Life insurance can be an important part of most peoples’ financial plan, but with so many different types of insurance, understanding which is best for you, and how much insurance you actually need can be quite confusing. Let’s simplify things a bit.
It’s important to understand the two basic types of life insurance: Term and Permanent.
Term insurance is intended to be used when there is a temporary need for insurance. Believe it or not, for most people, life insurance is generally needed temporarily. Consider if you have a child, and your goal is to ensure that if you die before that child is grown and on their own, there will be funds available for their support, then using term insurance to cover that finite time period is usually the way to go. Consider, too, that life insurance is usually used to replace lost income in the event of death. Once you have retired, and you’ve earned all of the income you ever will, does the economic risk of your death still exist? If the answer is no, then term insurance is probably the solution you need. Many term insurance policies can be converted to a permanent form of insurance, should your needs change (i.e., in the event of a terminal diagnosis).
Term insurance is pure utility. You pay a premium that strictly covers the cost of insurance. When the term is over, and your insurance need has ended, the policy goes away. From an efficiency perspective, it does one thing very well, and at a very low cost relative to permanent insurance.
Permanent insurance includes whole life, universal life, variable whole life, and variable universal life policies. These are all policies into which you make payments in excess of the cost of insurance, and the excess is intended to grow and provide a balance against which you can borrow in the future. Since these are insurance vehicles first, with an ancillary savings component, consider whether or not you have a permanent need for insurance.
Permanent insurance needs typically include two basic scenarios. First, in the event one spouse has taken a single-life pension, meaning their pension ends when they die, and they want to protect their spouse’s ability to maintain a standard of living, then using permanent insurance makes a lot of sense because the need will exist indefinitely, unless the second spouse predeceases the spouse receiving the pension.
The second scenario includes estate planning. Many people will utilize a special form of permanent insurance which insures two lives and pays after the second death, to either create an estate at death, or to supplement their estate. In this instance, the insurance must be in-force indefinitely and only permanent insurance will meet the need.
Permanent life insurance policies are often sold as savings vehicles, but are rarely funded at a level that makes them effective for this purpose. They work best if you have exhausted the other savings vehicles available to you, and you are looking to make considerable payments in excess of the cost of insurance. Because the cost of insurance in these polices is not level (it increases each year based on your age), the internal workings of these policies can be difficult to understand, and withdrawals or loans can have dramatic unintended consequences, including lapsed policies and sizeable tax bills. It is important to understand just how these policies work, and to fund them well beyond the cost of insurance in order to reap any real benefit from the savings component these policies can offer. In general terms, if your need for insurance is not permanent, or if you cannot afford to substantially fund them, then permanent insurance may not be in your best interest.
How much life insurance does a person need? The answer is highly individualized. You should work with your financial advisor to understand the unique risk to you and your family, and settle on an amount and types of insurance to best meet the need. We also recommend working with an advisor who has no direct affiliation with any insurance carriers. Different companies are priced to attract a different market. Some are better for higher risk clients, or clients of a certain age, and some are better with one form of insurance or another. Tying yourself to an agent who doesn’t have the flexibility to represent multiple carriers can easily cost you thousands of dollars over the life of a policy.
Stephen Kyne is a Partner at Sterling Manor Financial, LLC in Saratoga Springs, and Rhinebeck.
Securities offered through Cadaret, Grant & Co., Inc. Member FINRA/SIPC. Advisory services offered through Sterling Manor Financial, LLC, an SEC registered investment advisor or Cadaret Grant & Co., Inc. Sterling Manor Financial and Cadaret, Grant are separate entities.
