Investors Need Life Insurance

No competent financial professional could argue that life insurance does not play a critical role an individual’s investment plan. The purpose of life insurance is to ensure that the capital your family needs is available if you should die prematurely before you have had a chance to accumulate your own capital. Life insurance has also proved essential to the millions of people who, during the 2008-2009 market crash, lost up to 60% of the value of their retirement plans. The capital from life insurance proceeds replaced the lost investment capital for those who may have died before having an opportunity to recoup their losses.

When the debate is narrowed to the issue of using life insurance as an investment vehicle, the lines are more clearly drawn. Most planners would agree that insurance and investments serve two distinct purposes and that the two should be maintained as separate financial instruments. It should be noted, however, that life insurance was, at one time, a primary instrument for savings for a long while during and following the Great Depression when confidence in the banking system had evaporated. Cash value savings accounted for a large percentage of funds that were used to buy homes and supplement retirement incomes during the 1950s, 60s and 70s for the generations that emerged from the Great Depression and World War II.

Life Insurance is not an Investment Product

Since then, the financial industry has churned out an ever expanding menu of investment products and alternatives that provide even the smallest investors with access to the financial markets, and the U.S. Congress has created retirement planning options, such as IRAs and 401(k) plans for all workers to be able to take advantage of tax incentives and growth opportunities for their retirement savings.

Concurrently, the life insurance industry developed a number of insurance products designed to compete with investment products by offering investments wrapped inside of a life insurance policy in the form of managed investment accounts with variable life and high interest savings accounts with universal life. Both products offer attractive investment opportunities that parallel mutual funds and bank CDs respectively, but with the added benefit of tax free growth and access to the account values.

It is these life insurance products which lie at the heart of the insurance and investing debate. Although billions of dollars have flowed into these products over the last few decades, planners and pundits argue that people may be misguided if they are using these life insurance policies as investment vehicles. At the crux of their argument is the fact that investors should instead by maximizing their contributions to their tax qualified retirement plans, especially employer-based plans in which employer matches a portion of the contribution.

It’s not likely that they would receive any argument over that very valid point. Not only do qualified retirement plans offer current tax breaks that should be fully utilized, it is essential that people have a separate investment account earmarked specifically for retirement. To do otherwise can diminish the chances that you will accumulate enough assets to provide for a secure retirement.

Investment-Oriented Life Insurance as a Viable Protection Alternative

Taken in a different context, an equally strong case can be made for investment-oriented life insurance such as variable life or universal life, and to some extent, even whole life. Many people prefer permanent life insurance over term, or temporary life insurance for a number of reasons.

• They recognize that their need for life insurance will continue beyond a term policy’s expiration

• They want to protect their insurability.

• They are using life insurance to protect a business, fund business succession, or maximize the transfer of their estate.

• They recognize permanent life insurance to be a means of accumulating tax favored savings in addition to their qualified plans.

• They recognize that permanent life insurance may provide a more cost-effective means of maintaining life insurance coverage for the long term.

Those people who, for whatever reason, prefer to use a permanent life insurance policy for their protection needs, all have varying degrees of investment risk tolerance, and some are more likely to select an investment oriented product such as variable life because they prefer that their money have the opportunity to earn above average returns. Others are satisfied if they know that their money at work is earning competitive interest rates such as those available with universal life. Therefore, they might make the decision to “mix” insurance with investing to put the premium dollars that they are going to contribute anyway to work a little harder.

Their objective for their investment-oriented life insurance is not necessarily to get rich, or to replace their qualified retirement plans, rather, it is to provide for permanent life insurance protection that, through the opportunity to earn higher returns, could also create an asset that could provide supplemental income, or, perhaps, could provide the means to pay for their permanent coverage.

Critics will argue that these types of policies are loaded with expenses that can impede the growth of cash values, and therefore, are not good place to put your money to work. While these policies do have expenses, such as insurance and administrative costs, not found in non-insurance investment products, it shouldn’t bother the person who prefers permanent life insurance coverage that the net return of a variable life policy is 1% lower due to expenses, because their premium dollars are also providing the protection for which they are intended.

