[Editor’s Note: Yes, the Physician Wellness and Financial Literacy Hybrid Conference (WCICON22) has begun. But it’s definitely not too late for you to join us virtually! When you do, you’ll have lifetime access to the 50-plus hours of presentations, and you can participate in live Q&As, sponsor giveaways, and session chats. You’ll also be eligible for up to 17 hours of CME! Make an investment in yourself and sign up for the virtual version of WCICON22 today.]
By Seth Burstein, Guest Writer
One day I was thinking about my life and realized that enough people depended on me financially that getting a life insurance policy was a responsible step to take. I was married, had a beautiful little girl and had just bought a house in the suburbs. I decided it would be a good idea to make sure everyone was provided for if something went really wrong.
I’m an actuary, so I know more about this than most people, but I’m not a life insurance actuary (I’ve worked on things like home insurance and workers’ compensation). Anyway, I called an insurance agent and asked him to advise me on the best policy. “Do you have a mortgage? ” she asked. I did. Then the best option was a 30-year policy to cover the mortgage, a little extra for expenses, and send the kids to college. The policy didn’t seem too expensive and I was a little sleep deprived, so without much thought I bought it. It was a mistake.
I haven’t thought about politics for years. Then, on the eve of an operation, I was sorting out my finances with my wife and remembered the life insurance policy. How much was the payment? I looked at it and quickly realized that I hadn’t made the best decision.
Overinsured or underinsured? Depends on when the death benefit is paid
Here’s what I realized: If I died near the end of the 30-year term when all my retirement savings were in place, the mortgage was (almost) paid off, and my kids were out of college, then the death benefit would be largely, if not entirely, an unnecessary windfall. But if I died tomorrow, it wouldn’t be enough to replace all the investment income and profits I would create over the next 25 years. In the first scenario, I was overassured. In the second, I was underinsured.
Why did I buy this one policy that wasn’t good for now but also wasn’t good for later? This is a mistake many people make, but as an actuary I thought I should have known better.
Good news: the operation went well, but it was time to rethink the way I had structured my life insurance coverage. When I thought about it, I came to the conclusion that I needed a lot of short-term coverage in case I died and my family was in dire need of replacing my income. Luckily, being still healthy and relatively young, this coverage was somewhat inexpensive. Then, as the need for coverage diminished, the policies could shrink. In fact, what I really needed was a series of layered or laddered policies.
What do I mean by that? Let’s look at some math and some graphs to illustrate
Note that for the purposes of my illustration, in all of the scenarios below, you are a healthy 35 year old male earning $100.00 per year, is taxed at 25%, gets a 2% raise each year and plans to retire at 65. Any investment you or your spouse make pays an annual return of 5%.
How to layer your life insurance policies
Before you dive in, know that even if your goal is to replace all your future income, you don’t need your life insurance payout to equal the sum of all your future income. The payment will be less because, received as a lump sum in advance, it will earn interest over time. In the graph below, the orange line represents the sum of all future earnings. The blue line represents the amount that would have to be paid in a lump sum to replace the sum of future earnings, a considerably lower number in the early years.
[Editor’s Note: you can click on all the graphs below to get a larger view.]
Scenario 1: If you were to buy a 30-year life insurance policy
Let’s say your agent tries to match you on your mortgage and strongly suggests a single 30 year policy, like mine did.
In this scenario, a $1 million policy is the optimal choice. It would cost you around $1,000 per year, with the total cost adding up to around $30,000 over time. On average, you would be $420,894 under or over insured, with age 54 as the dividing line, that’s huge! In the graph above, the blue area represents the amount by which you are underinsured and the yellow area represents the area by which you are overinsured. It’s a fairly typical policy. As you can see, however, this is not a good way to replace your income at all.
Scenario 2: If you were to purchase a single benefit life insurance policy
In this scenario, you also purchase term life insurance that pays the same death benefit regardless of the expiry date, but you can choose the duration. What is the “best” option?
The optimal choice if you can only buy one life insurance, but any term, is a 20-year, $1.5 million policy. This policy would cost you around $900 per year, with the total cost coming to $18,000. On average, you would be $300,798 under or over insured depending on which side of 54 you are on. It’s still not great, but, compared to Scenario 1, it’s 29% what you need and costs 40% less.
Now, truth be told, if you died right after your policy expired, that wouldn’t be great. But note that this simplified model does not take retirement savings into account, which would obviously ease the burden since you would no longer need these funds.
Scenario 3: You are able to ladder life insurance policies as you wish
This is where the math gets fun.
The optimal structure for this scenario is for you to purchase four simultaneous term life insurance policies: a $250,000 10-year policy, a $500,000 20-year policy, a $500,000 25-year policy, and a $250,000 policy over 30 years. The coverage resulting from this configuration would be: $1.5 million for 10 years, $1.25 million for 20 years, $750,000 for 25 years and $250,000 for 30 years.
See how layering your life insurance policies can work?
In terms of cost, your first year is going to cost you around $1,100, and it will drop to around $270 over the last five years. The total cost of all tiered policies would be approximately $26,000. That being said, on average, you would be underinsured or overinsured by just $95,203 over the life of the policy. Compared to the first scenario, this is a 77% “best fit” for your needs, which isn’t too bad! And it will also cost you about 20% less – double bonus!
Can you have multiple life insurance policies?
Fortunately, laddering life insurance policies is an option, but it’s a pain for most agents. So you have to ask straight up (why would they want to do four times the paperwork for the same amount of commission?). It can also be troublesome because you have less disposable income when you’re young to avail of things like life insurance; however, these policies are surprisingly affordable. As we saw in our example, a 10% increase in price could result in a 50% increase in coverage in the early years of the policy, when your family would need it most if the unlikely happened.
So if you are considering life insurance or have recently fallen into the trap of the 30 year old policy like me, call your insurance agent today and ask them about the overlay or the laddering of life insurance policies. Your single term policy is an inefficient use of your resources, but laddering creates a scenario that is both effective and efficient for the best possible outcome.
Do you have more questions about life insurance and what type of policies would be best for you? Hire a WCI-approved professional to help fix the problem.
Have you considered multiple life insurance policies? If so, what would your strategy be? How many would you have and for how much? Comments below!
[Editor’s Note: Seth Burstein loves numbers, optimization, and personal finance, all of which led him to co-found Fortunately.io—a tool that uses data to provide simple answers to challenging personal finance questions. This article was submitted and approved according to our Guest Post Policy. We have no financial relationship.]