Life insurance can serve a very different purpose in retirement than it did when you were raising a family and trying to put kids thru college. Even though you may have had life insurance your whole life, it may be time to reevaluate whether you still need it, whether you need as much as you currently have, or whether you might need to switch to a different kind. Let’s start by looking at the main types of life insurance, and then talk about the purposes life insurance is best suited for when doing retirement income planning.
Three Types of Life Insurance
The first and simplest type of life insurance is term. This is pure insurance and does not have a feature where it accumulates a cash value inside or where you can take a loan out against its value. It simply provides insurance against an untimely death by paying your beneficiaries an amount of money known as the death benefit, or face amount. You have this insurance while you’re paying premiums, and you don’t if you stop paying premiums.
Term insurance typically lasts for a certain, well, term. Usually it lasts for a number of years like a 20-year term, or a 30-year term. Like all life insurance, the premium is based on a number of factors when you first get the policy: age, gender, health, length of the contract, etc. Sometimes it has features where the premiums or the death benefit can change over time, or even a feature called ‘return of premium’ where you can get all your premiums back you’ve ever paid for the policy, but often a term policy has a fixed premium paid for a fixed number of years. When the term is over, the insurance ends. Sometimes term policies will give you a chance to renew the policy when the term is over, but usually you will have to pay a much, much higher premium to continue it since the new premium will be based on your current age.
Whole life insurance lasts for your whole life. Wow, these names are straightforward and easy to remember, huh? A portion of each of the premiums you pay for the insurance goes toward building internal cash value inside the policy; the other part of the premiums go toward actually providing life insurance, along with a portion that goes toward covering the insurance company’s overhead costs. The internal cash value grows over time as a portion of each premium gets added to it, and as the entire balance grows by a certain rate of return each year.
Whole life policies can be funded in a number of different ways. You can make a regular, fixed payment like a monthly or annual premium payment and do so for the rest of your life. You can make a larger premium payment in early years of the policy and be done paying premiums after 20 or 30 years, for example, even though the coverage continues. Another way to pay is using a single, one-time premium to completely fund the policy.
The internal cash value can be borrowed against in the form of a loan. This loan amount due will increase over time at a certain interest rate, so when you pay it back you have to pay more than you borrowed. If you don’t pay it back before you pass away, the amount you owe will get subtracted from the death benefit. At any time, the policy owner can surrender the policy and walk away with the full cash value balance, although doing so early in the contract will likely have surrender charges that will reduce the amount you can take.
Universal life (UL) insurance is similar to whole life in the fact that it builds internal cash value. However, universal life isn’t necessarily guaranteed to last the rest of your life. Just like whole life, UL takes a portion of each premium payment and applies it toward your cash value. The other part goes toward what’s called the ‘cost of insurance’ (COI). In UL policies, though, the COI never stops increasing throughout your life. So as you get older, more and more of your premium goes toward the COI until premium payments are insufficient cover the COI.
ULs are generally intended to be permanent policies, but if your COI continues to increase, it will drain the cash value you have in your policy. Just like whole life, UL cash values will grow over time by a certain interest rate. However, even though cash values are earning interest and new premiums are funding the policy, the COI can get so large that it can get to a point where there is no remaining cash value. The only option to continue the policy at this point is to pay incredibly large premiums that continue to increase each year to cover the COI.
Generally ULs have two different interest rates: current interest rates, and guaranteed interest rates. The guaranteed rate is a minimum rate, like 4%, that the cash value will always continue to grow at. However, in times where the economy has high interest rates, the current rate will be higher than the guaranteed rate and thus your cash value will grow at this higher rate. ULs are often called flexible premium policies too because they allow you the freedom to not be locked into a set premium, but pay more or less depending on your desire. Lastly, some ULs do have a feature to guarantee them which will keep them in-force without requiring massive premiums even after the cash value runs dry.
One thing worth mentioning is that you often can get different types of both whole life and UL policies based on how the cash value grows. I’ve only talked above about certain fixed percentage rates of returns. However, policies can grow your cash value by investing it directly into securities (e.g. variable whole life), or have gains based on the performance of a broad stock market index like the S&P 500 (e.g. indexed universal life). These types of policies offer more upside in the amount of cash value growth compared to traditional policies with fixed rates of return. Some policies even offer to increase face amounts as cash values grow more than expected. But as with any other risk-reward tradeoff, underperformance and even negative performance of investments can cause the cash value and death benefit to decline significantly.