Variable life and universal life policies can provide higher returns than would otherwise be earned if your money instead sat in a low yielding, taxable savings account. Expenses can eat into returns over the long term, but many of the newer products available have cut their expenses significantly and many are available without sales loads. It is important to shop around and conduct a thorough comparison to find the most efficient investment-oriented life insurance.

Mistake #1 – Failing to Recognize the Real Reason for Life Insurance

You know you need life insurance, but do you understand your real reason for owning it? Yes, it will pay off your family’s debt, and provide for a college education for your children. And, it will be a much needed source of income for your spouse when your income stops. Those are the practical needs for life insurance, which, as discussed in the next section, are vitally important to the buying process.  But, unless the purpose of life insurance is understood at an emotional level, it will remain in your mind as a “need-to-have” as opposed to a “must have” which makes it somewhat expendable.

From your family’s perspective, the purchase of life insurance is one of the most unselfish acts of love and devotion to your family you could ever commit. While they may not recognize it in that way while you’re alive, it will be the way they remember you if the unthinkable happens.  For you, there is nothing you can buy that will give you the sense of satisfaction and the absolute peace-of-mind knowing that your family will not want for the things they need to live the life you envision for them. Those are the real reasons for life insurance.

Mistake #2 – Not Buying the Right Amount

One of the worst feelings is to wander through life wondering if you own enough life insurance, or worse, wondering if you own too much.  In either case, you wind up second-guessing your purchase because you don’t know if it will do enough, or, you are concerned that you’re paying more than necessary to protect your family. Why guess at the amount you need when you calculate, with much more certainty, the amount you really want?

Determining your need for life insurance is not an art – it is a mathematical science based on known facts and hypothesis to arrive at solid solution.  The facts are clear. Your family has a specific amount of debt that needs to be repaid.  You have certain obligations such as ensuring your children will have educational opportunities. Your family will have specific income requirements for be able to maintain their lifestyle. You currently have a specific amount of assets that are available and your family may have other sources of income that will be available to them after your death. Those are the facts.

Next, you hypothesize about the future so that you can apply some assumptions, such as the increase in the cost-of-living over time and the growth rate on capital including the proceeds from life insurance. This will enable you to calculate how long your assets and life insurance proceeds will last.

You can make some assumptions as well about how long the need for life insurance will last. For instance, once your children have graduated from college they should no longer be dependent on your family’s income.  If you have children with special needs, however, their dependency may last a while longer.  You can also assume that your spouse can eventually replace your lost income with his or her own earnings, however, it is important to account for a spouse who may not have the earning capacity to do so.

Using this practical planning approach, the amount of life insurance you will want to own will be based on a real life look into the future with actual facts (your current situation) and honest assumptions (inflation, growth rate and needs assumptions) so you will know it is the right amount.

Mistake #3 – Buying the Wrong Kind of Policy

With life insurance you have many choices which can work to your favor if you recognize the importance of matching the type of policy to your specific needs and wants.  The mistake many people make is to follow the advice of someone who knows little or nothing about their situation. You might read an article about why everyone should just buy term life insurance because it is the cheapest. Or, you might get an earful from a colleague who is raving about his variable life insurance plan. Your life insurance solution should stand on its own based on your needs, preferences and priorities.

Term life is an excellent choice for people are prescient enough to know when their need for life insurance will cease to exist. For people who are a financial track that will ensure that they will accumulate enough of their own assets, the need for life insurance may diminish over time. A tragic mistake that some people make is buying term because it can save some money currently only to find that their need for protection continues. They could find themselves in a situation where they need to repurchase some life insurance, but they can’t get it because they aren’t insurable or because it too expensive.

Permanent life insurance is not for everyone as well as it is a more expensive solution in the beginning.  But, for people who recognize that their need for protection is likely to continue beyond 15, 20 or even 30 years, it can be a much more cost-effective way to own life insurance for the long term.  The cash value growth in permanent policies is not only way to accumulate savings, it can be applied to pay for the premiums at some point so the policy becomes self perpetuating for life.  The same life insurance you bought to protect your young family will remain available protect a family business, or supplement your spouse’s income, protect your surviving spouse’s retirement income against investment losses, or protect the value of your estate from taxes and settlement costs.

There are many different types of permanent life insurance plans, such as whole life, variable life, universal life, variable-universal life.  Each has features and characteristics that can benefit people in different situations.  It would be well worth your while to study each of them to determine which would be the best match for you.

