In this episode, podcast host and author of “Control Your Retirement Destiny” Dana Anspach covers Chapter 6 of the 2nd edition of the book titled, “Life and Disability Insurance.”
Or, if you are looking for a customized plan for your retirement, visit us at sensiblemoney.com to see how we can help.
Chapter 6 – Podcast Script
Hi, I’m Dana Anspach. I’m the founder and CEO of Sensible Money, a fee-only financial planning firm. I’m also the author of Control Your Retirement Destiny, a book that covers all the decisions you need to make as you plan for a transition into retirement.
The book has incredibly thoughtful 5-stars reviews on Amazon. If you like what you hear today, go to Amazon and search for Control Your Retirement Destiny. Or, if you are looking for a customized plan, visit sensiblemoney.com to see how we can help.
This podcast covers the material in Chapter 6, on life and disability insurance. Both types of insurance can protect you and your family against risks that can derail your retirement security.
Today, I’ll be teaching you how to assess your insurance needs, and how those needs change over time.
Let’s get started.
As a financial planner, I think of financial products as tools… perhaps in the same way a carpenter might view his or her own toolbox. You look at the job, you look at the tools, and you figure out which ones will help you most effectively do the job.
Insurance is a financial tool. Unfortunately, many of us have an instant adverse reaction when we think about insurance, or even hear the word. I believe this happens because most of the time our experience with insurance is associated with either a salesperson trying to get us to buy more, or a benefit selection page where we feel like we are just guessing as to which options to pick.
Overall, we don’t have very many positive experiences with insurance.
That means you have to do a bit of a mental shift to begin thinking about it as a tool. For example, what if you begin thinking of insurance like a seat belt? Then, you view it as a safety feature. Hopefully you never need it, but, if you do, you’ll be glad you got in the habit of buckling in.
Of course, it’s a bit more complicated than that - because the type of insurance you need changes as you age and as your financial situation evolves. Overall, though, both seat belts and insurance are there to protect you against a risk – a risk that you hope never materializes.
Let’s discuss how to think about this type of risk.
Any conversation about insurance should start by assessing your exposure to a financial hardship, as insurance is all about shifting risk. When you buy insurance, you choose to pay a known premium so that if a devastating event happens, the insurance company bears the bulk of the financial burden.
Not all risks are equal. Take the common example of your home burning down. Although unlikely to happen, if it does burn down, the consequences are severe. Therefore, if you own a home, you carry homeowner’s insurance. You choose to pay a reasonable premium to minimize the financial impact of such an event.
Contrast that with death. There is no argument that death is a high-probability event. There is no question of “if” it will happen – it’s only a matter of when. The severity of the financial impact, however, depends on where in your life cycle it occurs, and who is financially dependent on you at the time.
If you’re young, and have a spouse and children, your premature death is likely to cause a big financial hardship for your family.
But, if you are retired, and either single, or your spouse will have the same income and resources regardless of your death, then the financial impact of your death is minimal.
Thus, in your younger years, particularly if you have dependents, death is a low probability but high severity event.
In retirement, it changes, and becomes a high probability and low severity situation.
When we apply this to your need for life insurance, it means when you are younger and still have many high-earning years ahead of you, you need a pretty large amount of life insurance. You buy it to replace the future income you would have earned.
Once retired, you don’t have any more future earned income to replace. If you’ve done a decent job of saving, there is likely not a need for life insurance any more.
Now, am I saying that no retiree ever needs life insurance? No. It’s not that easy. There are cases where you do continue to need life insurance, and there are cases where you may already own a policy that you bought when you were younger – and it may not make financial sense to cancel it.
To understand where you fit in this framework, let’s look at two things. First, I’ll briefly review the two main types of life insurance. Then we’ll look at cases where you may want to keep life insurance even in retirement.
Life insurance is sold in two main categories – either term insurance, or permanent insurance.
Term insurance works much like car insurance. You pay and if an accident happens, the policy pays out. There is no cash value to your policy with term insurance.
If you don’t need the insurance any more, you stop paying the premium, and the policy expires. This type of life insurance allows you to buy a fairly large death benefit for a low cost. It’s a great choice for most people when they are younger and need to protect their family. The terms usually last 20 to 30 years – which means in most cases you pay the same premium for a long time with the intention that you will let the policy expire at the end of the term.
Permanent life insurance has two components – an insurance component and a cash value piece. You pay a higher premium and part of that premium is used to buy the insurance – the other portion is deposited into a savings or investment account which is handled by the insurance company. Permanent life insurance comes in many variations such as whole life, universal life, and variable universal life. These types of policies can be useful for high-income earners, business owners, and in other situations where it appears you’ll need a life insurance policy in place for your entire life.
So, let’s take a look at five cases where life insurance may be needed for your entire life, or at least well into your retirement years.
