Life insurance is a subject that has all of the elements of a perfect storm for poor decision-making.
- It’s complicated.
- It’s boring.
- It can be expensive.
- It’s wrought with potential conflicts of interest.
- It deals with a subject we don’t want to confront.
Many people don’t purchase enough life insurance to cover their needs. Of those that do, many end up making critical mistakes and buying insurance that is not optimal.
According to the Life Insurance and Market Research Association, more than 30 million Generation X and Y households surveyed reported that they needed more life insurance in 2012. One-third of wives own no life insurance at all.
These are sobering figures.
The same survey found that most of us believe life insurance gives people “peace of mind.” Of those who have had a positive experience with life insurance, 80 percent indicated that the life insurance industry plays a “critical role” after the death of a loved one.
Americans are also confused about insurance. LIMRA found that the main reasons people don’t buy insurance is because they believe they can’t afford it and they have other financial priorities. However, the survey also showed that consumers seriously overestimate the cost of life insurance by as much as threefold.
Consumers find insurance confusing. Of those surveyed, 12 percent couldn’t decide what type of life insurance to purchase, 10 percent were concerned about making the wrong decision and 8 percent simply gave up because of a lack of knowledge about insurance.
These basics might help you find your way through the insurance thicket:
1. Determine whether or not you need life insurance. Not everyone needs life insurance. If you are young and without dependents, you may not need life insurance. If you plan on having dependents, it can be a good idea to buy insurance when you are young. By doing so, you guarantee your insurability (as long as you continue to pay the premiums).
Don’t fall for the argument that you should buy insurance when you are young just to lock in a low premium. Premiums are determined by your age, gender and risk classification. As I explain in "The Smartest Money Book You’ll Ever Read," a disadvantage to buying insurance when you are young is that you will likely be paying premiums over a longer period of time.
You may no longer have a need for life insurance if you are older with no dependents, have saved enough to provide for the needs of yourself, your spouse or partner and don’t wish to leave a legacy.
2. Determine how much life insurance you need. There
are two ways you can calculate how much insurance you need:
Income replacement: This approach considers your age and earnings. It generally produces a higher number than a needs-based approach. You start with your age and determine how many years of income you would need to replace in the event of your death. For example, if you are 40 years old, you might decide to buy insurance that would pay 15 or 20 times your yearly income. Some calculations using this approach take into consideration your projected after-tax earnings over your working years, factor in inflation and discount the results to present value. The basic problem with this approach is that it’s not very individualized.
Needs-based: This approach considers your particular situation and assesses the impact of your death on your dependents. Factors to consider include whether your spouse or partner would continue or start to work, the number of children you have, whether there is a mortgage you want to pay off and the cost of educating your children.
My preference is for the needs-based approach, but it will take more time and reflection to get it right.
Mint.com has a useful “life insurance wizard" that will help you calculate the amount of insurance you need.
3. Determine the type of insurance you need. The two basic types of insurance are term and cash-value insurance (which is also referred to as permanent insurance).
Term insurance has no investment component. You just decide how much coverage you need and the period of time you want that coverage to remain in effect. You can obtain term insurance that has a level premium over the term of the policy. Term insurance has lower premiums than cash-value insurance. Many financial planners recommend buying term insurance and investing the difference between a term-insurance premium and a cash-value premium.
Unfortunately, most people spend the difference. Nevertheless, for those with young children, term insurance will provide the most coverage for the lowest premium. By the end of the term, your need for insurance may be reduced or eliminated.
You can shop for term insurance on insurance company websites, through an affiliate group like an alumni association or AARP. Savings Bank Life Insurance, for one, has a history of being reasonably priced.
Cash-value insurance is one of the most confusing subjects in personal finance. It can be an excellent product, but it’s difficult to understand. Some insurance salespeople use its complexity to their advantage and attempt to sell high-commission policies when other policies would be more suitable. I will discuss cash-value insurance in detail in next week’s post. Until then, here’s a suggestion:
If your annual premium for insurance will be $10,000 a year or more,
consider retaining a fee-only insurance advisor, one who doesn't have any financial stake
in your decision. These advisors can save you far more than their fee, and you
can feel more assured their advice is objective and in your best interest.