Life Insurance (in Retirement) Part 1: The Most Common Use Cases + A 3-Step Process for Managing Risks
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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm kicking off our two-part series on life insurance in retirement. Specifically, I'll be tailoring these episodes to those who are already retired or close to it. And here are just a handful of the things that I'll be breaking down for you. First, what are the different types of life insurance and their pros and cons? How do you determine the need for life insurance? What are the costs? And more importantly, tax considerations to be aware of. The

How do you analyze an old policy and get straight answers from the insurance company? And then finally, I'll be sharing some resources for buying insurance policies without getting ripped off. So if you're finally ready to understand life insurance in retirement in plain English, this series is for you. For all the links and resources mentioned, head over to youstaywealthy.com forward slash 140.

At 22 years old, I was hired as a financial advisor by a large publicly traded wealth management firm. And on my first day, another advisor in the office kindly sat down with me to offer up some career guidance. And one of the questions he asked me was, do you know what the difference is? Or can you tell me the difference between a stock and a bond?

I had just graduated from one of the top undergraduate business programs in the country. I even had a brokerage account where I had a few stocks of my own, and yet I couldn't give them an answer. I was stumped and I was embarrassed. I couldn't clearly define the difference between a stock and a bond on my first day as a financial advisor.

The reason I'm sharing this is that we often talk about financial topics and make very important decisions around them, sometimes without ever stopping to challenge ourselves about what the thing is at its core, at its most basic level. For example, insurance. It's possible that we talk about insurance every day in some shape or form. It's a regular part of our vocabulary and day-to-day life.

iPhone insurance, travel insurance, pet insurance, homeowners insurance, health insurance. Heck, these days, it seems like every time you add something to your Amazon cart, you get a pop-up that asks if you want to buy a warranty, which is another form of insurance. But

But when's the last time you hit the pause button and really thought about what insurance is at its core? The technical definition is a practice or arrangement by which a company provides a guarantee of compensation for specified loss, damage, illness, or death in return of a premium.

But if we break it down into plain English, we might come up with something simpler like a means of protection from financial loss or a financial safety net that helps you recover if something unexpected happens or my personal favorite, a form of risk management. Really, my approach to retirement is to look at the types of risks my clients will face or might face in that phase of life and what kinds of assets best address those risks.

And life insurance is pretty good at addressing some of the risks that maybe other assets aren't. That was my friend and fellow financial planner, Stephanie McCullough. She's the owner of Sophia Financial out in Pennsylvania. And you'll be hearing more from her next week in part two of this series. But I loved what she said there. And I think it's the most appropriate place for us to start.

In this series, as you know, we're specifically talking about life insurance. So with our plain English definition of insurance in mind, how then might we define life insurance? Well, life insurance pays out a sum of money upon the death of the person who is insured. When you buy life insurance, you're managing the risk of death. More importantly, you're managing the risk of death causing a negative financial impact.

Life insurance is what's commonly referred to as an insurable risk. And from a financial standpoint, there are three steps to managing insurable risks. The first is to identify the risk, i.e. what is it that you fear might happen? In this case of life insurance, you might fear that if or when your spouse dies, it will cause a negative financial impact.

Step number two is to determine how much of this risk that you've identified, how much of it you can bear. This step is one that many people struggle with or just simply don't spend much time on. For example, can you bear the risk of your iPhone getting stolen? If your $1,000 iPhone gets stolen, that's an unexpected event, will your financial situation be dramatically impacted? Will you need help to recover from that loss?

For most people, at least people that should be buying iPhones, the answer is no. On the other hand, a matriarch or patriarch dying and causing a giant tax problem for the estate is likely a risk that the beneficiaries can't bear 100% of.

The biggest challenge with this step is that if you take too little risk in life, you'll overspend on insurance policies. And if you take too much risk, you might save some money on insurance premiums in the short term, but you'll be putting yourself in a position to potentially suffer giant, sometimes irrecoverable losses if luck is not on your side.