One such case I came across was a couple whom I’ll call Matt and Tina. Matt was a high-income earner and Tina, who was 28 years younger, stayed at home to care for their three-year-old daughter. Their retirement assets need to last not just for 30 years - but because of the age gap, assets may need to last 60 years or longer. Rather than try to save that much, it was more cost effective for Matt to maintain a whole life policy of about $2 million. That policy is what will make their financial plan work through Matt and Tina’s joint life expectancy.
In another case, a woman I’ll call Pat came in and already owned seven whole life insurance policies issued by NorthWestern Mutual. Her father had been a life insurance agent which is how she accumulated so many of them. The policies were in great shape and it made no sense to cancel them. Instead, we were able to change how the policy dividends were used. With most whole life policies, you have choices as to how to use the dividends – for example you can use them to buy more insurance, to reduce your premium, or to accumulate more cash value. In Pat’s case, her dividends were set to buy more insurance; however, she didn’t need more insurance. Instead, she needed to reduce her monthly expenses. We reset the dividends to reduce her premium. This change saved her $3,000 a year.
Small business owners are another group who may need to carry life insurance into their later years. If you own an interest in a small business, you usually want to enter into an agreement with a partner who will buy your share of the business upon your death. This type of buy-sell agreement is usually funded with life insurance.
Another group that will likely want to maintain a life insurance policy are those with large estates – in this case the insurance helps pay taxes upon your death. Life insurance used to be sold to lots of people to pay estate taxes, but laws have changed, and today estate taxes apply only to individuals with estates in excess of about $5 million, or married couples with estates larger than $10 million. If you fall in that category, you may need to maintain life insurance to provide liquidity for taxes and other expenses that your estate will incur when you pass.
The last group who may want to maintain a policy are those who did not save much and are living on Social Security or a small pension. People in this situation may not have much in assets, but they have monthly income. And they don’t want their children or other family to have to pay their final expenses, and so they maintain a small policy to help cover those costs at their death.
We’ve talked about five situations where it makes sense to maintain life insurance. What if none of these situations apply to you and you WON’T need insurance in retirement, but you own a policy already?
The first thing to do is identify the point in time where the need for life insurance really goes away. If possible you maintain the policy until it is no longer needed. For example, if you are married and one spouse is waiting until age 70 to begin Social Security, then it may make sense to keep any existing life policies in place on that spouse until they reach the age of 70.
Your options also depend on the type of insurance you own. If you have life insurance through your employer, in most cases it goes away when you retire so you may not be able to maintain it.
Or, perhaps you bought a 30-year term policy at age 45. Even though you may not need insurance past age 70, if the cost is low you may decide to keep it to age 75, which is when the 30-year term comes to an end.
Or, if you own a policy that has cash value, you may have the option of converting it to a monthly income annuity, instead of cashing it in. Or in some cases, the policy is paid-up and earning an attractive return, so you might keep it as a viable safe investment choice.
If you decide to cash in a policy that has cash value, watch out! There can be tax consequences. You have to look at that and determine if it will generate a chunk of taxable income. If it will, you might decide to terminate the policy in a year where your tax rate is low.
In general, before canceling a policy, make sure you have considered your options. Canceling a policy is not something you want to do on a whim as it cannot easily be replaced.
Now, let’s shift the discussion from life insurance to disability insurance. Where would you put disability on the probability and severity risk map? Do you think it is a high or low probability event? And what about the severity of it?
I figure that unless I sustain brain damage, I can pretty much do what I do for a living. I could lose a limb, an eye, or become paralyzed, and still I would be able to write and think and help people sort through complex financial decisions. Overall, I figure the probability that I will become disabled is pretty low.
Reality and statistics, however, tell me the probability is higher than I might think. Here are a few facts about disability:
Prior to age 60, you have a higher probability of disability than death.
Women are at greater risk for disability than men.
And, risk varies by occupation.
Now, what about severity? Even though I am a firm believer that I have a low probability of becoming disabled, if it were to happen, the severity is high. I have been single most of my life, and there is not a second source of income to rely on. Knowing that, I maintain a disability policy that would replace 60% of my income if something should happen.
Will I always maintain this policy? No. When I reach my 60’s I should be at a place where I have saved enough that my investment income can replace my earned income. At that point, even though I might still be working, I would no longer need to maintain disability insurance.
In conclusion, as you near retirement, both the probability and financial severity of a disability go down. The closer you get to retirement, the more important it is to review your existing coverage and make sure it is still needed.
And, as we have discussed, needs change over time. Which means your financial planning process should include a periodic insurance review – perhaps you review policies every three years if nothing has changed, and more frequently if you are near retirement.
Thank you for taking the time to listen today. Chapter 6 of Control Your Retirement Destiny has additional content which can help you evaluate your insurance needs. Visit amazon.com to get a copy in either electronic or hard copy format.
Or, visit us at sensiblemoney.com to see how we can help you create a plan to transition into retirement.