuals should ensure they have sufficient life insurance until they reach the point that they and their loved ones are financially independent.
Life Insurance Pitfalls to Avoid:
While life insurance plays a very valuable role in protecting families, there are also many pitfalls to avoid.
Insufficient Coverage: The first pitfall many families fall into is avoiding the conversation about life insurance altogether and either not purchasing any life insurance or having insufficient coverage. Families have a responsibility to make sure their loved ones are protected and a regular review of their life insurance coverage is necessary to ensure the necessary policies are in place.
Incorrect Beneficiaries: The second pitfall is failing to appropriately designate the beneficiaries on your life insurance policy. Once life insurance is purchased, it is important to make sure the beneficiaries are appropriately designated with the insurance company. This includes reviewing and coordinating the beneficiary designations with your estate plan which may dictate that beneficiaries should be trusts for the benefit of loved ones versus naming individuals directly as the beneficiaries.
Purchasing A Permanent Policy When Term Would Be Sufficient: The third pitfall is purchasing the wrong type of insurance policy for your specific situation. Before going out to purchase life insurance, individuals need to understand that not all life insurance is created equal. While there are certain circumstances where permanent life insurance makes sense, most families will find that simple term insurance is best.
Permanent insurance is expensive and complex. It typically blends insurance and investments into a single product which is unnecessary and costly for most families. In the unique case where an individual determines that permanent insurance is the best fit for their situation, they should be sure to understand why their situation is unique enough that term insurance is not sufficient.
Assuming A Permanent Policy Will Automatically Last a Lifetime: The fourth common pitfall occurs in situations where a family has purchased a permanent insurance policy. In many cases, they may have been sold the policy for a single, large premium paid initially when the policy was taken out. Alternatively, they may be paying a set premium over time.
While many families believe that this initial premium locked in the death benefit, that may not be the case. Permanent policies typically use the cash value of the policy to cover insurance charges. If the cash value in the policy is fully depleted by premiums over time, the insurance policy may lapse.
When this occurs all the premiums are lost and the insured individual will not receive the death benefit. Thus, it is important to understand whether sufficient premiums are being paid or whether there is a rider on the policy that prevents it from lapsing.
Purchasing An Insurance Policy As A Long-Term Investment: Pitfall number five is purchasing permanent life insurance as an investment. While there are instances where this can make sense, those instances are rarely present for families whose primary need is protecting against the loss of a loved one or saving for retirement.
Life insurance policies generally provide a much lower rate of return than other investment options due to high expenses. Keep in mind, the premium is set up to cover commissions for the selling agent, administrative costs to manage the policy, and overhead expenses for the insurance company. The insurance company invests what is left over knowing that, on average, the amount they will pay back to the policy holder will be low enough to leave a profit for themselves.
For individuals focused primarily on investing, avoiding the insurance company’s costs and profits will generally mean more money in their own pockets.
While life insurance does have a significant benefit in that it grows tax-deferred and any death benefits are tax free, generally, the higher costs and lower returns greatly outweigh any tax benefits. Accordingly, life insurance is better viewed as a risk mitigation tool than as an investment.
Purchasing Life Insurance For Children: Purchasing policies for children is pitfall number six. Life insurance policies for children are often marketed as a savings tool or a way to lock in future insurability guarantees. However, saving and investing separately from a life insurance policy will often yield better returns, especially given children have an extremely long period of time to invest which allows them to let their investments grow for decades.
Families who are concerned about future insurability due to family history of health issues should be sure to understand the details of the insurability guarantees. Often, the insurance companies place limits on how much additional coverage can be purchased and the timing of those purchases. Frequently, this limits the value of the guarantees in the first place.
While these are just a sample of the pitfalls to avoid, the key point is that while life insurance plays a vital role in protecting families, each family should be familiar with their unique needs and purchase a policy that specifically addresses those needs. In most cases, term insurance will represent the most cost-effective and appropriate solution.
Key Takeaway:
Most life insurance pitfalls will be avoided if individuals stick to purchasing term insurance and only resort to permanent insurance when there is a unique need that term insurance cannot address.
Conclusion:
Life insurance discussions are not easy and force us to consider events we’d prefer not to imagine. At the same time, ensuring your family is financially secure can remove the weight of financial strain and hardship from your family in the event that you pass away unexpectedly.
When purchasing an adequate amount of life insurance to allow surviving family members to maintain their current lifestyle, keep their home, and provide for the future, the type of insurance purchased is important.
While term insurance generally should be the default, there are certain circumstances when a permanent insurance policy may make sense. However, in those cases, individuals should skeptically investigate what makes their situation unique enough that simple term insurance isn’t sufficient.
For those who are interested in learning more about ways to protect their family’s financial future or would like to review whether they are exposed to unnecessary risks, our Family CFOs would be happy meet and discuss your specific situation. If you are interested in learning more, we would love to connect to see if what we do is right for you.