If you take the step seriously and you manage your risks appropriately, you'll likely figure out that most risks you take average out to be very close to their expected loss, allowing you to make intelligent and informed decisions with insurance. Finally, step number three, after identifying the risk and determining how much of it you can bear, go out and insure the remainder by buying an insurance policy.

So with that, let's put a hypothetical real life example to this using life insurance. Step number one is to identify the risk. What is it that you fear? Well, let's say my fear is that if my wife dies before we reach our retirement savings goal, I'll not only be trying to care for three kids on my own while grieving her loss, but I'll have to go back to work and replace her income. That's my fear.

Step number two, how much of this risk can I bear? Well, we figured out that we need about another million dollars in savings to reach our retirement goal. I can't bear the risk of coming up with a million dollars, but I think I could, let's say, earmark and part ways with $10,000 without impacting our lifestyle or savings goals. So given that, step number three will lead me to ensure the remainder of the risk.

that $990,000 by spending a total of $10,000 on insurance premiums to buy a $1 million life insurance policy. I know it sounds like a silly exercise at times, but insurance decisions can get complex. And sometimes the complexity drives us to make the wrong decision for us and our family.

Speaking of complexity, before we dissect the different types of life insurance and go any further, I want to stop and acknowledge that sleeping well at night is an important piece of this equation. It's okay if your fear is perhaps irrational. It's okay if technically you can bear the risk of something, but doing so keeps you up at night or causes anxiety.

Our comfort and our mental health is really important to pay attention to, which is why I always say that there's the textbook answer and then there's your answer because you might not need to buy life insurance. You might have more money than you know what to do with, but you might find a certain level of comfort in owning some life insurance. Or like one client once told me, you might just want, quote, your life to be worth something.

You might not care if at the end of the day, you die with a little less money and the insurance company ends up with a little more. So while crunching the numbers is certainly an important part of this process and being smart with your money is critical to financial success, give yourself permission and grace to divert from the textbooks and manage the risks in your life in a way that works best for you. As long as your diversion doesn't put your retirement or financial situation in jeopardy, I am here to support it.

With that, let's continue to set the stage for part two of this series by breaking down the different types of life insurance. I know many of you are well-versed here, but there are really a few important things to highlight that will, if anything, serve as good reminders before we get into the technical weeds. In short, there are two types of life insurance, term and permanent. Term insurance, as most of us know, is simple, straightforward, and cost-effective. You choose a term, i.e. the number of years that you want the insurance for, and then you choose the

Choose an amount that you want your life to be insured for, and the insurance company will calculate the cost based on your health, age, and life expectancy. If you pay your premiums and keep the policy in force, the death benefit will be paid to your beneficiary if you die prior to the term ending.

Term insurance is great for protecting against things that have known fixed periods of time where the risk exists. For example, you know or likely know when your mortgage debt is going to be paid off. If you or your spouse died before that date, you might want there to be an insurance policy that pays out to the surviving spouse so that they can easily pay off the remaining balance.

The same example can be applied to paying for college or saving for retirement. These risks have known fixed periods of time, which means once that risk is gone, there's no need to maintain the insurance. For example, if you've already reached your retirement savings goal, you don't need to carry insurance to protect against the risk of dying prior to retirement. And if you're debt and mortgage free, then there's no need to have an insurance policy protecting your debts in the case of an unexpected death.

Again, maybe you just want your life to be worth something or it helps you sleep well at night, and that's okay as long as the premiums aren't putting your retirement in jeopardy. But going back to our three-step process for managing insurable risks, if you can't identify the risk, step number one, then you likely don't need to buy or maintain term life insurance.

Two quick things on term life before we move on. Number one, many life insurance companies these days advertise what they call no exam policies. In other words, they will give you a term life insurance policy. They won't give it to you. You have to buy it. You can purchase a term life insurance policy without getting a medical exam, which is nice and convenient. You don't have to get your blood drawn, but just know that you're likely going to be paying higher premiums if you take them up on this.

you might also be limited to how much insurance you can buy. So if you're healthy, young or old, if you're healthy, opt for that medical exam so you can get the best possible pricing on the insurance policy.

