By Sean Follis, Moneta Advisor
Life insurance can be a critical component of your financial plan. This article will explore how to measure the amount of life insurance you need along with the different types of life insurance policies and how you might use them.
Generally, we view life insurance as a risk management tool and not part of an investment portfolio. From this perspective it is important to have enough insurance to cover your risks, but it can be expensive to have excess coverage.
What are some risks we often face for which life insurance is a good solution?
It can be a great tool to replace your income, especially early in your career. You may have a debt or obligation that you want to make sure is taken care of in the event of your untimely demise. Life insurance can also be a powerful estate planning tool.
So how do I know how much coverage I need?
There are rules of thumb, but these estimates often miss the mark. We recommend reviewing your coverage needs alongside comprehensive financial planning where you may be estimating your retirement needs, college planning needs among other objectives. Essentially, you are calculating how much capital your family needs “today” to meet all your financial goals and objectives. Early in your career, this can be a substantial amount. As you approach retirement or accumulate wealth, the amount may go to zero. This is where generalizations or rules of thumb tend to fall short because everyone’s goals end up being unique.
Now that you understand the big picture behind estimating how much life insurance you need, how do you accomplish it?
One solution is to speak with your Moneta advisor; they can help you with this conversation. There are also many online retirement calculators available. Calculators that account for volatility in investment returns can be especially useful so long as a realistic expected return rate leaning towards conservative estimates is used. When using a retirement calculator, you will solve for the lump sum investment you would need to make today. You may need to increase your current investment holdings until you find the amount that fulfills your goals.
What kind of life insurance do you need?
There are two broad life insurance policy types: term coverage and permanent coverage. Each comes with many different product options available.
The simplest life insurance policy type is term coverage. With term life insurance, you make a premium payment and – as long as the policy premiums have been paid – the insurance company will pay the death benefit to your beneficiaries at your death. If the policy has expired when you die, there is no benefit paid to your beneficiaries and no residual value. Term coverage is similar to car insurance. If you have a car accident and your coverage is in-force, the insurance company will pay the claim.
Permanent life insurance comes in a few different flavors (like ice cream). These policy types have one thing in common: a portion of your premium accumulates, creating cash value in the policy that will earn interest so the value grows over time. The idea behind permanent coverage is to build up cash value while you are young and the cost of insurance is low; then, when you are older and the cost of insurance is much higher, the cash value reduces the amount of coverage you need. Basically, you are buying a policy today (usually with a level premium amount) and it will last the rest of your life as long as you continue making premium payments. Since your premiums are covering both the cost of insurance and accumulating future cash value, the premiums are much higher compared to term coverage for the same death benefit. There are many nuances to permanent life insurance policies that we are not addressing in this article.
Which policy do you use?
Like everything in personal finance, it depends on your goals and objectives. If you are early in your career and need a substantial amount of coverage (maybe providing for a family of four) term coverage will be the most cost effective. Most term insurance buyers will lock in a level premium for a guaranteed period of time (5, 10, 15, 20, 30-years) that matches well with the length of their risks. You can purchase multiple policies, so the total amount of coverage declines over time. Permanent coverage is most useful if you have a minimum amount of coverage that never goes away regardless of the assets you accumulate. As you age, purchasing term insurance becomes very expensive and declining health may prevent you from qualifying for coverage. If you think you will need coverage later in life, having some permanent coverage is probably a good idea.
Reviewing your life insurance plans is a great idea every few years, especially if you have experienced major life changes. Your Moneta advisor can help you evaluate your life insurance plans to make sure it meets your needs and recommend any changes. If you are currently considering changes to your life insurance policies, your Moneta advisor can also give you a second opinion to ensure the changes will meet your goals.
©2021, Moneta Group Investment Advisors, LLC. These materials have been prepared for informational purposes only based on materials deemed reliable, but the accuracy of which has not been verified. Past performance is not indicative of future returns. You cannot invest directly in an index. These materials do not constitute an offer or recommendation to buy or sell securities, and do not take into consideration your circumstances, financial or otherwise. You should consult with an appropriately credentialed financial professional before making any decision.