No one likes to think about buying life insurance – it’s not quite as unappealing as buying a cemetery plot, but it’s worse than buying new tires. Life insurance is boring, a little morbid, and is often made to be very complex. It also satisfies the very real need to protect against a potential financial tragedy. For that reason, it’s an important topic to understand. The good news is that decisions about buying life insurance do not need to be complicated. In this article, we’ll discuss life insurance’s proper role, how much coverage to buy, and which types are appropriate. Our goal is to equip people with the right knowledge to check the life insurance box, so to speak, and not to explain everything about it.
The Proper Role of Life Insurance
The essential role of all types insurance is to protect against financial loss. Period. You don’t buy life insurance because it’s a good investment vehicle (it’s not). Nor do you buy it because you love someone. Although, because you love someone, you may feel the responsibility to provide for them financially after you die. You buy life insurance to provide money for one or more people when you die. It’s a financial means, and nothing else.
How much life insurance coverage you buy depends on how you want to provide for those you might leave behind. Here we find two distinct models: discrete expense coverage and the endowment approach. By discrete expense coverage we mean everything from paying basic burial expenses to fully funding college for your beneficiaries. To cover discrete expenses, simply add the various expenses you want to meet and purchase an amount of life insurance to cover the total. For example, you can easily pay for simple burial costs with $25,000 of coverage. But funding Harvard for four years would require $300,000 or more.
In the endowment approach, proceeds from life insurance generate a perpetual stream of spendable cash flow. If you invest the proceeds well, a balanced portfolio can support 4% annual withdrawals for decades, while providing for some growth. Suppose your spouse has been out of the work force for several years. It may be impossible for her or him to replace your lost income if you die. If your income is $80,000 annually, dividing that amount by 4% suggests a coverage need of $2.0 million. But realistically, part of your income currently is spent on your own needs. So your spouse may only need to replace, say, $60,000. This suggests a coverage amount of $1.5 million, or $60,000 divided by 4%.
We also want to point out that if you’re single or married with a working spouse, you may have no need for life insurance at all.
Types of Life Insurance
There are many different types of life insurance. The most common and useful distinction is between term and permanent insurance. Term insurance covers your life for a set number of years, usually 10 to 30, and then expires. Permanent insurance does not expire. As you can imagine, that can be an expensive proposition for insurance companies when policy holders become elderly. The way they make up for this cost is by charging a much higher premium. Every permanent life insurance premium payment includes the cost of the current death benefit, and an extra amount which goes to compensate the insurance company for covering your life in old age. The extra amount might accumulate to produce a “cash value.” It is true that if you don’t die, you could access the cash value of your permanent policy. But If you do die, your beneficiaries won’t get the cash value: they’ll just receive the current death benefit.
We believe term is a far more sensible type of coverage to buy than permanent insurance in most cases:
- Term covers your life for the years during which you have risk, and no longer. Once the kids are out of the house, the mortgage is paid off, and you’ve accumulated enough retirement savings to meet your expenses, you may have no need for life insurance at all.
- Because term doesn’t cover you in old age, its premiums are far lower than permanent insurance.
- You can save the difference between what you would pay for a permanent policy and what you pay for a term policy, creating your own “cash value.” You don’t need a restrictive insurance policy to save your money.
Check the Box
Buying life insurance is no fun, but obtaining some coverage can meet an important need for many people. With the information above, we expect that most readers can determine how much life coverage and what type of insurance they need. While Peloton does not sell insurance, we are happy to provide opinions to clients and members of their families how to obtain the right coverage.