Saturday, October 10, 2009

Do you need LIFE INSURANCE? Yes, No, and Maybe

Do you need LIFE INSURANCE? Yes, No, and Maybe.

Should you buy life insurance? Why? and Why not?

Over the years I have bought a number of life insurance polices - term life, whole life, adjustable life, variable life. Some are a basic insurance policy - a bet that you will die - and a means of protecting loved ones should you die prematurely. Others are investment vehicles of varying degree and usefulness. The following comments are based on my experiences.


1. TERM INSURANCE

For most people, there will be a time in their lives when a simple term life policy is appropriate. Term Life is the cheapest life insurance there is, the one with the fewest benefits to you directly.

Simply stated, a term life policy is a bet. You are gambling the monthly premiums, on the premise that before the policy expires you will die. The payoff is in the face amount to your heirs. The insurance company is betting that you will not shuffle off the mortal coil so quickly (the will to live is strong, after all) and will take your premiums and pay out nothing.

If you are young and have financial responsibilities to others, a term policy may be in order. For example, my friend John had a wife and child and a mortgage to pay. At age 30, he had hardly built up much of an estate yet. He had little to leave to his wife and child should he die. He bought a $100,000 term life policy. The premiums cost a few hundred dollars a year.

Tragedy struck, and he was killed in a car accident. The payout from the life insurance meant that his wife could pay off the mortgage and raise their child while only working part-time. If he hadn't bought that policy, his wife would have been destitute, and had to work full-time while raising a child. In his situation, a term life policy makes sense.

Shop around on term life. Rates are very competitive, but many agents mark up the policies a lot. Like extended warranties, it is easy to convince the customer that they are getting a "lot" (potential huge payout) in exchange for a relatively small amount (the premium). But since the odds of young people dying are long, the premium may be no bargain. Shop around.

Many associations, credit unions, and other organizations may have term life policies that may or may not be a good deal. In some cases they can be quite competitive. I have a policy through the American Bar Association. The only downside is that I have to pay dues to the American Bar Association to qualify, and the dues are quite hefty.

Most term policies are for a specific period - 10, 20 years or the like. Once the term is up, that's it. You walk away with nothing. That's why it is called "Term Life Insurance". As you get older, the odds of you dying approach 1:1, so the insurance company doesn't want to insure you forever.

Many term policies have level premiums, but most increase premiums over time as you get older. Eventually, you may have to make the decision to drop coverage, as the premiums become too large. Hopefully, by that point in your life, you will have some Estate to leave to your spouse and child (401(k), house, etc.) so that the life insurance is unnecessary. Figuring out when to drop coverage is hard to do. After all the payout seems so large compared to the premiums paid, right?

Some policies, like my ABA policy, pay dividends, but it is rare. Dividends are paid when the premiums taken in are more than the amounts paid out. Organizations may ask you to donate the dividends to them (as the ABA does) requiring you to request, in writing, every year, the cash equivalent of the dividends if you want them.

As I noted, when you get older, you are going to die, period. So life insurance for older people makes no sense whatsoever. Yet television commercials abound for "Senior Life" insurance, for folks too dotty to figure out that you can't get something-for-nothing. These "burial policies" basically provide little in benefits (maybe a few thousand dollars) for relatively high premiums. There is little bargain in these policies and I would advise staying away. Life insurance is a young man's game, and if you didn't buy it when young, then forget about it when you get old.


2. WHOLE LIFE

Whole life is an interesting concept. Originally, the idea behind it was to increase the premium beyond that needed for the insurance itself, such that the excess premium could be invested and the policy "paid up". "Paid up" means that no more premium is due and the policy is completely paid for.

Since part of the premiums paid are not going toward the insurance, they act as an investment vehicle. And the tax code has a "loophole" ("loophole" is a lazy man's term for the law) that allows you to take out money invested in a life insurance policy in the form of a loan or annuity, tax free. You can also "cash out" a policy and take the money, but you may have taxes to pay if the amount taken out exceeds the amount paid in.

