Key Takeaways
There's no inherent opposition to whole life and universal life insurance, the goal is for individuals to acquire suitable policies without overspending on unnecessary features.
Life insurance comes down to your financial obligations and the potential shortfall your family would face if you were to pass away prematurely.
Before paying large premiums for sophisticated insurance, consider the returns you’ll forgo by not investing that money elsewhere.
During the discovery process with new clients, we often find high-premium life insurance policies that were purchased from expert salespeople. These policies often include far more coverage than our clients need and are typically in the form of a Universal or Whole Life policy. For the most part, these policies have you pay premiums in perpetuity and those premiums increase as you get older. For instance, a 46-year-old father came to us with a complicated $1 million whole life policy that included a 20-year term policy with a $550,000 death benefit and a $450,000 whole life death benefit. Since he’s young and in good health, his premium for a $1 million policy should have been about $1,000 a year – but he was paying $16,000 a year!
Looking closer at the policy, we discovered he was paying about $1,000 for the 20-year term life policy – not bad – but $15,000 for the $450,000 whole life policy. At $15,000 a year, the premiums alone would have amounted to $450,000 by age 76 – the same as the death benefit. More concerning was the opportunity cost of not being able to put that $15,000 a year in premiums to better use – and grow a nest egg much larger than the death benefit.
More on that in a minute.
What’s The Purpose Of Life Insurance?
As the old saying goes, “life insurance is never bought; it must be sold.” But there are some exceptionally good reasons to have life insurance provided you have the right policy. At its core, life insurance is a tool to provide you with peace of mind. It protects you and your family from severe financial hardship should you pass away during your prime working years. Insurance covers the loss of your income and makes it possible for your spouse and family to continue paying any debts (including mortgage and student loans), living expenses, household repairs, etc., that would have been paid by your income.
Term Vs. Whole Life Insurance
With basic term insurance, you pay a fixed monthly premium for a set number of years, typically up to thirty. Since term premiums are not adjusted for inflation, the policy effectively becomes cheaper every year. Term is usually the least expensive option, but it has no residual value. If you don’t die during the coverage period, the insurance company gets to pocket all the money you’ve paid in premiums.
Whole life insurance is a common form of permanent life insurance that covers you for your entire life rather than for a fixed term. The reason many people pay more for whole life insurance is because it seems to have tangible value. Yes, Whole Life pays a guaranteed death benefit and has a cash value component that you can borrow against or withdraw under certain conditions. However, if you die before the loan is repaid in full, the death benefit will be reduced by the amount still owed. In addition to paying higher premiums for your whole life, those premiums aren't fixed. They can increase very rapidly as you get older.
Are the higher premiums for whole life worth it? Let’s go back to the example of our 46-year-old client. He’s paying $15,000 a year in premiums for the $450,000 whole life. In 30 years, when he's 76 he’s effectively paid himself the entire death benefit ($15,000 x 30 years = $450,000). Instead, if he took that $15,000 a year and invested it in the stock market with a conservative expected growth rate of 7% annually, that money would be worth about $1.5 million after 30 years – more than three times as much. Who pockets the difference? That’s right, the insurance company.
NOTE: We’re not anti-life insurance here at Novi. We just want people to have appropriate life insurance and not overspend on things they don’t need.
How Much Insurance Do You Need?
It really comes down to what your financial obligations are – mortgages, loans, education costs, day-to- day living expenses and any other substantial loans. Next, we look at what your family’s financial gap would be if you passed away prematurely, and your income is suddenly gone. Then we look at your surviving spouse’s retirement picture. How much more is needed if you, the breadwinner, are no longer contributing to a retirement account? Next, we calculate how much of your income needs to be replaced to maintain your family’s standard of living. For instance, if you want your money to last for 15 years and you make $100,000 a year, you will need a $1.5 million policy as a baseline.
Practically speaking, you only have insurable needs until you retire. Once you reach retirement age and your spouse is still alive, the only loss of income is your Social Security. By now your expenses are much lower. One caveat is if you have a large annual pension that goes away upon your death. Many pensions pay out survivorship benefits, so if something were to happen to you, your spouse could get 50% of that benefit. But if you opted for a 0% survivorship benefit (to receive larger benefits earlier) then you are facing a financial loss.
For example, if you have a $ 100,000-a-year pension and are using that money to cover you and your spouse’s living expenses, your spouse could face a significant loss of income if you die and there is no survivorship benefit. In this situation, we’d potentially investigate a universal whole-life policy. But for most people in most situations, whole-life policies are more expensive than they're worth.
Life Insurance As An Estate Planning Tool
Life insurance can be an effective estate planning tool for high-net-worth individuals with large estates. Since life insurance policies are tax-free (and generally protected from creditors), the right kind of whole-life policy can pay millions of dollars out of your estate and convert it into a large (tax-free) death benefit. For instance, you can set up an irrevocable life insurance trust and get a whole life policy that matches the annual gift exclusion amount (currently $18,000 a year) or you can file gift tax returns to pay higher premiums. You “gift” that money to the life insurance trust to pay the premiums. So, the money that’s used to pay the premiums is out of your estate and can be converted into a large policy to help pay for estate taxes when the time comes. I’ll cover this strategy in more detail in a future post.
Conclusion
If you or someone close to you has life insurance or estate planning questions, reach out any time. I’m happy to assist.
DAN SATZ MS, CFP® is a Wealth Manager at Novi Wealth
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