When shopping for this investment vehicle, most buyers compare annuities to evaluate which is best for their own situation. Comparing the overall annuity product, one can look at fixed, variable, tax-deferred, guaranteed, inherited, and equity indexed annuities. These terms refer to the different features that can be applied to the basic annuity product. Some of these features are great for certain investors, while others are not. The important factor to remember is that once you have decided on the type of annuity to purchase, you still must compare products within that category.

Considering Fixed Annuities

Fixed annuities are investments issued by insurance companies that are primarily geared towards retirement savings, and promising the investor a fixed series of payments for a predetermined length of time. Not all fixed annuities are the same, so investors must compare one fixed annuity with another in a couple of key areas.

First, there are two options for owners of fixed annuities when it comes to paying premiums. The first is the installment premium method where the annuity owner pays premiums over an extended period of time: say, 10 years, and the other is a single premium method whereby the owner makes one lump sum into the annuity account.

Next, fixed annuities typically provide the account holder options as to how benefits will be received, utilizing one of two distribution methods. Account owners must compare the annuity payout method to determine which will work best for them. These payout methods can be immediate, where the annuity issuer begins payments right away, or within a very short period of time, until both the initial investment and the interest are depleted. Deferred fixed annuities wait until the end of a specified time period prior to paying out funds. This time period may be a certain number of years, or it may be when the annuity owner reaches a certain age such as 65 or 70.

Once a time period is selected for payouts to begin, one must also compare the length of time that their fixed annuity will pay. There are primarily three payout periods with fixed annuities.

• Life annuities pay income benefits to the annuitant as long as he or she is alive. With this option, benefits cease once the annuitant passes away.
• Term certain annuities offer payments that are received until a predetermined date or term. If the annuitant were to pass away during the predetermined time period, the insurance company keeps the remaining value of the annuity contract.
• Life with term certain is a third option. With this type of annuity, payments are received as long as the annuitant is alive, however, if they were to pass away during the predetermined time period, benefits would continue to be paid to a beneficiary for the remaining term of the fixed annuity contract.

Considering Equity Indexed Annuities

Most fixed annuities only credit interest calculated at a rate set in the contract, whereas equity indexed annuities earn interest that is linked to a stock or other equity index.

Equity indexed annuities promise to pay a minimum interest rate. When comparing one indexed annuity to another, the following features must be considered: First, compare which indexing method the annuity contract uses to calculate interest. Next, compare the annuity participation rate, meaning how much of the increase in the index will be used to calculate the index-linked interest. In addition, the cap or cap rate must be compared. Some annuities may put an upper limit, or cap, on the index-linked interest rate. This is the maximum rate of interest the annuity will earn.

Indexed annuities can also be compared by looking at the floor on the equity index-linked interest. This floor is the minimum interest rate that the annuity owner will earn. A common floor is 0%, assuring that even if the index decreases in value, the interest rate earned will not be a negative amount.

An indexed annuity can improve the owner’s earnings potential, while at the same time keeping principal safe from market fluctuation. For retirees seeking no downside risk, an indexed annuity could be a good option. However, investors must compare these annuity features to make sure they have the right investment for their needs.

Considering Variable Annuities

In contrast to fixed annuities, variable annuities provide the opportunity for market appreciation through a variety of investment options, with tax deferred accumulation, as well as future income.

Factors to consider when shopping for a variable annuity are fees, fund choices, surrender charges, and financial strength of the issuing company. Compare the variable annuity fund choices available as well as their performance over time. With a variable annuity, one should compare like funds and sub-accounts, for example large-cap growth versus other large-cap growth funds.

Most variable annuities allow the account owner to withdraw either their interest or their interest earnings up to 15% per year without penalty. However, in doing so, most variable annuities also have a surrender charge for making an early withdrawal above these limits. Investors must compare variable annuity surrender charges, as they can differ significantly from one annuity to another and one company to another. Some companies have surrender charges for up to seven years, while others may be as long as ten or more years.

Insurance Ratings as a Final Crucial Factor

An annuity, regardless of whether it is fixed, equity indexed, or variable, is only as good as the insurance company that issues it. Investors must compare the financial strength ratings of the company issuing the annuity to ensure that the company will be there to make good on its obligations.

