Retirement Planning
December 13, 2022

Life Insurance: Not Just a One-Trick Pony

Why to consider this often-overlooked aspect of retirement planning.
Stewart Willis

When you think of life insurance, what comes to mind? If you’re like most, you think of life insurance as a way to maintain income for your loved ones should you pass away. But life insurance can do a lot more than just that!

As its name implies, life insurance is meant to help your family cope with the loss of income when you die by paying out a death benefit. It can also be used to save for retirement! Some life insurance policies have a cash value component. This means some of your premiums go toward funding the death benefit, while the rest gets added as a cash value to the policy. That cash value can even accrue interest. 

Considering these added benefits, life insurance can be a very serious financial tool.Whether you’re ultra-wealthy or middle-class, life insurance should factor into your financial plan. While life insurance can help you save for retirement, it’s important to know how different types of life insurance work and what pitfalls to avoid when shopping for a policy.

There are several different categories of life insurance that will give you different benefits both while you’re living and after you pass away. If you have a policy through your employer, it’s likely term life insurance.

Term Life Insurance

Term life insurance is a contract between you and the insurance company with a defined period of time — the term — often spanning a decade or two. If you die within that timespan, the policy will pay a death benefit to the person or people you designate in the policy. Premiums for term life insurance are usually based on your age, your health as well as how much the policy will pay should you pass away.

Depending on the policy, determining your health status could include required medical examinations as well as answering questions involving whether or not your smoke, what medications you take and may even include evaluations of your driving record or your debt situation! Once the term ends, you can choose to renew under recalculated premiums, let the policy expire, or sometimes you can convert it to a permanent insurance policy.

Whole Life Insurance

There are several key differences between term life and whole life insurance. While term life insurance lasts for a specific period of time, whole life insurance does not, which puts it in the category of permanent life insurance.As long as you keep paying the premiums, the policy never expires. 

Also unlike term life insurance, whole life insurance has benefits for you, the policyholder, while you’re still alive. Term life insurance will pay a death benefit if you pass away, and that’s all it will do. If you’re still alive when the policy’s term expires, it won’t pay out and the insurance company will keep all of the premiums you paid.

Whole life, on the other hand, has what’s called a cash value component in addition to the death benefit. While part of your premiums go toward funding its death benefit, the rest go towards that cash value component. That component is your money. You can withdraw it or borrow against it while you’re still alive, but there’s an important thing to consider if you do this. Your death benefit will be reduced by the amount you withdraw or owe the policy from a loan.

The cash value component also accrues interest. Some policies have a low guaranteed interest rate while others have non-guaranteed rates that can be higher depending on how the funds they’re invested in perform. That cash value component means a whole life policy can be part of your retirement planning because it will have money you can use to fund your living expenses once you stop working.

Whole life premiums are usually locked in. You’ll pay the same premium the first month as you will the last month, even if there are decades between them. Because of that, whole life policies are often much more expensive than term life policies for younger people, but then become less expensive than term life policies if you keep the term life policy for longer than the initial term period.

Term life becomes more expensive as you age to mitigate the increased risk that older people carry while the policy is in effect. On the other hand, with a whole life policy, the company knows it is much more likely you will die when the policy is active and they will have to pay a death benefit, simply because the policy never becomes inactive as long as you keep paying premiums! By charging you higher premiums, the insurance company is hedging its bet that you will live long enough for them to make more than they pay out when you pass away.

Indexed Universal Life Insurance

There’s another, newer type of permanent life insurance called indexed universal life. Like whole life insurance, indexed universal life insurance has a death benefit component and a cash value component. Unlike whole life, indexed universal life has the potential for higher earnings. That’s because it’s tied to a given stock market index such as the S&P 500. As the index experiences gains, so does the cash value component of the indexed universal life insurance policy.

A particularly nice thing about indexed policies is that generally, they rise as the market goes up, but do not drop when the market does; they merely stop rising. Of course, because there’s no such thing as a free lunch, this means they will not rise in a direct 1:1 ratio with the market they’re indexed to, but instead at a lower rate. This is to mitigate the risk of market declines to the insurance company.

The end result is that you will make less in gains with an indexed universal life insurance policy than you would if you invested in the same market directly.However, you do not risk losing your principal and gains should the market experience a downturn as you do with a direct investment.

Choosing the Right Plan for You

There are many more life insurance products available, so how should you approach choosing which plan is right for you? The first consideration is to determine what purpose the life insurance policy needs to serve.

Are you more concerned with making sure your loved ones get a payout if you should pass away, or are you more concerned with building wealth? If it’s the former, you want a product built around the death benefits. If it’s the latter, you want a product that focuses on the cash value component.

That can sometimes be problematic based on how the agent selling you the policy is paid. Agents are often compensated by earning a commission based on the size of the death benefit, so there’s a natural tendency for the agent to want to make that benefit as large as possible. Sometimes this comes at the expense of the cash value component. That overinflation of death benefits costs you some of the potential retirement savings value of that policy.

That brings up another potential pitfall. If an agent is only in the business of selling life insurance policies, they might have a tendency to only recommend life insurance policies for any goal you might have, even if there are other avenues that would be more appropriate for your situation. In general, if someone exclusively recommends life insurance policies for all aspects of your financial plan, that’s a warning sign that you may not be getting exposed to the best available options, so it would be a good idea to seek a second opinion from a financial advisor. At Asset Preservation Wealth & Taxes we regularly help clients find the most prudent options for all aspects of financial planning, including life insurance.

As with most aspects of financial planning, choosing the right life insurance policy for your situation is complex. You should always consult with a professional before making any decision.

StewartWillis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.

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