Straight Talk on Life Insurance Selection

As many people already know, life insurance is a critical building block in a rock-solid financial plan.  But when it comes to discussing with clients the various ins-and-outs of the best type of life insurance (i.e. term vs. permanent), I’ve found this topic yields the quickest yawns, eyes-glazing-over or bored-looks-out-the-window.   However, brushing this issue aside is a mistake because I believe choosing the right type of life insurance is not only important, but also one of the most common mistakes I see in clients’ financial lives.

DISCLAIMER: I don’t sell insurance or any other financial products.  But I do take and over-arching and integrated approach on families’ financial lives with life insurance being an important piece.

So why is this so important?  Because I believe for most people, buying term life and diligently saving throughout a lifetime is a much more efficient strategy than using life insurance as way to “invest”.  Now I realize I will probably get assailed by the insurance guys out there who are very sensitive to this topic and for some, I am essentially questioning the legitimacy of what is probably a large percentage of their income.  However, I believe my thesis is correct with one small caveat:  there are a few limited situations where it does make sense for a family to own permanent insurance (mostly due to a tax strategy, which I detail below) but the short story is the vast majority of folks are pitched permanent insurance when in my view, they would be much better off with buying term life and diligently saving their hard earned dollars in their own accounts.

Quick Primer: What’s the difference between “term” and “permanent” life insurance?

  • Term Life: Term insurance is where someone pays an annual (or monthly) premium to a life insurance company for a fixed period of time (a term) in exchange for a promise from the insurance company to pay out the death benefit in case that person dies during the term.  The premium is fixed but so is the time period of coverage so once the contract term is up, the policy is usually ended or the rate is adjusted upward (significantly).  So an example would be a 40 year old man pays the insurance company $584 every year for 25 years and if he dies during that period, the beneficiary gets $500,000 tax free.  He wins the bet: sort of- his beneficiary wins the bet because he’s dead.  If he dies after the policy terminates, the insurance company wins the bet as he does not get any of his premiums back.
  • Permanent Life (packaged in various forms: whole life, universal life, variable universal life): Permanent is just that, the insured is covered until death of the policy holder and upon death the beneficiary gets a death benefit (tax free) AND whatever cash balance has accrued from all the years of payments.  Sound’s great BUT there’s a big difference is premiums paid.  For example, a 40-year old male may pay $3,100 every year for ½ the death benefit ($250,000). The extra premium paid amounts to a glorified “savings” account where one portion of the $3,100 premium pays for the death benefit while the rest is “saved” with the insurance company.  Usually the insurance company promises a “guaranteed” rate of growth (somewhere around 2-4% today) and a potential rate of growth (maybe 4-6% today) which depends on how well they invest your money.  The big problem is that your money is usually tied up (i.e. you can’t get it all back for a surrender period- which could be 5 to 10 years) AND it could be years before the “growth” of the insurance company’s investments on your behalf break-even and surpass what you could have done by “buying term” and investing the difference yourself. The reason it takes so long is you have to recover the expense (commissions & fees) of the contract.

What are the scenarios where I would recommend someone look into permanent insurance?  I think there are two very limited scenarios, one where it makes financial sense and one where it make psychological sense.  For the financial example a client would qualify (in my opinion) if they can say “yes” to ALL the following:

  • Do you need a death benefit?
  • Are you already maxing out your retirement plans with your employer (401(k), 403(b), etc) or at your business?
  • Do you make significantly above $191,000 (for a married couple) and are thus phased out of saving with a Roth IRA?
  • Do you have ample excess cash flow targeted for aggressive savings?

If all four are “yes” it might make sense for a portion of life insurance needs to be fulfilled with a permanent policy.  This is because the cash value grows tax free (like a Roth IRA) and using permanent insurance acts as hedge on higher tax rates in the years to come, which I think is valuable.  Even then, folks need to shop around as it could be an expensive way to go and very restrictive in the early years.

The psychological scenario is when someone does not have the discipline (or a good advisor or both) to diligently save for their retirement themselves.   In this case, they are mandated to “save” with their premium payment and the cash value build-up would function as an investment account.  Again, they would need several years to break even after paying the commissions to the sales guy but at least they would have something saved.  Again- a very, very expensive and restrictive “piggy bank”.

So why do I think so many people have permanent insurance when they should really have term?  I would answer a question with a question:  Ever watch a golf tournament on TV?  You’re probably wondering how that’s related but it is.  If you ever watch a golf tournament you’ll see an abundance of advertising from large insurance companies pitching “safety” and “security” and “lifetime income” (i.e. annuities) to their audience.  The reason these companies are paying so much for advertising and selling so hard is because it’s so profitable for them.  I’ve seen some estimates where the sales guy could get 85-100% of the first year premium for a commission.  So if you were in the insurance business what would you rather pitch to someone: a whole life policy with an annual premium of $3,500 or a term life policy with a $500 premium?  Term isn’t nearly as profitable and for the most part, it’s commoditized so there’s not much margin there.

So wrapping up:  This isn’t to call out all financial advisors who work for insurance companies as bogeymen.  I happen to know a few good ones who “get it” and wouldn’t recommend something that’s not in the best interest of their clients.  However, I think people should be aware of the potential for “grey area” and rationalized justification on the part of an advisor for a recommendation with a juicy financial incentive.   Think about it: Have you ever received a recommendation for life insurance from anyone other than someone who sells life insurance for a living?

Maybe it’s time you did.

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