You’re Probably Doing Life Insurance Wrong
Life insurance is important, but most people just aren’t doing it right.
By Steven Higgins, Financial Advisor
Life insurance is a foundational part of financial planning, as is any risk mitigation tool. While people are aware of the need for life insurance, they generally cringe at the idea of talking about it. Maybe, it’s the morbidity of it, or maybe it’s the constant and almost “cheesy” reputation that the life insurance industry has deservedly earned by training all of their new sales mercenaries to push inappropriate policies on their friends and family. The result is a skeptical public who thinks they’ve checked the box of life insurance and they are not interested in talking about it. As a financial planning firm we address the issue directly and aim to incorporate life insurance as part of a strategic plan rather than a compartmentalized sale of a product. Part of the process often includes unwinding or replacing costly and inappropriate insurance policies. There are some life insurance mistakes that we consistently see. Avoiding these mistakes will aim to help you create a more cost effective and appropriate Legacy Strategy for your family.
Mistake: I have life insurance coverage through work so I’m good to go. (pun intended)
Portability – Almost all employer based life insurance coverage is tied to you actually working for the employer. If you change jobs or have to quit your job in the event you become sick, you lose your coverage. Employer sponsored coverage doesn’t protect you in anyway from an issue that would compromise your insurability, a concern I will dig into deeper later.
Inadequacy – Employer sponsored coverage is often a multiplier of your salary; three to five times your salary is somewhat standard. If you make $100,000 you would have between $300,000 – $500,000 of coverage. While that may seem like a significant amount of money, let me be clear, it’s not. If you have goals for your family that are important enough to be achieved whether you remain living or not then you need to make sure those goals can be accomplished by your life insurance or what we call Legacy Strategy. To simply replace a $100,000 income to perpetuity, a life insurance benefit would generally need to be at least $2,000,000. If you start considering paying off debt, funding college, and future retirement goals for the surviving spouse and you can see how inadequate your coverage at work may be.
Mistake: I bought life insurance as a plan to use it as tax free source of retirement income in the future.
While a Life Insurance Retirement Plan might work for some people, it is one of the most overused sales practices in the industry. The concept requires you to overfund a whole life insurance policy, a type of permanent life insurance policy. By overfunding the policy you are prioritizing cash value accumulation over death benefit. After many years you should have some cash value built up in the policy which you can essentially take as a loan. You have to leave enough cash value in the policy to cover the internal insurance costs or you have to start putting more money back into the policy with clearly defeats the purpose of using it as an income tool. If the policy lapses, every penny you took out of the policy above your premium payments is taxed as ordinary income in one year. The vast majority of these plans that we see are policies with $100,000 death benefits which will never be large enough to create any meaningful source of retirement income.
People are often sold on the idea of a “perm-term split.” This sounds like what is is; buy a term policy and a permanent policy. Sounds logical right? Let’s say you buy a $100,000 whole life policy, and a $500,000 term policy. Best of both worlds right? Wrong. The whole life policy could cost thousands of dollars per year and the term just hundreds. You’ll essentially be paying exorbitant premiums for an inadequate life insurance plan and terrible retirement income vehicle. Why is this sales practice so commonplace? Life insurance agents and companies are not fiduciaries. Long story short, they don’t have to act in your best interest. Life insurance is a highly commissionable product and commissions are based on the amount of premiums paid. Since permanent insurance is so much more expensive than term insurance, an agent can significantly increase their income by adding a “sidecar” of permanent insurance to every sale.
Life insurance retirement plans should be considered in rare circumstances. Unless someone is maxing out all qualified plans like IRAs and 401ks, has significant non-qualified assets, and a substantial cash reserve position, they should not be considering using life insurance as a retirement income vehicle.
Mistake: I’m healthy, I don’t need to set up a Life Insurance Strategy yet.
Good news. You are probably not going to die anytime soon. You are “healthy as a horse” as they say and that is exactly why you need to set up a Life Insurance Strategy as soon as possible.
Good health is probably the most under-appreciated asset in financial planning. While we can easily comprehend and quantify the financial repercussions of things like the impact of a shortened career due to illness, an extended long term care event, or disability, we tend to take our healthy years for granted. There are two key elements that drive health insurance underwriting outcomes; age and health status. I’m sure you are not surprised that younger, healthier people pay less for life insurance. What people may not understand is that your health status as far as insurance companies are concerned is fragile and fleeting. The difference in preferred health status rates and standard health status rates may be as much as 50%.* There are many health events that can compromise insurability. For example a young, healthy woman who is 30 years old would likely qualify for preferred rates. If the same woman develops gestational diabetes during an otherwise normal pregnancy, her underwriting status will likely be reduce to standard for the rest of her life because of a statistically increased chance of developing diabetes in the future. There are many issues that, as we get older, chip away at our insurability such as high blood pressure, increase in PSA numbers, and mental health issues. In fact, every note that your doctor might scribble in your medical file is reviewable and could impact your underwriting outcome.
Convertibility – Today, some insurers offer convertibility in their term life insurance policies. Convertibility gives policy owners the ability to essentially insure their own insurability. Generally, companies will allow an individual to convert all or part of their term insurance policy (within the term of course) to a permanent policy and the premiums will be based on the original underwriting outcome and the insured’s attained age. Example: Michelle, age 39, purchases a $3,000,000 20 year term life insurance policy with preferred health status. Michelle at age 55 is diagnosed with breast cancer and after successful treatment, Michelle is now fully recovered and is expected to live a full and healthy life. However, her term life insurance policy is nearing the end of the 20 year term. Michelle is a successful dentist and has been fortunate to create a significant portfolio of investments. She understands that there many be some tax challenges in the future for herself and her children when she passes. She knows that life insurance is one of the most tax efficient estate transfer tools but because of her bout with breast cancer, she is no longer insurable. Because her 20 year term insurance policy had the convertibility feature, she was able to convert all of her policy to a permanent, guaranteed policy with the premiums based on her original preferred health status and her attained age of 55.
Unfortunately, people ignore the value of their insurability only to become frustrated and financially limited when an adverse underwriting decision impacts their ability to meet their goals. If people are willing to create a Legacy Strategy when their health and insurability is intact, they can get ahead of the many normal health issue that we all face as we get older.
What do you do now?
To be clear, at HD Wealth Strategies, we create life insurance strategies for people with considerable assets and for those people who expect to have considerable assets. We incorporate the Legacy Strategy within the financial planning process and manage the strategy over time as we would any other part of a clients portfolio. While there are no doubt many many people who just want to get the process out of the way and check the “life insurance box” we believe that creating an appropriate and effective strategy is just too important to take lightly. Life insurance is not binary. It’s not whether you have life insurance or not, it’s whether you have a Legacy Strategy or not.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This article is intended to assist in educating you about insurance generally and not to provide personal service. They may not take into account your personal characteristics such as budget, assets, risk tolerance, family situation, or activities which may affect the type of insurance that would be right for you. In addition, state insurance laws and insurance underwriting rules may affect available coverage and its costs. If you need more information or would like personal advice you should consult an insurance professional. You may also visit your state’s insurance department for more information. Guarantees are based on the claims paying ability of the issuing company. This is a hypothetical example and is not representative of any specific product. Your results may vary.
*Source: iPipeline software, LPL Financial
