Young adults starting out in life, especially newlyweds, need insurance. But what kind? As a start, a good term life policy likely is a smart move. Term life insurance will minimize the dollars needed to secure the appropriate amount of protection needed for their family and free up discretionary income to accomplish other financial goals. Other types of insurance may become more relevant as they age, have paid off debt, secured a home and are saving towards retirement and other goals. A good deal of misunderstanding surrounds insurance protection planning so let’s briefly talk brass tacks as it relates to younger families…
Consider a couple, basking in the glow of their recent and beautiful wedding. For them, death is an abstraction that seems a remote possibility. But a life insurance agent, a friend of the groom, suggests that as a newly married man he consider life insurance – namely a $200,000 whole life policy. In the sections that follow, we’ll look at why that is probably an unwise strategy.
Two Basic Forms of Life Insurance
Term insurance is pure mortality coverage (death benefit), paying off if the insured dies within a specified term, usually 10 to 30 years. It has no cash value element, where extra premium is invested and functions as a savings account for the policyholder.
Then there is mortality insurance combined with a cash value element, often referred to by agents as permanent insurance and which may be in force for life. This type of coverage comes in various forms, with the differences being how the cash value accumulates over time.
Whole life: the insurer pays an annual dividend, based on at least a guaranteed minimum amount to build cash values.
Universal life: the insurer pays interest which can fluctuate but has a minimum guaranteed amount.
Variable universal life: builds value based on a basket of separate accounts similar to mutual funds while offering premium flexibility.
Obviously, if a policy combines cash value with a death benefit, premiums generally are higher– and considerably higher at younger policyholder ages – than one would see on a pure term life policy.
Permanent life insurance is not all bad. Different types of policies have uses relative to estate and charitable giving objectives, so one cannot make a blanket statement as to what kind of contract is best. For our newlyweds though, who likely have many financial priorities competing for a finite amount of income, something like a 30-year term insurance policy might be the preferred solution.
Think About What Life Insurance Does
The primary purpose of life insurance is to protect someone from the economic implications of your death. Let’s assume that with our couple, they both worked. What if he died and she was pregnant, or they already had one or more children? As a widow, perhaps with children what would the loss of his salary mean to her and the kids economic security?
Conversely, if she died and he had to raise children alone, what would the loss of her income mean to the family? A sum of $200,000 invested at 4% net of taxes produces $8,000 annually, $667 in monthly income. Is that enough? Hardly.
Suppose he or she made $100,000 yearly. At a 4% growth rate, you need $2.5 million in face amount to generate $100,000 per year. For each $10,000 of annual income replacement needed, at 4% withdrawal rate, a face amount of $250,000 is required.
One criticism of term insurance is that it is cheaper because people outlive it and never collect. Oftentimes agents will say why “rent” when you can “buy”. It is true that much of term life insurance goes uncollected but look at the bright side – you lived! Besides who cares if you don’t collect; if you live to age 65 and diligently invest, building savings and financial independence in retirement plans and other investments, all while not having the stress of a larger monthly or annual expense associated with more costly insurance.
If you want insurance to continue past 65 or so, a contract that pays off no matter when you die is a valuable part of estate planning, but you typically don’t know what your estate needs or desires are until later in life. That’s what some variation of cash-value-building insurance is for and the good news is that a good term life insurance policy can be convertible to a permanent life insurance policy with the same carrier later in life without having to re-qualify through a health assessment.
Insurance Should Be Part of Your Plan
Holistic financial planning looks at all of your potential needs for insurance. Playing good defense helps to protect you and your loved ones from events that are out of your control. By getting the proper type and amount of insurance coverage you will maximize the money left over to play offense which is paying down debt and building wealth for future goals.