IN MY ROLE as a financial planner, I hear a lot of stories. By far the most appalling and upsetting relate to life insurance. All too often, insurance salespeople leave clients with policies that are simultaneously overpriced, inadequate and inappropriate.
Are you evaluating a policy? Here’s a quick summary of the most important considerations:
What type of coverage should I have? Life insurance comes in two primary flavors: term and permanent. Term insurance, as its name suggests, provides coverage for a fixed term, such as five, 10 or 20 years. Permanent insurance, on the other hand, is designed to cover you for your entire life. You’ll often see permanent insurance referred to as whole or universal life; these are types of permanent coverage.
In virtually every case, I recommend term insurance—for four reasons:
1. Since everyone’s probability of dying within their lifetime is 100%, permanent insurance ends up being much more expensive than term. The insurance company knows you’ll eventually die, so it prices these policies accordingly.
2. You probably don’t need life insurance for your entire life. Most people need life insurance only during their working years and only when they have dependents. If you’re retired, with your mortgage paid off and your children out of college, you may not need coverage at all. Why continue paying steep premiums to cover a need you don’t have?
3. Permanent insurance is so expensive that families often end up underinsured. Everyone buys what they can afford, but because permanent insurance costs a fortune, most people don’t buy enough. The solution is easy: Opt for term insurance, where you can secure much more coverage for a much lower premium.
4. Permanent insurance usually includes a “cash value” component, which is essentially a savings account bolted onto the side of your insurance contract. These policies are virtually impossible for a layperson to understand—and that provides plenty of cover for insurers to layer on fees and commissions.
A final note: You may run into a product called “Term 80.” This is term insurance that covers you for almost your entire life—until age 80. I find this product particularly insidious because it costs a lot, like permanent insurance, but it isn’t actually permanent. Die at 81 and your family will receive nothing in exchange for all those years of pricey premiums.
Are there situations in which permanent insurance does make sense? Yes, but I believe they are rare.
How much coverage should I have? For most people, the answer is, “It depends.” That’s because your need for life insurance will vary over time. When you’re young and single, your need for insurance is probably zero (a reason why I see this famous product as particularly unnecessary). When you have children, a mortgage and college tuition in front of you, your insurance need will be significant. But as you put these obligations behind you, your insurance need will decline again. To calculate your life insurance need at each stage of life, I suggest this three-part formula:
1. Income replacement. If you have a family that depends on your income, the most important thing will be to replace your income with a pot of money large enough to sustain them going forward. A simple rule of thumb is to multiply your household expenses (excluding any debt or tuition payments) by 25. For example, if your expenses are $100,000 per year, you’d want to consider buying $2.5 million of coverage. Of course, you may already have savings. If that’s the case, then you’ll need that much less insurance.
2. Debt payoff. If you have student loans, a mortgage or other debts, you’ll want your family to be able to pay off these debts.
3. Education expenses. If you have school-age children, you’ll want your family to be able to meet future tuition obligations—but, again, your insurance need will be less if you have money in 529 plans or other earmarked accounts.
Which insurance company should I choose? One of the ironies of insurance is that you can’t personally evaluate the quality of the coverage until you have a claim. But here’s what I would look for:
1. Longevity. Look for a company that has been around a long time. Many insurers have been in business for 100-plus years. That’s obviously a good sign.
2. Ratings. Most insurers receive financial strength ratings from four independent agencies: Standard & Poor’s, Fitch, Moody’s and A.M. Best. As you evaluate your options, ask your salesperson about ratings. Keep in mind, though, that each of these agencies uses a different rating scale. Be sure you understand where an insurer’s rating falls on each scale. It’s not what you would expect. At S&P, for example, an A+ rating, which sounds like it ought to be the best, is only the fifth-best, behind AAA, AA+, AA and AA-.
3. Pricing. Many insurance companies have the word “mutual” in their name. This means the policyholders are the owners of the company. While you might assume this is a good thing, be careful. Just as there are many mutual insurance companies that charge very high rates, there are many for-profit, public companies that offer very low prices. Don’t judge a company by its name.
Adam Grossman’s previous articles for HumbleDollar include Higher Taxes, Moving Target and No Free Lunch. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.