I find myself writing about life insurance, not because I am particularly passionate about the topic, but because I have recently worked with some families who were misguided about the purpose and utility of the life insurance products they were sold.
Life insurance is a critical component of a comprehensive financial plan. I often recommend families should own a level of coverage based on their specific circumstance. However, only rarely would I recommend insurance be used as an investment savings vehicle. Insurance should first and foremost be purchased to protect a family, business or estate in the event of a death and not be substituted for other investment vehicles to accumulate wealth or provide retirement income.
What Is Life Insurance?
Life insurance, in its most basic form, is an agreement between you and an insurance company. In exchange for a relatively small payment (premium), the insurance company promises to pay a tax-free death proceed (death benefit) which is intended to cover the financial needs of surviving family members, a business or an estate at the death of the insured. The early death of an otherwise healthy individual is an event that is unlikely to occur, but it would be financially catastrophic to that individual’s family or business.
What Are the Types of Life Insurance?
There are various forms of life insurance and ways in which policies can be structured. However, policies are often categorized into two broad types: term or permanent.
Term Life Insurance
Term life insurance designs protection for a set amount of time — usually a horizon of 10–30 years. The parameters for this type of insurance are fairly uniform across insurance companies. There are enhancements that might be standard or available for purchase: a return of premium rider, disability rider, or the important one, the ability to convert a term policy to permanent policy. The basics across various term policies are the same. Pay your premium for a specific amount of death benefit. As long as you are making the premium payments on time, you will maintain coverage.
For example, a 40-year-old male in good health can obtain a term life insurance policy that provides $2 million of death benefit over the next 20 years for around $150 per month. Over the life of the policy, that individual will make $36,000 of total premium payments. That is a pretty good financial trade-off considering his family would receive $2 million if there is an early death. That policy can often be continued after that 20 years, by paying an annually increasing premium or, if available, converting to a permanent policy.
Permanent Life Insurance
Permanent policies are more complicated. Broken down to the basics, when a premium is paid, the insurance company subtracts certain costs: the pure cost of insurance (mortality cost), the operating expenses of the company itself, and the cost of marketing the insurance — the largest component being commissions. Whatever is left over after these costs are subtracted from the premium are invested for the benefit of the policy owner. The investment is either held in the general account of the insurance company or in a segregated separate account similar to a mutual fund. Policies that invest in the general account are labeled as whole life, interest sensitive policies or indexed policies. Those that invest in a separate segregated account are called variable policies.
The declared, ongoing investment returns of the policies that are invested in the general account are controlled by the insurance company and can change as often as monthly. Investment returns of policies that are invested in segregated funds get the return of an underlying investment stipulated in the policy and are not controlled by the insurance company.
How Do You Know Which Type You Should Purchase — Term or Permanent?
If your goal is to pay as little premium as possible for the greatest amount of life insurance coverage, we almost always recommend term life insurance. You want to work with a financial advisor to determine the appropriate amount of term insurance for the appropriate duration.
Who Should Purchase Permanent Life Insurance?
Permanent insurance should generally be considered when the time horizon for the insurance need is undefined or extends beyond the available time periods for term insurance. Additionally, policy owners must have the financial wherewithal to pay significantly higher premiums and not need access to that cash element in the next 10–15 years. Situations when permanent policies may be appropriate include:
- Individuals or couples who may be subject to the federal estate tax or state estate taxes. In 2023, your estate would need to be greater than $12.92 million for individuals and double that amount (almost $26 million!) for married couples to trigger federal estate taxes. For those who fall into that cohort, life insurance premiums can be a much more effective way to fund those taxes. This need typically grows, not diminishes over time for this cohort.
- Individuals or couples who have a dependent with special needs. This need typically extends beyond the period of time available through a term policy.
- There are some particular circumstances in business where the need will extend beyond the available time periods of a term policy.
There are other situations when permanent policies may be appropriate, but they are one-offs and not mainstream.
None of the above examples have anything to do with the many reasons permanent policies are commonly sold. Insurance agents who present themselves as “financial advisors” will sell these policies as a great way to obtain life insurance AND invest. They utilize catch phrases such as: provide tax free retirement income, invest in the market without downside risk, and self-completing retirement plans. They offer hypothetical illustrations which have little chance of happening as presented.
Many of these policies require your “investment” to be held by the insurer for 7–15 years before you can withdraw the money without a penalty. Additionally, it will typically take 10–15 years, or longer, to break even between the dollars spent on premiums and the surrender value of the policy.
Permanent insurance is often sold on the idea you can generate “tax-free” retirement income. Policyholders often do not understand that they are simply borrowing their own money and paying the insurance company the interest being charged! Further, if during this scheme, the policy cash “runs out” before the death of the insured, there is often phantom income tax to pay on any gains that were deferred during the borrowing phase!
Consider that if you instead invest the excess premiums in tax-efficient ETFs inside a taxable brokerage account for the same 20–30 years, you could borrow against that value, if you were trying to avoid taxes in any one given year. Borrowing itself is not a unique feature only found in insurance. You also have unlimited, penalty-free access to your funds during the entire period of investing.
Financial Incentives Matter
If you have purchased or are considering purchasing a permanent policy, did the insurance agent do a financial plan to ensure you will not need these funds over the next 10 years? Did they evaluate your debts to see if high-interest-rate debt should be paid off first? Have they talked about other savings programs,
traditional or Roth IRAs or optimizing savings in your employment’s retirement plans? Sadly, most do not do this necessary work up front before selling these policies. They are not incentivized to do this work. If they were, they would probably have given advice to put your extra premium payments to higher and better uses.
Insurance agents holding themselves out as advisors whose primary product they sell is permanent insurance, seem to use insurance as the Swiss Army Knife of planning. It has all the tools on it. However, would you try to build a house with a Swiss Army Knife? A fiduciary advisor, by law, places your best interests first and will construct a financial plan and investment strategy using all available tools.
What Should You Do if You Already Hold a Permanent Life Insurance Policy?
There are many factors that would influence whether you should continue to hold your policy or possibly consider replacing it (i.e., terminating the policy and taking the cash value). Consideration needs to be given to any surrender charges/penalties previously mentioned, any tax implications from surrendering the policy and current health factors that may affect your ability to obtain other coverage. Analysis, if needed, can be done by a fiduciary advisor who works with a team which has the expertise to provide an objective opinion in this complex area.