Life Insurance Planning
Life insurance is probably the least understood of products in the world of personal finance. Few people, advisors and clients alike admit to understanding them completely and many believe them to be an expense that should only be incurred when the need is obvious.
But there is a reason that the insurance companies continue to prosper. In spite of criticism from the media and from most investment advisors, their products provide true and predictable value with guarantees unavailable in any other financial instrument. In these uniquely uncertain times this fact alone makes them more valuable. Once clients are properly informed and their objectives are defined, insurance products often rise to the level of most prominent choice.
We don’t believe insurance provides a strategy for every situation. But we do understand its role in retirement planning. When included in a well-managed investment portfolio, insurance products reduce volatility and uncertainty and increase predictability, thus reducing financial stress.
Consider this: Many retirees suffer a lower than desired standard of living because of their desire to leave something behind for their children or grandchildren. Yet by including a life insurance policy in their portfolio they can determine in advance precisely the amount they are willing and able to provide as a legacy no matter when that time comes. Once in place, they are then free to invest the remainder of their assets in such a way that will maximize the amount of income they can achieve from the remainder of their assets.
This is only one example of how life insurance can benefit a retiree and his/her family. When we hear such an issue expressed by a client, we know enough to present this as an option to address the need. Only by understanding that this option exists can a person make an informed decision regarding the issue of legacy planning.
Other applications may include:
- Providing capital to maintain or enhance the income of a surviving spouse.
- Providing liquidity to pay estate taxes and other costs without requiring estate assets to be liquidated.
- Providing early access to a death benefit while alive to provide the additional income needed to pay for long-term convalescent care.
- Providing specific tax-free “gifts” to grandchildren for college education or other capital needs as they enter adulthood.
- Creating a tax-efficient plan to save for retirement and receive tax free income.
Life insurance purchased at older ages is different than the family protection policies we purchased when younger and raising a family. Then it was about providing significant financial assistance IF you die too soon. Now it is about WHEN you die. That means that every dollar paid into a policy represents an investment in the ultimate benefit. We know what you pay into the policy and we know what will come out. To calculate the rate of return all that is not known is WHEN that will happen.
But typically the legacy available at life expectancy represents a rate of return of about 5% after tax. Should you die before then (or with linked-benefit policies – need long-term care) the financial results of your premium investments become outstanding.
The money you pay into a policy goes into the cash value account and is credited by the company with interest that is typically greater than you would receive if left deposited in a bank or money market account. This interest is then used to cover the cost of providing benefits; the death benefit or long-term care benefit. Any that is left over adds to the balance in the cash value. From a portfolio perspective, this cash value is an asset that remains on your balance sheet and is available at any time for any reason. Depending on how much you move into the cash value from, say, a savings account, you may be able to purchase the insurance benefits with the extra interest the insurance company is paying on that money, making the economic benefit to you and your family much greater.
You may not choose to include insurance in your portfolio. But it should not be because it is too expensive.
Those who say that life insurance is a bad investment are not relating to real life.
Since everyone dies, we know exactly what the end result of a life insurance program will be. But because we don’t know when any individual will die, we don’t know how financially efficient the program will be.
- Walt purchased a $1million life insurance policy at the age of 47 and died from a brain tumor at age 53. Anyone disagree that (no matter what Walt paid for it) he made a good investment buying that policy…an Internal Rate of Return (IRR) of about 92% per year?
- Sharon purchased the same kind of policy at the age of 63 and died at the age of 93. After 30 years of paying premiums….an IRR of about 4.5% per year. Should have put her money in a mutual fund. Who knew?
Most folks sell life insurance for a living must concentrate on the “need”. That is what all the critics of insurance and the financial press focus’ on. How expensive is it, and do you really “neeeed” it? They will sell only to those clients to whom they can effectively point out that the individual’s untimely death will leave a significant deficiency in the financial condition of those he/she leaves behind. Then they must be convincing, and good at motivating the client to take action to “purchase” the policy so the money will be there “in case” they die.
On the other hand, those of us who deal with life insurance in the context of our clients overall financial and retirement planning clearly have a different perspective when we consider the investment aspect. We can see the value in our clients’ portfolio and to their family when a portion of their assets are “invested” in a life insurance policy. But just like any other investment, it is impossible to tell what the final rate-of-return outcome will be because we do not know when the insured will die. But we do know the range one can usually expect. In most cases the tax free rate of return is about 3.5% if one dies at age 93 and much greater (8.5%/yr.) if our client dies at 85 (about life expectancy) and EVEN GREATER (24%/yr.) if death occurs at 75.
Now consider the risks of Critical, and Chronic Illness that (in many cases) occur before death. Just think of the rate of return on your money (and what a wise decision you made) if you were to have a heart attack or kidney failure or need a lung transplant after only 10 or 15 years owning and paying for that policy. That is assuming your advisor was wise enough to make sure the insurance you were “investing in” contained an “acceleration rider” allowing you to access some or all of the death benefit while you are still alive and need some serious money to cover the cost of that lung transplant.
The critics of life insurance are many; mostly because of a lack of understanding of what it does and how it works. They miss a fundamental concept in financial planning; that the only time one can judge success or failure is when it is time to spend the money. Until then, all investing and insurance is a work in process. The big difference between “investing” in life insurance versus mutual funds (for example) is that with life insurance you always know “what” the end result will be, it’s only a matter of “when”. With the mutual fund you don’t know the “when”. But you also don’t know the “what”. But that’s OK because, given enough time in the mutual fund it also could be much more. That’s why having some of both increases predictability of results, reduces volatility along the way and (for most people) reduces stress.
We understand the value of committing a portion of a clients’ portfolio to insurance that creates large assets just at the time they are needed, no matter when that may be. And yet….if it is never needed, the heirs will think the client a hero for doing such a good job of protecting the portfolio from life’s many occurrences that could have befallen their folks and maybe caused great damage to their portfolio…. just when it was about to make great gains in the upcoming bull market.