Life insurance

Life insurance

Life insurance should be simple

Life insurance is similar to disability insurance because it can provide for your dependents when you aren't able to. But at least with life insurance, there should be no quarrel over whether you meet the definition of qualifying for benefits!

Life insurance should be a simple proposition. You need to provide income to your dependents in the event of your untimely departure. It should be easy to sit down, figure out how much income you need to replace for how many years, and buy the required amount of insurance.

Unfortunately, it doesn't always work that way. If, in your quest for affordable life insurance, you hear phrases like, "guaranteed return", "borrowing against your policy" or "tax-free growth", you've stumbled into the world of whole life or its cousin the more flexible universal life.

Cash value life insurance explained

Whole life and universal life are forms of cash value life insurance. They're both attempts to combine plain old life insurance with investments, although I can't imagine why an insurance buyer would want to do so.

What would you do if your automobile insurer called you and said, "Hey, I've got a great idea. How about if we increase your auto insurance rates by five times so that at the end of five years you can get an underpowered, used Ford Pinto?" You'd probably hang up and look for a new agent.

Yet thousands of people sign up for a similar deal with cash value life insurance each year. Instead of chaining your investments to a single life insurance company, you should keep your insurance and investment needs separate. That way you can shop around for the best of both worlds.

Some agents emphasize the fact that the cash value portion grows tax-deferred. This is true, but this isn't much of an advantage. It's pretty easy to get all the tax-deferred savings you want through retirement accounts.

And, as a bonus, retirement accounts offer immediate tax savings. This is something cash value insurance can't provide.

Term life insurance

So if you need life insurance, look for something called term insurance. Term insurance is pure insurance with no investment aspect.

Term insurance is much cheaper than cash value insurance. For example, a middle-aged man might pay $2,000 a year for $250,000 in whole life insurance, while the same amount of term insurance can be bought for only $400 a year, depending on your health.

If you buy cheaper term insurance, you can invest the difference in a retirement account or other asset. The key here is to buy term and invest the rest.

Of course an agent may tell you that term insurance is only "temporary insurance" while cash value insurance is an "investment" or "permanent insurance". Fair enough, but cash value life insurance is an inflexible, expensive investment with a poor track record for performance.

One drawback to buying term insurance is that the premium may increase over time. But you can lock in rates for ten years or more if you want. Plus, increasing rates for term insurance isn't that big of a problem because you probably won't need as much life insurance after your children have grown up.

High fees in cash value life insurance

One reason why cash value life insurance is bad from an investment standpoint is the fees and commissions.

When you buy cash value life insurance, about 80 percent of your first year's premiums go to pay the agent's commission. This could mean you're paying more than $1,500 to the agent in the first year.

Maybe now you're beginning to understand the old joke that says that cash value life insurance is sold, and not bought.

However, many of those who buy cash value life insurance wise up and drop their policies. Within two years of buying cash value insurance, about 20 percent of Americans drop their policies, and the vast majority drop their so-called permanent insurance before 20 years.

Life insurance needed

So if you decide to buy life insurance, buy term life insurance. But before buying life insurance, see if you even need it.

This may go without saying, but few single people or couples with no children need life insurance. People who are already fairly wealthy probably don't need life insurance either.

But if you have dependents, like children or elderly parents, you probably need some life insurance. You'll also need coverage for your spouse if the spouse provides income or necessary household work. If your spouse is gone, household chores require time, and it will cost money to provide these services.

But how much coverage will you need? This of course will vary depending on your needs and current savings.

If you already have a large nest egg, your need will be lower than for someone who will have to replace their income completely with insurance proceeds.

Also note that the required amount of coverage will vary depending on how long your family will need income replacement. If your children are very young, you'll need enough money to replace your income for 20 years. If they're older, you'll probably need less coverage.

Also remember that Social Security provides survivor benefits. A widow with two children can probably receive $1,300 a month in Social Security benefits although you'll probably need more than this for your family.

Keeping these principles in mind, as a rough rule you'll need to buy a policy that provides a lump sum of about five to seven times your annual income.