Buried beneath the straightforward life expectancy tables is a statistic that is of special interest to investors and financial planners. And that is the life expectancy beyond the retirement age of 65. Once someone reaches the age of 65 statistics show that person is likely to live an additional 16 to 19 years. That number has, like life expectancy, improved steadily in the past several decades. Researchers predict that these numbers will continue to increase.

So as we’ve learned to take better care of our physical selves and done what we can to extend the Golden Years so too have we learned to take better care of our financial selves. We can be assured that the years we’ve added on to our lives can be free of financial worry. How have we done that? Through a vast array of financial products, but, most notably through the use of annuities.

A Definition

What are annuities exactly? The best way to think of an annuity is to look at it as a savings account that you’re not supposed to use until after you’re retired. An annuity takes parts of two other financial tools—life insurance and retirement planning—and combines them into one versatile investment strategy. It features the guarantee that comes with a life insurance policy as well as the growth that comes with a retirement savings account.

How It Works

There are many different types of annuities but the one that is most appealing to people who want to have financial peace of mind after they retire is a life time annuity. A lifetime annuity is, first and foremost, about security. In this way, it is very much the most traditional of all the annuities. The investor, seeking security, pays an insurance company an amount, over time or all at once, that he believes will be sufficient enough to provide him income in his old age. Inherent in the agreement between the investor and the insurance company is the guarantee that no matter how long the investor lives he will be provided an income. In order to keep their side of the bargain, the insurance company takes the money that has been given to them by the investor and invests it high-rated government and corporate securities. The earnings that accrue from these securities will help the insurance company pay back those investors whose life spans exceed the statistical norms determined by their actuaries. Over the course of time the insurance company knows that the money earned through the investment of its clients’ money will surpass the amount it pays back.

Mutually Beneficial

While there’s no doubt that the insurer benefits from the concept of the lifetime annuity, the benefits to the insured are quite substantial as well.

In addition to providing guaranteed income for the investor for the remainder of his life, some lifetime annuities can have a death benefit as well. Should the investor die before he has received all of his initial investment, the remaining amount can be distributed to his beneficiaries. There are plenty of variations in the way in which the remaining amounts can be distributed. Who gets what and when is a question an investor can address in many different ways, which is also a source of comfort.

When an investor decides to place his money in a lifetime annuity he is making a conscious choice to ignore the lure of potentially large earnings in exchange for stability. Many other retirement options—mutual funds, IRAs, 401ks—are subject to the whim of market forces whereas the fixed lifetime annuity is not.

That being said, lifetime annuities can have just as many features as are available in other annuities with respect to contribution and distribution. The lifetime annuity is most closely related to a Fixed Annuity, an annuity meant to minimize risk and guarantee return. Slightly riskier is the Indexed Annuity and riskiest of all is the Variable Annuity.

It may seem that a Variable Annuity and a Lifetime Annuity aren’t necessarily a good fit, but it’s important to note that one’s willingness to take on risk is not the same throughout an entire lifetime.

Another great benefit of the Lifetime Annuity is that it’s an excellent match for investors who’ve just purchased an immediate annuity with either their own savings or as a result of rolling over their company-sponsored plan. They can take this money and spread it out over the course of their remaining years in the interest of guaranteeing income and financial stabilization.

Taxes

One of the great features of a lifetime annuity is that while wealth is being accumulated it isn’t being taxed. Unfortunately, that changes once the distribution of the money begins. The distribution will be comprised of both principal and interest, with the interest portion getting taxed at the rate of ordinary income. Even though income rates are probably lower in retirement than they were at earlier points, the rate of taxation is still higher than it would be on capital gains. Still, annuities explained can offer tax advantages over other retirement vehicles like the 401(k), which gets taxed principle + interest upon withdrawal.

Conclusion

A noted financial adviser once said that annuities are kind of like the opposite of a life insurance policy. Whereas life insurance allows for financial security in the event of dying too soon, annuities allow for the financial security of living longer than expected. At some point we transition from worrying we’ll die young to worry that we’ll live too long. The lifetime annuity more than capably addresses this concern.

