Lesson 6: A Contract on Your Life

No. This isnt about a hitman coming out to get you. Its about protecting your family against losing your potentially biggest asset. What do you think that is? Your house? No. Your car? No. Your IRA or 401k? No. Its your ability to earn an income. In this and the next lesson, well look at how insurance can protect your ability to earn an income. There are other reasons to carry insurance, which well also explore, but for most people, this is life insurances primary purpose. Why Buy Life Insurance? There are three main reasons why you want to buy life insurance. 1. You want to provide for your family in case of your untimely death. This is the most common reason why people purchase life insurance. You have people who are dependent on you for your income or for the time you spend in raising or maintaining the family, and on your passing, there would be an undue financial burden on everyone else. There are two main contexts in which this is important. The first is for a working spouse. That spouse brings in income and the family expects that spouse to bring in income for the foreseeable future until retirement. An untimely death means the end of that stream of income and makes life much more difficult for the rest of the family. The second context is for a stay-at-home spouse who takes care of the kids as a full-time job. In this case, the early demise of the stay-at-home spouse would mean that the surviving spouse would have to hire assistance, either in the form of childcare, or in the form of a nanny or au pair to take care of the kids until they leave the nest. Again, this is an increased financial strain on the survivors. Thus, the purpose of life insurance for most families is to replace income or to account for increased expenses in the event of the early passing of one of the adults in the family. 1

Even if you dont have kids, having life insurance is still important so that the surviving spouse can retain your current standard of living without having to make undue sacrifices. 2. Special needs planning. This is the case when you have a family member who will not be able to take care of him or herself without assistance. You are currently taking care of this special needs family member, but you want to make sure that there is enough money to fund a special needs trust to be able to afford care services for the remainder of the special needs family members life. 3. Estate planning and bequeath purposes. For families who have a net worth which is higher than the amount that would be excluded from federal and state estate taxes, life insurance can be a way to achieve intergenerational wealth transfer or additional charitable giving without having to pay estate taxes. This is one of those cases where trying to implement a do-it-yourself plan isnt going to work, unless youre already a trust attorney. Get a good trust and estate planning attorney; the amount you spend getting everything set up and appropriately documented will be worth the money. For cases 1 and 2, life insurance is appropriate when you dont already have the funds in place to accomplish those goals. For example, if you already have 50 times your annual expenses saved up in liquid assets, and youre debt free, then you dont need life insurance to enable your family to retain the same standard of living. What if youre single? Do you need life insurance? Most planners will tell you no. As long as you have enough money to conduct a funeral, you shouldnt need more, as your estate will stand good against any debts that youve accumulated. This advice works if you plan on being single and childless for the rest of your life. However, if you dont plan on being single and childless for the rest of your life, then you should consider life insurance; its a product which is cheaper when youre younger. That way, when you do get married and have kids, where youre to the point where others are dependent on you and would be financially harmed by your death, youll already be insured. However, when youre single, not getting life insurance isnt going to be critical to your life plan. Types of Life Insurance There are two basic types of life insurance, although you may hear about different flavors of one type.

Term life insurance. Term life insurance is insurance set for a given period of time with a specific benefit amount. The price remains the same for the period of time that the term covers and then it expires. Some policies allow you to extend the term when you get close to the end of the term, but you will pay a higher price. Whole life insurance. Whole life insurance is designed to be a permanent insurance policy. With it, as long as you continue to pay premiums, you will be insured, no matter how old you get. There are varying types of policies, such as universal insurance, but, at their core, theyre all the same designed to keep you insured from the day you start the policy until the day you either die or you stop paying. The payment terms of whole life policies differ dramatically. Some policies have a single premium amount, meaning that youll pay the same amount for the rest of your life or for a given time period, and youll be permanently insured. To accomplish this, the premiums are higher, relative to term life, when youre younger, and eventually become lower, relative to term life, when youre older, since the insurer expects some people to quit paying (called a lapse) or to die. The policy may also keep a cash value which can be used to pay payments and participate in the market, although I have yet to see a policy which performs that particular function as well as actually investing in an index mutual fund.