A whole life policy is a complicated financial instrument, and my mantra that "the more complicated a financial transaction is, the easier it is to fleece the mark" applies here. Like a car lease, it pays to read the fine print - or in many instances, just walk away. And as I noted in my previous article, don't make the mistake of assuming the insurance agent is your friend acting in your best interests. He is on commission and gets paid to sell polices. Verbal representations he makes are worth nothing. Read the policy before buying.

For the first few years you have a whole life policy, it seems like a waste of time. You pay into the policy and the cash value remains flat, or increases slightly. In terms of an investment, it is a lousy one. Many people drop out of such plans at that point, not seeing any rate of return and figuring their money will do better elsewhere. After a decade or so, the policy is no longer "upside down" and the annual increase in cash value will exceed the premiums paid that year. For my whole life policy, this is the case - each dollar I put into it in premium equates to nearly two dollars in increased cash value.

Whole life policies generally pay dividends, again based on the profitability of the company - how much is paid out versus taken in. These dividends can be used in a number of ways. Your agent (again NOT your buddy!) will suggest you use them to buy more insurance. He gets a taste of this and the company make more money this way, so naturally he suggests it. But most policies allow you to take the dividends as cash or apply them to reduce your premiums. After a number of years, the policy may be self-funding based on dividends.

Again, your agent will suggest you don't do this, but rather buy more insurance with the dividends. Buying more insurance will increase the size of the policy and also increase the cash value more quickly. However, you may find that you already have enough insurance and would rather invest the money in other areas (tax-deferred accounts such as IRAs).

In fact, you may encounter extreme resistance from your agent if you try to change the option in your policy to use dividends to reduce premium or take them in cash. For example, such a policy change may only be available during a window period on the anniversary date of the policy. The Agent will conveniently forget to tell you this, and hope that by the time of the next anniversary date, you will have forgotten all about it. Or the policy may not allow you to use dividends to reduce premium until the dividends exceed the premiums - but you can still take the dividends in cash, of course. My Northwestern Agent told me that on one policy I could not use dividends to reduce premiums. He conveniently "forgot" to tell me that I could take them as cash.

You have to read the policy carefully to understand how it works, and keep in mind the various rules and anniversary dates. Like any financial instrument, you have to be proactive and get involved.

Most policies also have a loan provision, allowing you to borrow against the policy cash value at a predetermined fixed rate. If you took out the policy during a time of low interest rates, this can be a good deal later on if rates go up. But if (like me) you bought a policy when rates were high (8%) then the loan provision may be no big bargain, except as a lender of last resort.

On the "back end" of whole life, you can take out money when you retire. You can do this in one of a number of ways. You can borrow against the policy and spend that money, with the proceeds of the insurance (when you die) paying off the loan. Since this is a loan, the money you spend is tax-free (life insurance proceeds are not taxable). Others have annuity provisions, that pay out X dollars per month (e..g, $5) for every $1000 in insurance. So, for example, for a $100,000 policy, you may get an annuity of $500 a month, if you retire at a certain age. Again, you have to read the policy to understand these options.

You can also cash out the policy at any time, although this usually is the least profitable thing to do, as the cash value is usually worth far less than what you paid in, and there may be tax consequences.

Is whole life right for you? Probably NOT. If you have an IRA, 401(k), SEP or other tax-deferred retirement plan you can participate in, such plans are probably better use of your investment monies. You can control (to some extent) where the money is invested, and when you retire, you take the money out as cash, without hassles.

However, a small whole life policy can be a good way to diversify a portfolio. During the recent downturn in the stock market, my whole life policies did fairly well in comparison to my other investments. But as a primary investment vehicle, they are a bad choice, as the rate of return is far less than in equities. I have maybe 1/10th of my net worth in Life Insurance at the present time, and that is probably a good amount.

Bear in mind that life insurance is a contract, and is not guaranteed in any way. If the company goes bankrupt, you can lose everything, although such incidents are rare. Life insurance companies generally invest their proceeds in commercial Real Estate and the like, and thus can be subject to downturns in the Real Estate market, as particularly happened in the late 1980's.