Purposes of Life Insurance
I’ve listed below some of the most common uses and strategies life insurance can be used for in retirement. Taking advantage of using life insurance to fill one or more of these needs is greatly dependent on your health history and whether or not you smoke. If you are managing a chronic health condition or are a smoker, life insurance is probably not the right financial planning tool for you (other than final expense) since you won’t be able to get it for a very cost-efficient price.
The simplest reason to get life insurance is to have a fairly small policy to cover what are called final expenses. These could be expenses to buy a headstone, casket, one or more days of a viewing at a funeral home, cost of cremation, burial plots, even left over medical bills and other unpaid debts. Final expense policies are typically whole life and have face amounts ranging from $5,000 - $25,000. These policies usually have simplified underwriting, meaning that they just ask basic health questions without requiring a paramedical exam. They usually have ways for folks in bad health to still qualify but would have to pay a higher premium in return, and may not pay out the full death benefit if the insured dies within the first few years of taking out the policy.
Income replacement is one of the biggest reasons to get life insurance in your working years, but it can be important in retirement too. If one spouse has a large pension that has no survivorship or even just a 50% survivorship to the other spouse, then that couple may get life insurance to protect the surviving spouse in the event the first spouse dies suddenly. This consideration can be part of the decision making process when trying to figure out which pension payout option to take from an employer at retirement. This is called pension maximization. Taking a larger income amount with no survivorship may be a better option for the soon-to-be retiree if he or she is in good health and doesn’t smoke and thus is able to get life insurance at a cost effective rate.
Long-term care (LTC)
A fairly new feature on life insurance in recent years is the ability to get a rider on the policy to help with long-term care expenses. The way these life insurance policies work is that if you qualify for LTC (meaning that you can’t perform 2 of the 5 activities of daily living [ADLs], which are eating, dressing, bathing, toileting, and transferring) then you can use your face amount to help pay for custodial care. Now there are usually restrictions on the policies, such as you can only use a maximum percentage of your face amount each month toward LTC expenses. Also, some policies will only pay for custodial care if you’re admitted to a nursing home, and will not pay for these services if they’re provided to you at home. If you never use the LTC feature, then your beneficiaries get your full face amount; if you do use the LTC coverage, your beneficiaries will receive the unused face amount.
So, to give you an example, let’s say Jack got a $250,000 policy with a LTC rider that allowed 2% of the face amount to be used each month toward custodial care. Jack goes into a nursing home that costs $7,000 per month for a period of 24 months before he passes away. His policy will pay out $5,000 maximum each of the 24 months, so a total of $120,000 of the face amount is used. Jack’s beneficiaries will receive the remaining $130,000.
You can also get what’s called a hybrid life insurance/LTC policy. These life insurance policies are usually funded with a lump sum. Also, the amount that you get to use for LTC is typically much larger than the amount your beneficiaries would get as a death benefit. To give another example, you could fund this type of hybrid policy with $100,000, get a $350,000 amount that could be used toward LTC expenses, and a $150,000 death benefit. Any amount that you use toward LTC will get subtracted from the death benefit, and again, you beneficiaries keep what’s left.
For folks that want to be able to transfer wealth tax-efficiently to their non-spouse beneficiaries, life insurance is a good solution. Life insurance death benefits are inherited tax-free, where investment accounts like IRAs and vehicles like annuities are not. Life insurance is a good estate planning tool because it leverages premium dollars and immediately increases the amount of money available to be inherited. You don’t have to worry about having to achieve investment gains to pass along a certain legacy to your kids; you can guarantee the amount using life insurance.
To learn more about various life insurance solutions, contact me for more information. If you have an existing life insurance policy and are in good health, it may be able to be "upgraded" to include some of these newer features. Also, as people are living longer these days, insurance companies revise their mortality tables every so many years. This just means they're able to give you a larger death benefit for a current cash value of a policy. Oftentimes you can roll your existing cash value into a new policy using a tax-free 1035 exchange, and have the option of increasing your death benefit, lowering your premiums, adding a long-term care feature, or possibly even all of the above. If you haven't had a life insurance review in several years, it may be time for a check-up.