What Type of Insurance Policy Should You Purchase? Unless you have an estate that is large enough to trigger the federal estate tax or you have a special needs dependent, then we recommend that you purchase term life insurance. Using whole life insurance as an investment simply does not perform as well as purchasing term life insurance and using the remaining money what youd pay to brokers for commissions and for funding the cash value to invest in the market. If you have a special needs dependent, then I do recommend whole life insurance because the risk of not setting aside enough money to fund the special needs dependents special needs trust during the time period of a term life insurance policy is too great. If youre close to having the trust fully funded and have reasonable certainty of getting there in a short time period, then term life insurance is acceptable, but in most of the cases, its going to be wiser to have a permanent life insurance policy as a buffer. If you are looking for estate planning purposes, then using a whole life policy can allow you to put more money into a tax-deferred shelter, called a modified endowment contract which will allow you to pass along a higher amount of wealth to your desired beneficiaries. Beneficiaries Before we continue, it is important that you realize the value of naming the correct beneficiaries to your insurance policy. Life insurance proceeds pass estate tax free to named beneficiaries. However, if you fail to name a beneficiary, or you name your own estate as the beneficiary, then your estate will receive the proceeds. 3

This causes two problems. The first is probate. Probate, the process by which a will is proven valid or invalid by a court and then the instructions in the will are executed, is a time-consuming and sometimes messy affair. In estate planning, you want to avoid probate wherever possible. If the life insurance proceeds are tied up in probate, then your family or your intended recipients wont have access to those funds. The second problem is that insurance proceeds which pass into your estate are subject to estate tax. Youll have defeated some of the benefit of life insurance by having the proceeds pass into your estate. Life insurance proceeds that are paid as a lump sum directly to a beneficiary, that is, not your estate, are not taxable. Furthermore, what is in your estate is subject to whatever your will states, or, if you dont have a will (which you need to fix ASAP), to the state laws of intestacy. This may result in the life insurance proceeds not going where you intended them to go. Therefore, its important that you correctly name your beneficiaries in your insurance policy, and if your life situation changes, such as getting a divorce or having grandchildren whom youd like to receive the proceeds, you need to update the beneficiaries as soon as you can. How Much Insurance to Buy? If your family faces having to receive a life insurance payment, then youre going to want for that payment to eliminate all debt and allow for safe withdrawal rates for the remainder of your spouses days, and, if necessary, to fund your special needs trust to allow for prudent withdrawals for the remainder of your special needs dependents days. First, lets address the usual use of life insurance, which is to replace your income to support the family. In order to know how much insurance you need, regardless of whether or not youre working or the stay-at-home parent, you need to have a good handle on your debt and remaining term of the debt.

Type
Mortgage (including HELOC) Student Loans Personal/Medical Debt/Car loans > $50,000

Balance Years Left to Pay off

Note that I did not include small debts. Usually small debts are too small, relatively speaking, to justify insurance policies, and because of the denominations involved with life insurance. Its impractical to get a $20,000 life insurance policy in most cases. Next, you need to determine your current annual expenses. You should have this amount after Lessons 4 and 5. Simply take the monthly expenses from Lesson 4, multiply by 12, and add in the annual expenses from Lesson 5. If you have a stay-at-home spouse, you need to add the annual amount of expenses for child care or having a nanny or au pair to care for the children which having the stay-at-home spouse keeps you from needing to spend. DO NOT include 4

retirement savings in your expense calculations. The lump sum insurance payment will replace retirement savings, as youll now have the assets required to replace those expenses; the point of saving for retirement is to accumulate enough assets to be able to safely withdraw those assets when youre no longer working and not run out of money. Well discuss the topic more in Lesson 12. If you have a special needs dependent, then you will need to calculate the expenses that would be incurred to care for that person if you were not able to do so and add those expenses into the total annual expenses.

Monthly Regular Expenses Expense

Multiply By
12

= Annual Regular Expenses

Amount

Annual Regular Expenses Annual Irregular Expenses (Lesson 5) Total Expenses Once you have your total annual expenses, both regular and irregular, youll need to multiply by an age factor to determine how much youll need to have to support regular lifetime withdrawals and not run out of money. Sometimes, you will hear insurance agents and finance gurus say that you need to multiply your income by 12 or 15 or 17 to figure out how much insurance you need. The rule of thumb doesnt look at your expense picture, which is what is truly important. Youre looking to life insurance to replace a family members ability to pay for expenses. Thats why were reevaluating your expenses from Lessons 4 and 5. Well discuss safe withdrawal rates in a later lesson; these multiplier ratios are a factor of safe withdrawal rates to have a limited chance of running out of money during your lifetime. These are good rules of thumb, but they are rules of thumb.

Age Range Multiplier

< 30 30 40 40 50 50 + 33 30 28 25

We have these multipliers because, over time, you should be saving and investing towards your retirement. As your asset base grows, the amount of money you need from insurance should decrease.

Now, lets calculate how much total insurance you need. When you get to the total required, round up to the nearest $25,000 (e.g. $934,150 becomes $950,000), as most insurance policies are based on these rounded numbers.