Note also that a whole life policy is a forced investment. You have to pay the premiums, like clockwork, for the life of the policy, or the policy lapses and you'll get back only your cash value. Thus, if your life circumstances change, you may find that you want to scale back on some investments. But a life policy can't be scaled back in many cases.

For that reason, don't buy more whole life than you can easily afford. Limit the premium to an amount you are comfortable with. When I was 29, I bought a $100,000 life policy for about $99 a month. I figured that no matter what happened in my life situation, I could swing $99 a month from then onward. If you buy too much insurance, you'll be more inclined to drop the policy if you need the money later on.


3. MUTUAL OR STOCK COMPANY?

When selecting a company, you should understand the type of company you are investing in. Stock companies, like the name implies, sell stock and pay dividends to shareholders. As such, they have to bosses to answer to, the shareholders and the policy holders. Both want to get paid, and the proceeds have to be divided in two.

In a mutual company, the policy holders ARE the shareholders, so any dividends or profits are paid back in the form of policy dividends to policy holders, not in stock dividends to shareholders. Thus, a mutual company is preferred if you are purchasing whole life.


4. Adjustable Life, Variable Life

There are other forms of whole life which are interesting vehicles for investment. These types of polices allow for the investment vehicle to comprise a larger part of the policy, or allow the amount invested to vary over time. The IRS has stringent rules on the ratios of investment to insurance, lest the whole concept of whole life be turned into nothing more than a tax avoidance sham.

Some of these policies are almost like a investment account, in that you can direct the surplus funds into one or more of a number of investment accounts (mutual funds and the like) and can control, to some extent, the amount invested over time.

These are more complicated polices and it pays to read the policy and understand it and also understand how and when you can take your money out. Again, the more complicated a financial transaction is, the greater the chance it works to your disadvantage. You may find your agent strangely less-than-helpful in helping you understand these polices. The Agent will want you to take actions that result in a higher rate-of-return for the company and himself. He will not volunteer useful information to you.

I would not recommend these more esoteric investment vehicles for the average investor. I have one of each, and while they have done OK, I probably would have been smarter to put the money into my 401(k) or IRA.


5. A Note on Beneficiaries

The beneficiary is the person or persons who will receive the proceeds of your life insurance, should you die. You can leave the money to your spouse, children, a friend, or even a total stranger. It doesn't matter. Or, could leave the money to your estate.

As part of your estate, the money would then be dispersed according to your Last Will and Testament, or according to the State law, should you die intestate (without a Will). Leaving the money to your estate can be handy, as the money can be used to pay debts of the estate, and also you can change who gets the money by changing your will.

However, the money, when left to your Estate, may be taxable to the recipients or may be taxed at the State level.  Contact your local tax expert in your jurisdiction for more information.   The other disadvantage of designating your Estate as beneficiary is that it puts the money into probate, and thus delays payout and also raises the specter of hateful relatives who decide to sue for "their share" of your Estate.   If you designated Joe Blow as your beneficiary, the money goes directly to him (all he needs to do is file a copy of the death certificate with the company and wait for his check) and it is tax-free and the hateful relatives can't touch it.

Designating a child as a beneficiary can be a bit tricky, as insurance companies will not pay money out to a child under the age of 18. Any child under 18 can renounce any contract upon reaching majority (age 18). So if you pay out to a child, at age 18 they can say "I changed my mind, pay me again! the first time didn't count!".

Thus, if you designate your children as beneficiaries of your life insurance, someone will have to be appointed as custodian of the money on behalf of the child. Alternatively, the life insurance company will keep the money (with or without paying interest, depending upon the terms of the policy) until the child reaches age 18.


6. SO.... Do you need LIFE INSURANCE?

Short answer: For a young breadwinner starting out with a family and no assets, a small term policy is probably a good idea. Whole Life is an interesting toy to play with, but don't let the agent talk you into investing any major amount of money in a whole life policy, as it really isn't the most effective investment vehicle.

And never, ever, trust an Insurance Agent. They are salesmen, plain and simple, and they will do anything and say anything to make a sale and to cover their ass.

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