Life insurance isn’t sexy, but it’s an important component of nearly everyone’s financial plan. When death interrupts life, it provides a blanket of security that allows survivors to, well, survive.
As a Certified Financial Planner®, I find that many people are confused about what kind of life insurance they should have. At its core, insurance falls into two categories: permanent and term.
The type of insurance you have depends on your anticipated need. If you feel your need for insurance will be permanent, meaning you’ll need it whether you die today or at age 95, then permanent insurance should be considered. Most people, however, only need life insurance to cover a specific period of time, making term insurance a preferable option.
Let’s take a closer look:
Term insurance is intended to cover a basic need: to replace the economic loss resulting from a death during a specific period of time. It sounds clinical, but that’s all it is. For example, if I have a child today, I may want to purchase a 25-year term policy to ensure that, if I were to pass away before that child became independent, there would be sufficient assets to provide for my child. Once the child has left home, the need may no longer exist and the insurance term expires.
With term insurance, you’re only paying for what you need, when you need it. Because of that, the premiums are much lower, relative to many permanent forms of insurance.
Permanent life insurance is intended to cover a permanent need. The most frequent permanent needs I encounter are:
1. Estate planning: In order to provide for liquidity at death, or to create a tax-free estate at death, permanent life insurance strategies can be utilized.
2. Pension replacement: In the event one spouse elected a single-life only pension, a permanent insurance policy can be used to replace the pension in the event of the pensioner’s death.
In both of these circumstances, a permanent insurance policy is used simply because the insurance need exists for an unknown period of time. It would be unwise to use a term policy in these instances.
Many people have been sold permanent insurance policies who may not have had a permanent need, on the premise that permanent insurance can build cash value against which tax-free loans can be taken in the future. Truth be told, in my nearly twenty years in private practice, I’ve never encountered a person who funded their retirement using their life insurance cash value.
This is true for a variety of reasons.
In order to grow significant cash value, the policy premiums needed are significantly higher than just the cost of insurance (which is all you pay in a term policy). While many people are well-intentioned on the front-end, life happens, and very often people reduce the amount they pay into their policies, which dramatically affects the policy’s performance.
Another reason these policies often don’t live up to expectations is that life insurance agents may use unrealistic assumptions when illustrating future policy performance.
The only time I see permanent insurance work as a savings vehicle, is for a client whose cash flow is such that they have maximized contributions to every other retirement savings vehicle, and still have significant money they need to sock away. So, if you’ve exhausted your ability to contribute to your 401k, 403b, IRAs, and other retirement vehicles, then permanent insurance could be another avenue for saving.
It should be noted that some people start out with a temporary need which evolves into a need that is more permanent. Luckily, many term insurance policies are convertible into a form of permanent insurance for just this reason.
In the battle between term and permanent, as planners, we overwhelmingly favor term insurance. It is by far the most cost-effective way to solve for a need, while preserving the option to convert to permanent insurance if the need changes.
Your Certified Financial Planner® will be the best person to help you assess your need by helping you to understand your overall financial circumstances, and can tailor a policy to provide proper coverage. If your advisor is independent, they will also have dozens of carriers to choose from, and can help get you the most competitive rates.
Stephen Kyne, CFP® is a Partner at Sterling Manor Financial, LLC in Saratoga Springs, and Rhinebeck, NY.
Securities offered through Cadaret, Grant & Co., Inc. Member FINRA/SIPC. Advisory services offered through Sterling Manor Financial, LLC, or Cadaret Grant & Co, SEC registered investment advisors. Sterling Manor Financial and Cadaret, Grant are separate entities.
