A Few Good Policies

Daniel Yerger Financial Planning Leave a Comment

As promised, I come with post-Christmas-pre-new-years good tidings of the few decent use cases for permanent life insurance. Let me just get the facts out of the way: These conditions are rare and are unlikely to apply to you. If they do happen to apply to you, terrific, you should approach the purchase of life insurance with great skepticism and get a second opinion every step of the way. Life insurance is a great tool for its stated purpose, but you should always be cautious when someone with a financial interest in selling it to you (your agent) is trying to convince you it’s the right thing for you. It could save you hundreds of thousands of dollars to ask a fee-only financial planner what their opinion on the sale is, or simply your good friend who’s financially knowledgeable and who likes to play the ‘Naysmith’ role. With that, let’s get cracking!

Buy Term and Invest the Difference

A term popularized in the late 80s was “Buy Term and Invest the Difference”; argued to be the solution to high premium permanent life insurance policies, the idea was to buy a much cheaper term life insurance policy (sometimes as cheap as 1/20th the price of permanent) and to invest the difference. While the life insurance wouldn’t last you until your 100th birthday, it was argued that the need for life insurance really declines as you get older and build up financial resources and that by buying the cheaper policy and investing the difference you’d net out better. Here, I wholeheartedly agree, but there’s a word of caution around this tactic: Studies have shown time and time again that what really happens is that people “buy term and spend the difference.” It is critical that if you want to take this cost-savings tactic, you must commit to ongoing retirement account or brokerage account contributions, automatically drawn from your bank in order to ensure that you actually reap the benefits of the cost savings. To its dubious credit, the one thing a permanent policy will do is force you to save (much as a mortgage forces you to invest in your home’s equity.)

Pension Maximization

While pensions are steadily going the way of the dinosaur for young employees and new businesses, they still exist to the tune of several trillion dollars for older Americans. Pensions by design will traditionally come with a couple of payout options, including 100% of the benefit for the employee until their death and a binary or range of options that boil down to a 50% benefit for the employee and their spouse until the second passes away. Tragically, the 50% benefit is often taken out of a concern for the unknown, but this 50% cutoff of benefits often is far more expensive than a pension maximization strategy. Assuming the employee who earned the pension is in decent health, a permanent life insurance policy can offset the loss of a “second to die” provision on the pension. Let me give you an example: A pensioner has a $10,000 monthly benefit and is faced with 100% for their life or 50% for their and their spouse’s life choice. The pensioner takes the $10,000 monthly option and applies for a very expensive permanent life insurance policy that will pay out several hundred thousand dollars at a cost of $2,000 per month. By doing so, even net of the extra one-to-two thousand dollars of potential income tax, the pensioner is now netting a larger income than their $5,000 50% version and has sufficiently protected their spouse. This also has the offset benefit of meaning that if their spouse passes away first, they can cancel the life insurance policy and increase their income again. A secondary strategy that can be added to this is discussed next.

Life and Long-Term Care Hybrid

If you’ll recall from my last piece, I have a permanent life policy that provides both a death benefit and a long term care protection element. This is a valuable strategy for many older Americans because life insurance is much easier to qualify for than long term care insurance. If I had to put it on a 1-10 difficulty scale, life insurance for an American over the age of 50 is a 6 while long term care is a 10. How is this the case? Because long term care and life insurance underwriters protect the insurance carrier against very different things. Life insurance companies are worried that you’ll die young of an ailment like diabetes, cancer, or heart disease. Long-term care insurance companies are worried that you’ll live too long but as a consequence, suffer from difficulty with the activities of daily living that can trigger the benefit. Thus, for a life insurance company, it’s a nominal risk to adopt a long term care benefit, because most people entering into long term care are not long for this world (the average entry into long term care lasts two years and three months), and thus the death benefit is likely to be paid out soon anyway. Thus, for Americans who are concerned about the rising cost of long term care insurance, or who have conditions that make it difficult to qualify for traditional long term care, a life/long term care hybrid can be the solution.

High Net Worth Estate Planning

A touted but often undervalued component of life insurance is that the death benefit is tax-free (again, to reduce costs for consumers and carriers, not out of Uncle Sam’s sense of generosity!) As a result, Americans who are at risk of exceeding the $11.7 million individual or $23.4 million married estate tax exemptions, or their individual state estate tax exemptions, may find themselves turning to life insurance to provide liquidity for their estate or significant tax-free benefits to their heirs. There are whole textbooks written on the use of “irrevocable life insurance trusts” and “charitable remainder trusts”, but suffice to say, the majority of these tactics are not applicable to the average American. If you are at risk of needing life insurance for your estate’s liquidity, do yourself a favor and call a fee-only financial planner first to discuss the presumed necessity, build out a robust estate plan, and then you can call your agent, knowing exactly what type of policy and amount of benefit you’ll need.

Business Continuity and Buy-Sell Agreements

Life insurance fundamentally is about shielding the family members of the potentially deceased from the financial loss of their death, and that can extend to the businesses they’re involved in. Policies known as “key man” policies are often taken out on critical employees to ensure that a business won’t be devastated by the unexpected loss of an important team member. These are often bought as permanent policies, but one should certainly ask if the employee is likely to be around until they’re 99, or if their career is more likely to fit into a ten, twenty, or thirty-year time frame (this goes back to buying term and investing the difference!) Another common purpose is to fund a “buy-sell agreement”, which allows the partners in a business venture to purchase insurance on each other to buy out the ownership of the company from the owner’s heirs in the event of their death, which avoids the complication of a person uninvolved in the business (such as a spouse or children) suddenly becoming voting members of the organization.

Wrapping it Up

If two weeks of my rambling about life insurance don’t teach you anything, there’s one lesson to take away: Insurance is a risk management tool and should always be applied as a risk management tool. If ever someone comes to you with the suggestion that life insurance (or any other form of insurance) be used to accomplish a task that is not fundamentally “risk management”, they are likely selling you a bill of goods. But if you have family, a business, or even yourself to protect, it can sometimes be the right tool for the job.

 

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