An Important (often overlooked) Feature of Term Life Insurance – Case Study #5

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I’m currently doing a Life Insurance Checkup for a couple in Tennessee that underscores an important cost aspect of level term life insurance…but it’s not the premium rate.

The first step in a Checkup is rightsizing the size policy. This couple, like many, used a rule of thumb (a multiple of income plus debt) promoted by Dave Ramsey, whom I highly respect. However rules of thumb are a crude way of giving wholesale advice. I prefer fine-tune efficiency which comes best through customization. The difference can be dramatic, as it was in this case.

He is a veteran construction manager who had already retired from one employer and had a pension with a significant monthly survivorship benefit for his wife. (This is tantamount to a lot of life insurance.) There are no kids in the picture, they have a reasonable 401(k) and a $750K life insurance policy on him with Allianz. Their emphasis is on debt repayment and they don’t want to spend unnecessarily on anything, including life insurance. After reviewing her income needs and their assets and debts, they think the appropriate insurance need is $350K rather than $750K. How do we best make this adjustment?

The easiest way would be to reduce the current policy. Allianz is a strong company, ranked AA with Standard & Poor’s. He bought this 20 year level term policy four years ago when younger, so a comparable policy would cost more today at his older age. Also, if he had had a health decline it would put him in a higher rate category.

The problem is, though many companies allow a policy reduction during its lifetime, Allianz does not. Some allow it only once during the policy’s life and some allow multiple times. Since Allianz doesn’t at all, it forces him to consider a new (appropriate amount) policy, at an older age, subject to insurability, losing the reserves of the old policy, new contestability period, new commissions, etc.

Let me take a moment to emphasize an important aspect of insurance planning: the amount of insurance you need is rarely static. For most people it reduces as assets grow (401(k), savings, etc.) and liabilities diminish (mortgage is repaid, young children mature, etc.) So the thought that you’re going to need the same amount of insurance for 20 years is probably unrealistic. Yet many people buy such policies and keep them at the original amount for decades. This accounts for the invisible waste of much premium, as people imperceptibly become over-insured. Few people reassess (even if it’s only every 5 to 10 years) their insurance needs…though it’s usually profitable to do so.

Reducing term policies (almost a relic of the past) recognized this dynamic: the amount of insurance needed declines over time. Today’s most competitive policies (level term policies) do not. Thus it’s incumbent on the consumer to make his own adjustments. To do so your policy must permit it.

So when you’re buying a term policy, be sure to find out if the policy owner can reduce its amount at least once during its life. Another possibility is buying multiple policies for different durations: for example a 20 policy for $350K, and 10 policy for $400K. This automatically schedules a decline in insurance as your needs likely decline. The problem with this is that you don’t know the rate at which your needs will decline. Another problem is poorer pricing on multiple/smaller policies.

We tend to think that buying a good term life policy is simply a matter of buying a strong company with low premiums. However there are other important features. The ability to reduce the policy at least once during its life is one of them.

The Paradox of Insurance

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Moderating or even skipping life insurance can strengthen the widowhood most wives will experience, if those premiums are invested well.  Doesn’t seem right?  It’s a paradox.

There are many economic paradoxes: using a home equity loan to get that new car or vacation “you deserve” ends up reducing long-term life style, raising tax rates decreases total government tax revenue; sponsoring welfare kills personal initiative and fosters generational poverty; lowering lending standards to encourage home ownership creates a housing crisis.

Wouldn’t it be nice if we could trust our instincts to do the right thing?  We can’t.  Since most people pay more into insurance than they receive from it, astute consumers use it sparingly not liberally; and as soon as they can responsibly afford to, they’ll not use it at all.  That’s why Larry Burkett said, “Don’t insure that you can afford to pay for yourself”.

Recently a well-intentioned 61-year old husband called about buying a $250k 15-year level premium term life policy for $1250/year.  The actuarial tables say the chance (after screening with an exam and blood work) he will die within 15 years (by age 76) is highly unlikely.

