Conventional wisdom: you should only pay insurance coverage for significant potential losses that would represent a serious financial hardship. Most people need insurance on their home but not on a phone. Replacing a phone is annoying but, unlike losing a home, wouldn’t represent a financial catastrophe for most of us.
If we apply this principle to life insurance, only people who are the primary breadwinners of their household and whose death would cause significant financial hardship to their loved ones should get life insurance. After all, life insurance is designed to provide a safety net for heirs and dependents, not as an investment vehicle.
If this is true, wealthy people who don’t have debt are wasting their money on life insurance, right? Their death wouldn’t cause their family financial difficulties and they could invest their money much more effectively in other financial products.
Not so fast, say financial advisers who specialize in estate planning.
There are scenarios where life insurance can be a valuable, even necessary, element of a high-net-worth individual’s investment portfolio. Here are two worth considering.
The Asset Rich, Cash Poor Scenario
If you own a business or have a lot of property, most of your money is probably locked into assets that are worth a lot but are hard to sell quickly in an emergency. That is usually not a problem, except when you die. Wealthy people have to pay capital gains tax, which means the government owns a big piece of their estate. When you die, your estate can choose to either pay the government for its share in your estate with cash or sell your assets and share the proceeds with the taxman and your heirs.
For instance, if your assets are worth $100 million, you can expect about half of that to go toward federal and state taxes. In most cases it would be impractical and certainly not a good investment to have half your net-worth in cash, just in case you died. Still, your estate will only have nine months to pay this huge tax liability. If your estate hasn’t got the liquid assets to pay the taxman, it could throw your heirs into fire sale mode and force them to liquidize your assets below market value.
A life insurance policy could provide the necessary liquidity to pay your estate’s taxes without having to keep huge reserves of cash or forcing your heirs to auction off your business, farm, yacht or Bentley.
Life Insurance as Tax Mitigation
As well as providing life insurance, whole life insurance policies offer a cash value that grows as you pay your insurance premiums. It’s useful to see them as the bonds in a balanced investment portfolio. They provide boring but safe returns on investment. So why do financial advisers, at least those who don’t make a living off selling life insurance, generally discourage people from investing in whole life insurance? The answer lies in their high fees and because there are other tax-sheltered funds, such as 401(k)s, IRAs and Roth IRAs, that historically have generated a better return on investment.
However, if you are filthy rich, you are already paying as much as you are allowed to in tax-sheltered contributions. Whole life insurance provides an additional asset class for your investment portfolio that offers low-risk, reliable, tax-sheltered growth. Some policies will even guarantee a minimum growth rate, which can translate into a generous return once account for the tax savings included.
In a Nutshell
So, do wealthy people need life insurance? No, yes and maybe. It all depends on what you mean by wealthy and how the assets are structured. If your net-worth is around $5 million (the federal estate-tax exemption) and you don’t have significant liabilities, then you probably don’t need life insurance.
On the other hand, if you are ultra-rich and you want to maximize the wealth you transfer to your heirs, and spare them the stress of scrambling for cash to pay for taxes, life insurance can be an invaluable estate planning tool.
Life insurance is a valuable financial tool that can provide financial help to your loved ones when you’re not around to do so. However, life insurance is also a huge and highly profitable business with the main purpose of taking as much as possible of your hard-earned cash as you are willing to spend, whether you need the coverage or not.
It’s important to make sure you have the life insurance coverage your loved ones need, but it’s also important to show some mild skepticism about the claims insurers make. Here a five facts you are unlikely to hear from the mouth of an insurance agent that every life insurance buyer should know.
1. Around 9 in 10 life insurance policies lapse without any payout.
What insurance agents say?They prefer not to talk about this.
The Facts: Around 4.2% of all life insurance policies lapse every year, which represents around 5.2% of the face value insured by those policies. This leads to 85% of all term policies and 88% of cash value life insurance policies terminating without a death claim. What’s even more surprising is that 74% of term policies and 76% of cash value policies sold to seniors older than 65 never pay a claim. Sadly, lapsation rates are higher among those who need it the most, the households with low incomes.
In every case a policy is dropped, insurers save money, which allows them to pad their profit margins. In the case of whole life policies, the policyholder may receive a cash payment, but it will be significantly reduced by fees and early withdrawal penalties.
Although the topic of insurance companies profiting from clients lapsing on their policies is taboo among insurance agents, it doesn’t mean insurance companies are doing anything wrong. Overall insurance companies don’t make particularly high profits when compared to other businesses in the finance sector, and the high rate of lapsation also has the effect of reducing the premiums for those who do stick with their policies. However, it should make you think whether life insurance, particularly the whole life variety, is the right “investment” for you.
