Does anyone like life insurance? Typically, the answer is no. Client’s do, however, use life insurance for a variety of different purposes (income and estate tax reduction and wealth building); and when using life insurance in a tax favorable manner, it can make a lot of sense.
We believe that more people would warm up to life insurance if they just understood how it works and why one policy over another can be beneficial. In the following sections of the material, I am going to explain the three main types of life insurance, and why we prefer to use one type of life insurance to another.
Term Life Insurance
Unfortunately, most people, if they have life insurance have term life. Why? The simple answer is because it’s inexpensive and because there is a need to protect the family financially if the “bread winner” dies during a term of years.
Unlike the other life insurance policies, term life has no cash value; and if you do not die, you (and your beneficiaries) do not get a benefit. For a 33-year old to purchase $1,000,000 worth of term coverage, it might cost as little as $250 a year.
The problem with term insurance is that clients who amass any amount of wealth during their lives should have “permanent” insurance (insurance that will be paid up until age 100+). If you knew that 97%+ of all term policies never pay would that give you pause to pour money into a term policy?
Types of term life
Non-guaranteed term simply means, as you get older, the company will charge you more every year for the insurance. The pros of non-premium guaranteed term is simply that every year you will get the lowest possible term cost, but you have no guarantee what that will be in any given year.
Level term is the most common. You can purchase 5-, 10-, 15-, 20- and 30-year term policies from almost any company. Level term means that the premium will be level for a particular death benefit. After the term is up, typically you still have the contractual right to purchase insurance from the company; but there is no guarantee what the rates will be (this is called Convertible Term).
Summary on Term Life – Buy it if you have a short term need for life insurance and if premium costs are an issue. As soon as you know you have a need for “permanent” insurance, you should purchase a different type of policy.
Side note: There is also such a product as Return of Premium Term Life. I personally like this product, and I did a newsletter on it several months ago. For a copy of that newsletter, please e-mail firstname.lastname@example.org
Whole Life Insurance Policies
Whole life (WL) provides a death benefit and an accumulating cash value. By definition, it has a fixed premium and a level death benefit to age 100. The premiums do not increase with age, which averages the client’s cost of the policy over the life of the policy (although there is a high internal upfront load with whole life). The cash value increases with time until it equals the death benefit at age 100.
WL is considered by most as “old-school” permanent life insurance. If you’ve ever run into a Northwestern Mutual Life agent, you would have been pitched WL insurance.
WL is the most expensive type of life insurance you can purchase due to the large up front load. Cash is credited in the policy based on the financial returns of the life insurance company which ironically come form overcharging clients for premiums and then crediting X amount of the overcharged premium back into the cash value of the policies (this is called a dividend). WL insurance policies are also very conservative policies due to the fact that the investment returns inside the policies are usually very stable even if they are not spectacular.
Generally speaking, I personally have very little use for whole life when working with clients. Why? WL used to be sold on the “guaranteed” death benefit (in the old days, this was the only kind of policy which would “guarantee” a death benefit). Today, there are several less expensive types of policies that provide a guaranteed death benefit. WL is also sold as a cash accumulator/retirement vehicle. My personal preference would be not to use a WL policy due to the high up front costs and limited potential for growth. There are simply better products for this purpose.
Variable Life Insurance
Higher income clients are typically aware of variable life because it has been pitched to nearly every high income client in the country by salespersons trying to talk a client into purchasing the policy as a post-tax investment.
Variable life (VL) is simple to understand. When you pay your premium, X amount of the money goes to pay term insurance for someone your age; and the rest of the money goes into the stock market via mutual funds. Many clients seem to love this policy because they seem to like the fact that they are buying life insurance, but their money is really going into the stock market.
The sale’s pitch is that the cash value in a VL grows tax free and comes out tax free and makes for a terrific investment. That is true of any properly setup cash value life policy.
Most people also do not understand that when you get over 70 years old, the costs of insurance in a variable policy are tremendously high due to the fact that the policy is using your annually renewable term insurance rates (which are very high after the age of 70).
Also, there are no guarantees on investment returns in the majority of variable policies. That means that, if you have a negative year (or several like 2000-2002), the cash value in your policy (the money invested in mutual funds) takes a nosedive with the stock market. You might think that is not a big deal due to the fact that over the long haul the policy will still average your assumed rate of return of 10-12%. What you have not probably thought of is that the expenses in your policy increase every year, and the insurance company does not care if you do not have cash in your policy to pay premiums because the market is in a funk. The insurance company on schedule still takes out its chunk of your money for life insurance premiums. We call that a double whammy, to use a not so sophisticated term, to describe premiums coming out and cash value decreasing.
My position on VL is very simple, there is virtually no use for it in today’s marketplace. With the new equity indexed life policies (see below) which have a guaranteed minimum rate of return each year with upside growth pegged to the best measuring index (the S&P 500), there is no reason to “risk” your money in a VL policy which has very high expenses when you reach retirement.
Universal Life Insurance
Universal Life (UL) is sort of a hybrid between whole life insurance and variable life. UL is the most flexible type of life insurance because of the fact it does not technically require that a premium be paid into the policy every year (out of your pocket), and because the investment returns are much more stable than a variable policy. Interest on the cash value is usually guaranteed at a certain rate (2-4%) but will vary according to the investment performance (which is pegged to Bond returns). Each month’s deductions are made from the cash value in the policy to pay for the costs of the insurance protection. As long as the cash value is substantial enough to maintain the monthly costs, the policy will remain in force. The key to any form of Universal Life is that it is interest sensitive and allows for an adjustable death benefit.
I will not spend much time on traditional UL insurance because my favorite type of policy is what’s called an Indexed Equity Life Insurance policy (see below).
Equity Indexed Life Insurance Policy (EILIP)
An EILIP is a UL policy with a twist. The twist is that the investment returns on the cash value are pegged to the S&P 500 index (which has consistently outperformed most mutual fund returns).
Like any UL product, the cash value in the policy has a guaranteed return (usually 1-3%). Therefore, unlike a variable policy which could tank if the equity markets have a bad time, the EIULIP never allows a negative crediting year on the cash value in the policy.
Like anything in life, nothing is for free. With the EILIPs, there is a guarantee, but there is also a “cap” on the returns you are allowed to participate in each year. The caps range from 10%-17% in the policies.
So ask yourself this, what kind of policy would you want to build cash? A VL policy which could tank if the stock market doesn’t go well and which has very high expense when you are in retirement? A WL policy which has big up front loads and only a modest ability to build cash annually? A traditional UL which has it’s returns pegged to the mode Bond markets, or….
An indexed life policy which gives you a minimum guaranteed rate of return each year on the cash value and has the growth in the policy pegged to the best performing stock index?
To me the answer is simple, if you want permanent insurance that has cash value so you can potentially borrow from it “tax-free” in retirement, the choice is simple, you should purchase an EILIP.
Side Note: You should also know that there are EILIPs that will credit 140% of what the S&P 500 returns and ones that will give you a “free” long-term care insurance rider. The policies get better and better each year and if you have a cash value life insurance policy that is NOT an EILIP, you should strongly consider 1035 exchanging your current policy for an EILIP.
For more information on EILIPs including the policy which credits 140% of what the S&P 500 returns, please e-mail email@example.com