Normal life expectancy is young 80’s for men, comfortably (for the insurer) beyond the reach of the 15-year level period. Think about it: how many $250,000 claims can they pay collecting $18,750 (15yrs x $1250/yr)?  After 15 years, at age 76, the premiums explode as he approaches normal life expectancy, forcing most policyholders to discontinue.

Many people play this game, speculating on a premature death for a segment of time ending well before normal life expectancy, (age 61-76 in this example).  Somewhat like the lottery, it’s a loser’s game.

Our imagination is often our enemy.  In this case they just had a close family member die from an accident.  With this fresh in their mind, their most easily recallable fear lures them to a plan unlikely to deliver.  She is likely to become a widow, but not in the next 15 years.

Here are some things to get firmly in mind:

  • How well are you self-insured? Get a handle on Social Security widow’s benefit, 401k assets, support from children, etc. “The cheapest form of insurance is self-insurance.”
  • Know what normal life expectancy is, considering your health, etc.
  • Know what future term policy premiums are after the level period.
  • Know the opportunity cost. Figure what premiums would accrue to if invested for the same duration.  Consider a Roth IRA.  Investing that cash flow at 8% grows it to over $50k by his age 81 normal life expectancy.  This is what the policy will likely cost her, i.e. the opportunity cost.

Many people bought level term policies 10,15, and 20 years ago who have exhausted that period and now must decide to let it go or re-up.  Often what made them buy that duration has been accomplished: the kids are independent, the mortgage has been paid, the 401k has grown…but they feel they need a little more time.  What to do?

Re-upping appeals because it creates an illusion of addressing the problem…for a low monthly outlay.  But it’s more illusory than real and for most it’s just kicking the can down the road and at 76 (in this example) they’ll be facing the same decision, but at much higher premiums.

Rather than taking the easy way out, it may be time to do some serious soul searching:

  • Do you have any inheritance coming?
  • At your death where will your widow live? If she moves to be near kids, what will housing cost there?  Will downsizing release equity for income?
  • Seriously consider not taking Social Security until your age 70, which will make her lifetime pension larger.
  • Have a heart to heart talk with your kids. What kind of support might mom expect from them?  I know you “don’t want to be a burden”, and you won’t unnecessarily, but the family unit is the oldest form of insurance, so don’t ignore it.  (This answer impacts the Long-term Care insurance decision too.)
  • Take a pulse on your wife’s fear and contentment level. The more content she is, the less you may have to dissipate on insurance today, the more you can invest, and the better off she’ll like be. If anxiety compels you, try to think like an actuary, and see if you can achieve unity in this delicate decision.

Most advice is given by commissioned agents who are happy to sell a policy.  They will not point out these weaknesses, nor advantages of alternative uses of premiums.  The commission is $900 if you buy, and nothing if you don’t.

Don’t insist on a perfect contingency plan for an unlikely segment of time.  It’s a contingency plan, not a probable plan.  Insisting it be perfect (“comfortable”) today, robs resources and usually leads to less financial margin in later years when health care and other unknowable’s may need it most.

If I’m with a Good Company, Isn’t that Enough?

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Some people are so convinced of how great their insurer is, that they cannot see any benefit from outside advice. Nothing could be further from the truth.

Perhaps the best way to illustrate this is by example. I just finished a life insurance review that illustrates the dramatic potential for improvement within the same company. This client was a little extreme for most of us: his income was higher and what he was asked to spend on life insurance may seem absurd (though it happens all the time). But it graphically shows what frequently happens, albeit often on a lower scale.

A Northwestern Mutual agent approached this newly practicing doctor earning a very strong income and recommended a life insurance policy as an investment. The doctor contacted me for a second opinion. The agent emphasized what an outstanding company he represented (true) and proposed a 3 million dollar policy costing 25k/yr with a surrender value of 3k at the end of first year. I suggested a variation with the same company: a lower death benefit, costing 12k/yr with a surrender value of 10k at end of first year. Over 12k less premium for 7k more value!

The gist of this recommendation was to shelter money in an investment that would be exempt from a medical malpractice lawsuit. Whole life cash values fall in this category. The thing to keep in mind is that it was an investment.