The Bottom Line: Whole life insurance policies are a bad investment when compared to other financial products to begin with. But their value is further reduced when you terminate them early. “About 90 percent of life insurance policies lapse without any payout,” – The Monitor
2. Whole life insurance is a terrible investment.
What insurance agents say:“Why throw your money away on a term life insurance you’ll probably never use? You’re much better off getting a whole life insurance policy. Not only will your heirs receive your life insurance payment; part of your premiums will be invested and you will be able to borrow some of it tax-free for your retirement, your children’s college education, or anything else you may need. The Facts: There are two main types of life insurance, term life and whole life. Term life is what you generally think of as a life insurance. You pay monthly premiums and if you die within the term covered by the insurance, the beneficiaries get a big fat check. Terms usually last for 10, 20 or 30 years. Once the term ends, so does the coverage. If you don’t die within the term, all those payments you made over the years were technically wasted; but you’re still alive, so it’s not all bad news.
Whole life insurance, on the other hand, is a hybrid between life insurance and an investment product, such as a 401(k) or a mutual fund. Whole life is much more expensive but has the upside that it covers you until death and includes a cash value that can be withdrawn. The cash value element of whole life policies allows insurance agents to market it as an investment product. The pitch they use can be quite compelling.
The only problem is that it’s a terrible investment because, historically, the returns are low compared to other investment products. According to a June 2014 report by the Wall Street Journal, insurers pay between 4% to 6% annual dividends and guaranteed minimums of 2% to 4%. Compare that to the S&P index, a good indication of the performance of the stock market as a whole, which had an annual rate of return of 13.6% in 2013 and an average rate of return of 12% since its inception, in 1926.
The Bottom Line: Keep your insurance and investment separate. Sure, whole life policies provide a two-in-one life insurance/investment product, and if you had to choose between getting life insurance and no retirement investments, or a whole life insurance; a whole life insurance policy would probably be better. But we live in a world where you can buy a cheap term life insurance and invest in low-cost mutual funds that are geared to generate the highest return on your investment. (Wealthfront)
The Caveat: Whole life insurance offers tax benefits to policyholders, so it can be a sensible option to a wealthy people who need insurance and expect to consistently max out their contributions to all other available tax-advantaged plans every year until they retire.
3. A lot of people just don’t need life insurance.
What insurance agents say: Everybody needs insurance, even if only to pay for their funeral. People don’t realize how necessary and affordable life insurance is. Meanwhile, the ratio of American households with individual life insurance has hit a 50-year low: 30% of U.S. Householders have no life insurance and only 44% have individual life insurance.
The Facts: The purpose of life insurance is to bridge the gap between financial needs of your dependents and the money you leave behind from other sources. If you are the main breadwinner in your household and you have dependents who would have trouble maintaining their current standard of living if you were to die, you probably need life insurance. According to the Life Insurance and Market Research Association (LIMRA), 70% of U.S. Households with children under 18 would struggle to make ends meet within just a few months if a primary wage earner were to die today, while 40% would immediately have problems meeting everyday living expenses.
The Bottom Line: If you have dependents who rely on you for financial assistance and your current savings would not cover their needs, you need a term life insurance that provides you with sufficient coverage to take care of their needs until they are financially independent. However, if you don’t have people who are financially dependent on you, you probably don’t need insurance, and you would be better off investing as much as you can in a tax-sheltered investment fund.
4. Most people carry more insurance than they need.
What insurance agents say:You need as much coverage as you can afford. An often quoted guideline is 15 times your annual income. So if you make $100,000, you need $1.5 million, preferably in a whole life insurance policy so you don’t let all those premiums go to waste.
The Facts: Life insurance is just one of many financial tools available to provide for your loved ones. Life insurance agents only get a commission from the money you spend on life insurance, which is why they want you to buy as much coverage as possible. Whole life insurance policies are particularly popular with agents because they offer higher commission rates. However, fee-based financial advisers are more likely to suggest 3 to 4 times your annual income plus enough to cover any debts you may have.
The Bottom Line: Ignore the sales pitch of insurance agents and determine how much term life insurance coverage you need. Don’t be stingy though. If you calculate you need $350,000, you might as well get $400,000 or even $500,000, because the cost difference will be minimal. A good guideline is four times your current annual income and enough to pay off all your debts, including student loans, mortgages and credit cards. However, if you have young children, you may want to increase your coverage to reflect how long it will take them to take care of their own financial needs.
5. Your first year of insurance premiums go to your agent as commission.
What do insurance agents say? It’s such a beautiful day today, don’t you think?
The Facts: Life insurance policies are front-end loaded insurance policies. This means that most of the commission earned by agents is paid in the first year. For term life insurance, agents receive 70% to 90% of the first year premiums and 5% to 10% of the premiums from the second to tenth years. Whole life insurance policies, which involve much larger amounts, pay agents 50% to 85% of the first year’s premiums and also 5% to 10% of the next nine years. In other words, not a penny of what you pay the first year goes toward the cash value of your whole life insurance policy. In fact, your insurance agent’s commission will probably push your policy’s value into negative numbers for the first few years. (Renaissance Group)
The Bottom Line: There’s nothing wrong with successful agents making a decent living, but you must take into consideration incentives when listening to the advice of insurance agents. If you were a car salesperson and were paid twice as much for selling a BMW than for selling an Audi, which brand would you sell the hardest?
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