How Much Life Insurance Do I Need? – Part 1

Planning for the future?………… Good for you!

Planning for the future can be exciting.  It enables thinking about what a person wants to accomplish with their life, what they want to be known for, and what their legacy will be. Planning for the future also enables the creation of a “bucket list” and can not only give a person motivation but a purpose to live for.

It also forces a person to think about what could go wrong and how to protect themselves from life’s unexpected pitfalls. The key protection instrument people use to provide safety to themselves and their loved ones is life insurance.

Life insurance is defined as a contract between an insurance policy holder and an insurer (i.e. insurance company). The insurer promises to pay a designated beneficiary a sum of money in exchange for regular or lump sum payments from the policy holder (aka premiums) upon the death of the insured person.

In other words, an insurance policy is a defensive instrument, a shield or safety net per se, used to protect the insured person and their family from unforeseen events.

What most people either don’t realize or don’t take advantage of is that insurance can also offer benefits that can be taken advantage while still living. As they say, “the best offense is a good defense”. Let’s dig into the possibilities………

insurance as a safety net

Types of Life Insurance

Per Policy Genius, there are 3 basic types of life insurance:

Term Insurance

Term life insurance lasts for a finite number of years (typically between 5 – 35 years) and then expires. If death occurs before the term is up, a set amount of money, known as the death benefit, is paid to the designated beneficiary.

Payments made go towards paying the death benefit that will go to beneficiaries. The death benefit can be paid several ways: lump sum, regular payments, or as an annuity. Most people elect to receive the death benefit as a lump sum.

Term life insurance is considered the simplest, most accessible life insurance and is much more affordable that other types of life insurance. This results in low cost premiums. For example, a 35-year old male in good health can purchase a 20-year, $500,000 term insurance policy for around $22-30/month.

Universal Insurance

Universal life insurance is a form of permanent life insurance (policy expires at demise) that has both a death benefit and a cash value. Unlike term life insurance, premiums paid goes toward both the death benefit AND a cash value.

A unique benefit of universal life insurance is that both the premiums and death benefit can be changed during the life of the policy without having to obtain a brand-new policy.

A minimum premium is required to keep the policy in good standing. However, if enough cash value is accumulated over time, the cash value can be used to pay the premiums. The good part about this cash value component is that funds can be access while the insured is still alive. More on this later in the article…….

The cash value of a universal life insurance policy has an interest rate that is sensitive to current market interest rates. If the interest rate being credited to the policy decreases to the minimum rate, the premium needs to increase to offset the reduced cash value. In other words, the universal life policy has a variable rate set by the insurance company.

A variation to universal life insurance is indexed universal life insurance (IUL). What makes it different from typical universal life insurance is the way the interest rate behaves.

In an IUL policy, a stock or bond index is used to set the interest rate. S&P 500, Nasdaq 100, and Russell 2000 are examples of indexes. The insurer does not directly invest in the market but uses the interest rate and performance of a specific index to set the interest rate for the policy.

A benefit (or detriment depending upon point of view) is that there is a built-in cap on both losses and earnings. The floor is typically 0 or 1% and the ceiling is typically 14-15%. So, the overall range on most policies can be 0% – 15%.

The good news is that a person cannot ever lose money on a policy. The bad news is that gains would be capped at 15%. While this is a good rate of return, if the market goes up to 20%, the policy only gains 15%.

Here’s how it works:

The insurance company will track the index from January 1st to December 31st.  Whatever the S&P index is trading at on December 31 is the ending value in which the index credit is calculated.

For example, let’s assume the IUL tracks the S&P 500 index and has a cap range of 0-14%. Assume the index is trading at 2000 as of January 1st. If the S&P 500 index is trading below 2000 on December 31st, the policy gains 0% for the year and does not lose money. Good news for you! 😊

On the flip side, if on December 31st, the index is trading at 2200, the policy gains 10% for the year and your policy get the full 10% increase. However, if the policy is trading at 2400 (20% increase), your policy will only receive a 14% gain.