Number two, one common strategy with term insurance is to ladder multiple policies to help reduce the overall costs. For example, maybe you only need a policy to cover your mortgage for the next 10 years, but you need 20 more years to reach your retirement savings goal. In that case, many people will buy two policies with two different terms and two different coverage amounts. However, there's another approach that can get you to the same place without having to manage multiple policies.

Many insurance companies these days, one of them being Haven Life, will allow you to reduce your policy coverage amount at any time and reduce it multiple times throughout the policy's life as long as it's not lower than their $100,000 minimum.

So, for example, you could start with one single $2 million term policy to cover everything. And then once college is paid for, reduce it to $1.5 million. And then once the mortgage is paid off, drop it to $1 million and so on. Some insurance companies only allow you to do this once or twice. So be sure to ask about their policy around reducing coverage before taking action here.

Okay, let's get into permanent insurance where things get a lot more complex. And before I break down a few of those complexities, let's not forget about what we previously covered with regard to using life insurance to manage risk and protect against something catastrophic happening that causes financial harm. Because most permanent life insurance policies are wrongly sold. Most are sold to protect...

protect against risks that can be managed much more prudently and more cost-effectively using a different solution. Again, I loved what Stephanie said, you know, what asset best protects or manages the risk at hand?

I am not against permanent insurance. It serves a purpose. It's important to understand, and it's a really effective tool for managing certain types of risks. Before I share what those risks are, let's first define permanent life insurance. Permanent life insurance is also referred to as cash value, whole life, variable, and universal life. And in plain English, permanent life insurance provides coverage for your entire life.

It is life insurance that does not expire. Whether you pass away the day after you purchase it or at 100 years old, your beneficiary or beneficiaries would receive the death benefit amount. Permanent insurance also has a cash value component, which we'll talk about shortly. But just note that your beneficiaries don't typically receive the cash value amount at death.

So at its core, the purpose of permanent insurance is to protect against something that you know is going to happen. You just don't know when it's going to happen. You know that death is inevitable and you know that when your death or someone else's death occurs, whenever that might be today or in 50 years, you know that when that death occurs, it's going to cause a sizable financial loss.

Given that, it's not totally surprising to see that most common use cases for permanent life insurance are for estate planning purposes. One example is using it to transfer a large amount of wealth to heirs tax efficiently. Another is paying estate taxes or other sizable expenses at death. Also using it to avoid probate. It's also used for special purposes like divorce or child support or to fund a business buyout.

In reality, a very small percentage of the population is exposed to the risks being managed and covered by permanent insurance. For example, the estate tax exemption in 2022 is just over $12 million. In other words, you would have to die with more than $12 million in the bank, $24 million and change if you're married, in order to be subject to an estate tax bill. In

In 2020, just under 0.04% of the people that died that year had to pay an estate tax. And by the way, the total amount of tax collected that year was $9.3 billion. We're talking about some very wealthy people here that make up a tiny fraction of the population.

The same comment can be made about large tax-efficient wealth transfers, the need to avoid probate, and business buy-sell agreements. These are all very nuanced situations with very specific risks that, yes, permanent life insurance can be very effective at managing, but most retirement savers aren't exposed to these risks. Again, going back to our three-step process with step number one, asking you to identify the risk.

If you can't clearly identify the risk, you can likely stop there. Now, where things begin to get a little more confusing is when permanent life insurance is being purchased as a retirement savings vehicle. And there are two primary reasons that this occurs. The first is that, as mentioned, permanent life insurance policies have a cash value component, aka a savings or investing component.

When you pay your permanent life insurance premium, a portion of it goes to fund and maintain the death benefit, and a portion of it builds up as cash value. A portion of it also goes into the insurance salesperson's pocket, but we're going to push that aside for right now. Just know that dollars are accruing in a savings or investment account that can grow over time depending on the policy type and features.

The second reason it comes up in these conversations is that permanent life insurance is tax friendly. The cash value grows tax deferred like an IRA and proceeds, the death benefit proceeds like all insurance policies, including term insurance, are paid out tax free as well.