One should not tuck an investment inside a 3 million dollar life insurance policy, with its ever-increasing internal mortality costs, unless you need the death benefit. This was a newly married couple, with no mortgage debt, no school debt, and no children. She was a Peace Corp worker who had never dreamed of marrying a high income professional anyway.

Part of this misdirection lies in the fact that the company has some policies that are (much) better values than others. The consumer doesn’t know that and the agent has no incentive to tell it. The commission on the proposed policy was over 12k; the commission on the variation was less than 2k. The influence of this commission on advice can be profound. It’s much better to get your financial advice from someone not under that influence. How is my compensation influenced by his choice? Zip. I’m paid to help clients find good values.

The conclusion is that connecting with a fine company is just the beginning. Northwestern is such a company that I deal with frequently, and I cannot recall a single time when arrangements with them were not improvable, either with proposed or in-force policies. * There will always be a conflict between your interest and the company’s, no matter how good they are. Paying a guide is money well spent and if you think because you are with a good company you don’t need a guide, think again. This doctor made a 2000% return on his guide fee. Extreme? Yes. But excellent returns on fees for impartial insurance advice (even when you are with a good company) are common- the rule, not the exception.

If you don’t mind living with the advice of an agent who is “under the influence”, you can save that fee. Most people will never know how much better it could have been. However more and more people are discovering the advantage of using an impartial guide, while they save their fee back many times.

*These all had Northwestern policies (see Testimonials):

  • Mark and Liesl Marmon
  • Paul Caldwell
  • Roger Smith
  • Charlton Veazy
  • Bob and Peggy Arrington

How to Best Care for Your Future Widow

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Let’s say you’re in your mid 50’s, the kids are leaving the nest, the mortgage is nearly paid, and the 401k has grown well.  Your financial position isn’t where you want it, but it is within striking distance.

But you’ve also lost a parent or two, and the brevity of life is coming into clearer focus.  You consider the final quarter and envision your wife as a widow, as statistics say most women become.  You can buy a 20-year level premium $250,000 term policy for only $100/month to bridge the gap while getting closer to Social Security age and completing financial goals. Is that a good idea?

Or is there a better use of that money, say to accelerate the mortgage or fund a Roth?  Which is likely to help her more?  Let’s see how it usually plays out.

We are more emotional than we would like to think, especially when it comes to fear-driven issues like life insurance.  It leads to overbuying.  It may be motivated by noble intentions of a husband, anxiety of a wife, or an agent.

It’s often accompanied by unawareness of other survivorship benefits like a death benefit under a pension plan, or how the 401k could bridge the gap to Social Security Survivorship benefits.  Agents whose compensation is a percentage of premium collected are more tempted to fan those embers of fear than explain to their clients how they are insured already, how unlikely they are to get a return on their insurance premium dollars, or alternative uses of those dollars.

The paradox of overbuying is that, while creating an immediate illusion of security, those expansive decisions rarely help the family.  Well over 95% of 10-, 15-, and 20-year term policies expire before the insured does.  They are paid for over their term and then thrown in the trashcan.  Like playing the lottery: a bad bet.

On the other hand, your wife is likely to become your widow.  Men on average die five years before women and their wives are sometimes younger too.  How should you address this need?

Ironically, it’s not necessarily by buying more life insurance.  Look at some simple probabilities.  These are tapes that are always running in the back of my head when advising clients on life insurance.

What will $100/month, directed three different ways, likely become by the time our 55-year-old dies?

After 20 years: In another 10 years, near normal life expectancy
Term life ins. 90%+ get nothing
Prepay 4% Mortgage $36,000 greater house equity $53,000
Roth IRA @ 8% $59,000 $130,000

This example considers a male in his mid-50’s, buying a $250k 20-year level term policy for $100/month, or using the same amount to prepay the mortgage, or fund a Roth.

Compounding $100/month savings for 20 years, and then compounding that total another 10 years without further premium contribution (puts him closer to normal life expectancy), equals $130k in a Roth for his wife’s (or his) ultimate use, versus a term policy in the trash can.  Which better cares for their likely future?

 

(This is a revision of a guest blog on Sound Mind Investing Editor’s blog, February 4, 2011.)