The protection from loss is a great way to achieve peace of mind while watching the assets grow. The protection from negative return years is a key benefit of purchasing an IUL policy.

As an added bonus, the policy also has a feature called an annual reset. This means that each year’s interest credits are locked in and a new starting point is determined.

Let’s use the same example as above to explain. Let’s assume the S&P 50 is at 1800 on December 31st. This is 200 points lower than when started on January 1st. Instead of losing 10%, you lose 0% and the new starting value on January 1st the following year is 1800.

This is the great thing about the annual reset. You do not have to wait until the index reaches 2000 to start achieving gains again!

Whole Life Insurance

Whole life insurance is similar to universal life insurance with some key differences. Both universal life and whole life are permanent life insurance that have a cash value component and a death benefit component.

A whole life policy provides a set amount of coverage for your entire life. As long as premiums are paid, the beneficiary will receive the benefit amount upon death.

Like universal life, whole life also has a cash value and can be accessed by the insured person while still alive. This cash value is built up over the life of the policy and people can access this money as the policy grows.

The main difference between the 2 polices is how the interest rate accrued. In a whole life policy, the interest rate is fixed by the insurance company for the life of the policy. Typically, it falls in the 4-6% range. In addition to the interest rate, whole life policies can also earn a dividend that can be added to the cash value component to increase growth.

The good news is this interest rate is not dependent upon a stock market index, bond rate, etc. since the insurance company sets the interest rate. This provides steady, consistent, and predictable growth for the life of the policy.

Also, riders can be added to the policy to further increase coverage that could benefit the insured while still alive.

Here is a quick summary of the 3 types of insurance:

insurance summary

We’ll discuss the pro’s and con’s of each of these policies in more detail next……

Which Type of Insurance is Best For My Needs?

Term Life Insurance – Pro’s / Con’s

Let’s start with the benefits:

First off, term life insurance is essentially designed to cover your wages in the event of demise. It is very plain, simple, and straight forward. Nothing fancy, just pure coverage. If a person passes on, the beneficiaries will receive a payout from the policy. Term lengths are anywhere from 5-35 years. Typical length is 20 years.

Secondly, a person can buy ALOT of coverage for literally pennies on the dollar. The insurance company is essentially betting on the fact that you will not pass in those years. More often than not, they are right! This is why it is so cheap.

For example, let’s assume a person who is 30 years old and in great health decides to buy a 30-year term policy for $1,000,000 in coverage. Average cost for a policy like this is $64 per month. That’s it!

People use this type of policy to protect their families in case something happens. They know the family will be compensated for the lack of income coming in and will be able to cover major expenses like the mortgage, daycare, college, etc.

People without families tend to only purchase as little coverage as possible to cover funeral expenses and maybe something leftover for their parents / loved ones.

Now for the Drawbacks:

 The first drawback is the coverage is finite and temporary. Once the policy term expires so do the benefits. It like renting an apartment instead of buying a home.

The second drawback is there are no living benefits for the person being insured. The benefits available only help the beneficiaries, not the insured. For example, what if the insured becomes paralyzed in a car accident? Term insurance does nothing to cover this.

How about if an elderly person needs long-term care or cannot perform basic daily life functions? Term insurance does not help them.

What if a child is born with Down’s syndrome? Term insurance does nothing to help the family with medical bills related to raising and caring for the child.

Third, costs tend to increase over time. The older a person is, the more expensive the policy is.

Lastly, term insurance does not allow cash value to be built up over time that can be leveraged for emergencies.

Universal Life Insurance – Pro’s / Con’s

The Upside:

As discussed before, universal life insurance has both a death benefit and the ability to build a cash value within the policy. In other words, universal life insurance has benefits for both the insured person AND their beneficiaries. For the benefit of this discussion, we’ll discuss benefits / drawbacks of IUL’s.

First, the most significant advantage of IUL insurance is the potential for healthy, relatively safe growth in the cash value.  Gains that are potentially higher than other types of financial products including traditional universal or whole life policies.