The Basics

An Immediate Annuity is an annuity that is payable within a very short period of time after an account has been opened. Typically, a lump sum of money is deposited into an account and then it is distributed back to the depositor in specific amounts at specific intervals.

As an example, let’s say an investor has just retired and has received $240,000 from the 401k he had with his employer. He wants to utilize that money as an income stream for his retirement. If he chooses to invest it in an Immediate Annuity, he will be taking the money from his 401k and placing it an interest bearing account. He then must decide how often he wants to distribute the money back to himself and in what monetary increments. He can choose to spread out the re-distribution over a fixed period of time, say 10 or 15 years, or over the remainder of his lifetime. Either way his deposit gains interest and he can access his account usually within a month after it was opened.

A Deferred Annuity is an annuity that is paid into over a longer period of time. An investor may choose to place $100 a month in his annuity for 20 years. He would, before interest, end up with the same $240,000 as the investor in the previous paragraph (240 months X $100). Of course, he can deposit more or less money and do it over a longer or shorter period of time. He can base his deposits over a defined length of time or he can choose to deposit money until his account reaches a certain amount total. These variables will affect the interest rate he receives on his deposits.

Benefits and Costs

The benefit of a Deferred Annuity is that it allows for flexibility in the case of the depositor. It is very user friendly in that it can be customized to meet different financial and chronological needs. The trade off is that there will be a level of uncertainty in the rate of return.

Conversely, the Immediate Annuity is inflexible in that it is locked in to a particular rate of interest and rate of repayment. But the recipient of an Immediate Annuity has a greater level of certainty than the recipient of a Deferred Annuity.

To Each His Own

The Immediate Annuity is perfect for someone who wants to have stability in his income stream during his retirement and is able to invest a reasonably large sum of money at one time. As mentioned above, it is common for people who have cashed out their 401k to then convert the proceeds from that into the guaranteed income that comes with the Immediate Annuity.

Another group of people besides recent retirees who often utilizes Immediate Annuities are the beneficiaries of a lawsuit and lottery winners. Generally, any person with a lump sum that they would like to use it as income protection for their later years.

The Deferred Annuity is a great option for people who are unable to invest a large amount of money at one time and those far from retirement. Many people who are still in the workforce utilize the Deferred Annuity as a tool for their retirement planning. Investors who opt for the Deferred Annuity can take advantage of high interest rates over the course of many years whereas investors with an Immediate Annuity are subject to the interest at the time of their lump sum deposit. Still, it is entirely possible that a person could take the money earned from a Deferred Annuity over the course of 15 or 20 years and later invest it in a product that guarantees income, such as the Immediate Annuity. In fact, this is a typical retirement strategy.

Distribution

While the way money gets into an annuity is straightforward—it’s either a lump sum or contributed over time—the way it’s distributed back to the account owner can vary considerably. Many people link their annuity to a death benefit. For example, if there is still money remaining in their account at the time of their death, the account owner may have attached a rider to their annuity that acts as a provision for the re-distribution of the funds. The term Period Certain refers to a death benefit from an annuity that is to be paid out over a fixed period of time.

Some people simply take their distribution and then re-invest it in a whole life insurance policy rather than wait for a death benefit.

These examples are merely the tip of the iceberg as there is a seemingly endless array of strategies available for investors when it comes to distributing the funds from their annuity.

Taxes

From a taxation standpoint, the Deferred Annuity is preferable to the Immediate Annuity if only because along with deferring income it also defers taxes.

Once the money from an annuity is distributed, the income portion is still taxed as regular income and the corresponding rate. Deferring taxes until retirement is good tactic since most people won’t be in their highest earning years and subject to the rate of taxation they were while they were still working.

As with most investment planning tools the IRS wants to do everything it can to motivate taxpayers to keep money in their retirement accounts. The way they motivate people with annuities is by taxing them at a rate of 10% should they withdraw their funds prior to the age of 59 ½. This is in addition to any fees that the insurance company would charge the account holder for early withdrawal. The IRS places identical disincentives on 401(k) and IRA accounts.

A Final Note

With any annuity there are many factors that can affect interest rates and rates of return, such as the amount and frequency of the deposit and insurance company issuing the contract. Be sure to make use of all the online resources at your disposal to help determine which annuity is right for you.