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Financial Planning Basics: Permanent Life Insurance

This month we cover some of the basics of permanent life insurance.

Financial Planning Basics: Permanent Life Insurance

By Scot Whiskeyman

Nothing lasts forever, but what if you could own something that at least lasted for a lifetime?

Last month, we covered term life insurance, and discussed the difference between your coverage through work and owning your own individual policy. We mentioned that it’s important to consider buying a term policy from a company with a good mix of life insurance products, and that offers you the option to convert your policy to a permanent one.

This week, we’re going to pick up where we left off, and discuss the different types of permanent insurance and its upsides and downsides.

The Permanent Insurance Universe

There are four major types of permanent life insurance: whole life insurance, guaranteed universal life insurance, indexed universal life insurance, and variable universal life insurance. While not exhaustive, this is the list of permanent insurance products that impact most of our clients, so it’s what we’re going to focus on.

Whole Life Insurance

Whole Life Insurance is the original permanent life insurance – well, actually, it’s the original life insurance, period. Designed to provide a death benefit that will last forever, whole life insurance builds cash value over a lifetime, can pay eventually pay for itself, and even help cover the costs of long-term care.

Choose Whole Life Insurance if you want:

  • Life Insurance you never have to worry about getting again
  • Automated (and effectively mandatory) savings
  • Supplemental retirement income
  • An alternative source of cash you can use throughout your life without being penalized
  • To avoid the risks that come with investing in the market

How it works:

  • Sometimes referred to as “the Cadillac” of life insurance policies due to its features
  • Builds cash value that can be used throughout your lifetime, or in retirement
  • A “non-correlated” asset, meaning the performance insider is not linked to the stock market
  • Can often pay for itself after enough cash has been accumulated
  • Can provide tax-free income in retirement

Universal Life Insurance

What exactly does the “universal” in Universal Life Insurance mean?

To be honest with you I have no idea.

But I can tell you universal life policies have been around since the early 1980’s, and have changed a lot since then – for the benefit of the policyholder.

When they were introduced, interest rates – and inflation – were at all time highs. Major insurance carriers took advantage of this by creating a new product: one that was similar to whole life in that it built cash values, but different in that its interest rates were variable and paid no dividends.

The results? Catastrophe.

Policies collapsed once interest rates fell from double digits. Agents and insurance companies did not project the historically low interest environment of the late 2000’s. Thus, the cash value couldn’t even keep up with internal costs, causing policies to collapse.

Today’s Universal Life policies really share nothing more than a name with their predecessors. Rather than being dependent on interest rates, new policies function with performance linked elsewhere.

There are three major types of of Universal Life policies used today:

Guaranteed Universal Life Insurance (“GUL”)

  • Resembles term insurance in that it doesn’t build cash value
  • Resembles whole life insurance in that it is often guaranteed until your mid-90’s or beyond
  • Great for individuals 55+ with a permanent need for coverage, but who don’t want to pay the much higher cost of whole life insurance
  • “No-lapse” guarantee – the policy will last forever as long as you pay your premiums on time

Indexed Universal Life Insurance (“IUL”)

Choose Indexed Universal Life Insurance if you want:

  • Life Insurance you never have to worry about getting again
  • Automated (and effectively mandatory) savings
  • Supplemental retirement income
  • An alternative source of cash you can use throughout your life without being penalized
  • More opportunity for cash value growth than you’d get in whole life insurance

Variable Universal Life Insurance (“VUL”)

You might consider variable universal life insurance if you want:

  • Life Insurance you never have to worry about getting again
  • Premium flexibility – you want to be able to use policy cash values to pay for the premiums
  • Supplemental retirement income
  • An alternative source of cash you can use throughout your life without being penalized
  • The maximum opportunity for cash value growth in a tax-favored vehicle

Criticism of Permanent Life Insurance

You won’t hear many financial pundits say favorable things about permanent life insurance.

The common criticisms are that it’s expensive, and the cash value build up – at least inside of whole life insurance – would perform better if invested elsewhere, specifically a stock market index like the S&P 500.

Here’s my response to that criticism: first, financial security is expensive.

The powerful things whole life can do for you that term cannot more than warrant the premium.

Second, who was it that decided to compare whole life insurance to the stock market – or even call it an investment- in the first place?

“Buy term and invest the difference” makes a lot of assumptions (and it’s wrong to make assumptions in financial planning!).

First, it assumes that anyone who wants whole life insurance would also be comfortable being 100% in stocks. As you can see from the chart above, whole life offers lower growth potential, but it offers more guarantees.

Second, if you have permanent life insurance, you have to pay for it, or you’ll either lapse your policy or have to reduce your death benefit.

What’s at stake if I decide to turn off that automatic investment plan? Whole life insurance encourages one of the most important financial behaviors anyone can possess – disciplined saving.

Finally, the idea that one needs to either select term insurance or whole life insurance is a false dichotomy. Few individuals will be able to cover their entire insurance need with whole life insurance, because it would be cost prohibitive. However, there’s nothing wrong with having a foundation a permanent insurance – perhaps that’s guaranteed to be paid-up at retirement – so that when your term insurance is gone, you’re not left unprotected.

Why Someone Might Need Permanent Insurance Later

It’s common for people to think that beginning in retirement and beyond, life insurance isn’t necessary. Their rationale is that once they’ve retired, they’ll have accumulated wealth and have guaranteed income sources, and that they no longer have children who depend on their income. However, it’s important to understand that while the scope of your needs might change in retirement, the need isn’t altogether gone.

Many people aren’t aware that if both they and their spouse are collecting social security, the smaller of the two benefits disappears at the first death. This might not be a big deal if the smaller benefit is a negligible amount, but what if it makes up half of a retiree’s income?

Though less common, pensions have the same problem – the benefit is often reduced or even eliminated upon the first death. What will you have to sacrifice to live on that kind of reduced income?

If you’d thought about whole life insurance 30 years ago, you’d be relieved. Unfortunately, many people haven’t, which puts them in the unenviable situation of applying for insurance later in life, which dramatically increases the cost.

It’s also important to remember that life insurance death benefits are almost always tax free.

For those in states that have inheritance taxes (including Pennsylvania), this suddenly makes permanent life insurance much more attractive, especially after you consider income taxes beneficiaries will have to pay on inherited retirement accounts, court costs, and the time-consuming and expensive probate process.

The Bottom Line

Permanent life insurance has a place in everyone’s financial picture. The key to financial success is to think big and start with a small action.

Getting permanent insurance into place, or reviewing what you already have, could be that first step.

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