Also as part of the rate capping, a floor of 0% or 1% is set that protects the existing cash value from losses in a poorly performing market. For example, if the index generates a negative return, the policy does not experience a negative cash value. You’re protected from crashes which is a vital component to a successful portfolio.

insurance moat

As discussed here, what truly impacts your portfolio are the market crashes. Overfunding an IUL can be a useful tool to protect your overall portfolio when your 401K goes down 35% in a week (i.e. like it did in March 2020 during the pandemic).

Having a portion of your retirement savings in assets that eliminates stock market risk is one of the most powerful weapons a person has against running out of retirement money. Moats are a good thing! 😊

Second, there are huge tax advantages with overfunding an IUL. Money already taxed at current rate is added to the policy. Money can be taken out tax-free via withdrawals (up to the amount of premiums invested in the policy) and loans against the policy.

When a withdrawal from a policy occurs, the face amount of the policy is permanently reduced. The withdrawals are generally tax-free up to the amount of premiums that have been paid into the policy.

Loans on the other hand have huge advantages. Loans are not taxable (i.e. like taking out a home equity line of credit loan) and do not necessarily have to be paid back provided there is enough accumulated cash value in the policy. Usually the loan rate is less than the policy interest rate which enables the cash value to continue growing.

Another beautiful thing about loans is that it does not impact the accumulation of the cash value.

The best way to visualize this is to imagine 2 pillars of money: 1 is for cash value and the other is for loans against the policy. The cash value accumulated is used as collateral against the policy loans. This way the accumulated cash value grows uninterrupted. If the loan is defaulted, the insurance merely deducts it from the cash value after the policy expires.

If structured properly so that the death benefit is minimized and the cash value maximized, the policy can be designed to provide regular tax-free payments via periodic loans against the policy. Being able to withdraw money tax-free makes it similar to how a Roth IRA behaves.

In other words, the policy can be designed to act like a pension providing regular tax-free money to the insured person. Imagine having enough money between the policy and social security to cover life’s daily expenses and using the 401K / Roth IRA funds to cover unexpected expenses, major purchases, and “fun money” …. sounds like something I talked about in this article. 😊

Third, IUL’s has other useful benefits for the living providing the correct riders were implemented. For example, an IUL policy can be setup to pay for long-term care nursing home expenses if the policy holder is unable to perform 2 out of 5 basic daily living functions. This is HUGE! Especially considering the current average annual cost of a nursing home is approximately $255/day ($93,000 /year).

Think Medicare / Medicaid covers the full cost?… Think again. Read this article for details.

One of the biggest worries for retirees is the cost of both medical care and long-term care. Even if a person has a couple of million dollars in retirement assets, this can be quickly eaten up by unforeseen medical bills. Use permanent insurance to protect yourself against this.

There are other riders that can be purchased such as critical illness protection (i.e. heart attacks, cancer, stroke, kidney failure, etc.), overloan protection, terminal illness protection, waiver of premium, child riders, long-term nursing home care, etc. Investigate not only the policy rates charged by the insurance company but what other riders and perks are available. These may be even more valuable than the policy itself.

Fourth, when a permanent insurance policy is purchased, an asset is being purchased. You are essentially “buying a home”. This asset can be bought and sold like any other commodity. For example, my in-laws had a universal life policy that they cashed out when they retired and felt they had plenty of retirement funds and pensions to cover their living expenses.

In most cases, the cash surrender value is tax-free up to the amount of premiums paid into the policy. However, any capital gains or dividends earned that were paid to the cash value will be counted as taxable income.

Fifth, IUL’s offer beneficiaries get both cash value AND Death Benefit. This way the cash value is not absorbed by the insurance company and goes to who truly need it…. your loved ones.

Next Week

We’ll look at the con’s for IUL, explore the possibilities of whole life insurance, discuss the strategy I used, and my two cents on what you should do…. Stay tuned!