Also, in many cases, money can be taken out of the policy tax-free. The cash value can be taken out tax-free because it's withdrawn as a policy loan, which is not considered taxable income. You're essentially taking your own money back out of the policy. And for that reason, withdrawals can generally only be taken out tax-free up to the sum of the total premiums paid in.

So when someone hears about cash value growing at a guaranteed rate and the tax benefits that I just mentioned, it's not all that surprising that it begins to come up in retirement planning and retirement savings conversations.

I'll be breaking this down in more detail next week with Stephanie and sharing the pros and cons and what to take into consideration. But before we part ways today, I want to quickly highlight some of the key differences between the different types of permanent life insurance. As I shared, permanent life insurance comes in a few different flavors. In short, we have a whole life, variable life and universal life. And to make matters even more confusing, we also have some combo flavors like variable universal life insurance or indexed universal life.

The primary differences between all of these confusing policy types really have to do with two things: how the premiums are paid and how the cash value grows over time. For example, with a basic whole life policy, your premiums are level for the length of the policy and your cash value grows at a guaranteed rate determined by the insurance company.

With basic universal life, minimum and maximum premium amounts are established, and you can choose to pay any amount between them. You can also use the policy's cash value to pay the premiums, which, unlike a whole life policy, grows based on the performance of the stock market, although it does have a minimum guaranteed annual return.

Lastly, a plain vanilla variable life can have level premiums or variable premiums. It depends on the policy. And unlike the other two policies, with a variable life policy, you get some control over how the cash value grows. Kind of like a workplace 401k, you're given a menu of investment choices similar to mutual funds that you can choose from.

Again, there are some combo policies that combine some of these different attributes. I'm not going to get into each one, but I do want to highlight one known as guaranteed universal life. This policy type is unique because it typically has little to no cash value, making it the most popular choice for those who are interested in permanent life insurance coverage and

without the need for the investment component. Naturally, it's still going to be more expensive than term insurance because it covers you for your entire life. But these guaranteed universal life policies are typically the most cost-effective solution for buying true permanent life insurance.

And speaking of covering you for your entire lifetime, there is one little known fact about permanent life insurance that's important to bring up. And that is that sometimes policies are sold with a maturity date tied to your age. And if your policy reaches that maturity date while you're still alive, the insurance company can and often will pay you a predetermined sum of money and terminate the policy.

Just know that oftentimes you do have the option to specify a maturity date, sometimes as high as age 121, to mitigate the chances of that happening. So just keep an eye out for maturity dates if you're shopping for a policy or you're looking into a policy that you currently own.

Now, I've spoken to many of our listeners over the years and the consensus is to avoid permanent insurance altogether. Most of you seem to follow the "buy term insurance and invest the difference" approach, which I do think is prudent for most people. But there are two main reasons for recording a part two of this series and digging further into the weeds. The first reason is that there is some academic research supporting the use of permanent insurance as a retirement savings tool.

I'm not suggesting that's going to change your mind or anything, but I think we all take an interest in thoughtful research here. So I'll be sharing more on that next week with friend and financial planner, Stephanie McCullough.

Second, many listeners that I've spoken to have old legacy policies that were purchased years ago, some of them decades ago. And one of the most common questions I get is what do I do with this? Because some of them do have desirable features that don't exist anymore. And most have meaningful tax consequences attached to them if they're terminated.

So I've got some good stuff to share next week on how to handle those old policies and navigate the taxes. So I'm looking forward to continuing this conversation and sharing part two with everyone next week.

For this week's episode, you can grab the links and resources by going to youstaywealthy.com forward slash 140. And in case you're wondering about the difference between a stock and a bond, stocks represent an ownership stake in a company. When you buy a stock or even a fraction of a share of a stock, you gain partial ownership of the company. That's why stock is often referred to as equity.

When you buy a bond, you're loaning the company or the government in some cases. You're loaning the company or the government money. They're borrowing money from you to fund their operations. And in return, they'll pay you some interest on that loan. So in plain English, stocks represent ownership. Bonds represent debt.

Thank you, as always, for listening, and I will see you back here next week.