Total Expenses
X

X Multiplier

Equals

Plus Debt

Total Required

How Long to Buy Insurance? Were a fan of a concept called laddering for term life insurance. Laddering means that you purchase insurance for the term that youll need it for. If you have a special needs dependent, you can still purchase term life insurance to match against the debts while purchasing permanent insurance to meet the spending needs of the special needs trust. Lets look at an example. Lets say that you have a home mortgage. Youve lived in the home for ten years, and when you bought the home, you borrowed money on a thirty year mortgage. You now have twenty years left on your mortgage. You should have term life insurance for 20 years in an amount enough to pay off the home. Theres no point to have insurance for longer, since youll have the mortgage paid off and wont need that money. Additionally, you should be saving money for retirement and increasing your net worth as you go. Well address retirement planning later, but for now, well make some assumptions about your saving progress. Most people work for about 40 years before they retire, and then they fund their retirement with a combination of savings and Social Security. However, their net worth picture does not follow a straight line. They have very little net worth in their younger years and then slowly accumulate wealth, and in the final few working years, compound interest has started to have an effect, and thats when they, generally, see the biggest gains. Thus, well base your insurance terms with the assumption that you will be saving and investing for retirement and will make progress along the way. Consequently, when youre 50, youll already have a reasonable amount of money saved for retirement, so wont need as much insurance to replace the lost income because there will already be some money in the bank.

# of Years Policy Has Been in Effect

0 10 10 20 20 30 30 40 100% 87% 50% 20% 6

Annual Expense Insurance Coverage Required

Obviously, this is dependent on how successful youve been at saving and investing and in income generation as well as at what age you start your insurance, so, again, this is a rule of thumb. We need to address two exceptions to the rules above: 1. Dont buy insurance beyond when you plan on retiring. If youre 50 and plan on retiring at age 65, then you only need to buy 10 and 20 year term policies. 2. If your insurer doesnt sell 40 year term policies. If this is the case, add the amount from the 40 year policy into the 30 year policy and buy a 30 year policy for the combined amount that you calculate for 30 year and 40 year policies. An example Jay Gatsby and his wife Daisy have a one year old child. Jay is 27 and his wife is 26. They both work. Jay makes $50,000 a year and Daisy makes $75,000 a year, for a combined income of $125,000 per year. They have the following debts:

Type

Balance Years Left to Pay off

28 12

Mortgage (including HELOC) $200,000 Student Loans $100,000 Personal/Medical Debt > $50,000 N/A Their annual expenses are:

Expense

Amount

Annual Regular Expenses $65,000 Annual Irregular Expenses (Lesson 5) $20,000 Total Expenses $85,000 Thus, based on the multiplier, the amount of insurance they need is:

Total Expenses
$85,000

X Multiplier
X 33

Equals

Plus Debt

Total Required (rounded)

$3,125,000

$2,805,000 $300,000

Now, lets consider how much insurance they need over time.

# of Years Policy Has Been in Effect

0 10 10 20 20 30 30 40

Annual Expense Insurance Coverage Required

100% 87% 50% 20%

Amount Required

Plus Debt to be Serviced

$300,000 $300,000 $200,000 $0

Total (rounded)

$2,805,000 $2,440,350 $1,402,500 $561,000

$3,125,000 $2,750,000 $1,625,000 $575,000

Since Daisy makes 60% of the income, she should have 60% of the total insurance coverage. She would buy the following policies:

Term
40 years 30 years 20 years 10 years

Amount
$350,000 (60% * $575,000 rounded to nearest $25,000) $650,000 (60% * difference between $1,625,000 and $575,000 rounded to nearest $25,000) $675,000 (60% * difference between $2,750,000 and $1,625,000 rounded to nearest $25,000) $225,000 (60% * difference between $3,125,000 and $2,750,000 rounded to nearest $25,000)

Since Jay makes 40% of the income, he should have 40% of the total insurance coverage. Since weve already figured out Daisys share, we simply need to subtract to get Jays share.

Term
40 years 30 years 20 years 10 years

Amount
$225,000 ($575,000 minus $350,000) $400,000 ($1,625,000 minus $575,000 minus $650,000) $450,000 ($2,750,000 minus $1,625,000 minus $675,000) $150,000 ($3,125,000 minus $2,750,000 minus $225,000)

Stay at Home Parent Stay at home parents need insurance too. If the stay at home parent were to pass, then the remaining parent would face additional expenses in caring for the child expenses that are removed by having a stay at home parent. To calculate the value of a stay at home parent, we recommend determining the annual cost of having a full-time nanny. If the child is under age 8, multiply that cost by 12, and purchase a 20 year policy for that amount. If the child is over age 8, multiply that cost by 8, and purchase a 10 year policy for that amount.

Weve looked at one of the functions of insurance, which is to protect your family in case you meet your maker before you expected to. In the next lesson, well examine how to protect yourself in case you get sick or injured and can no longer work.