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Life insurance is one of the least favorite financial topics to address, and for understandable reasons. Unfortunately, it cannot be ignored particularly for people with dependents. It is also a complicated area, with a seemingly endless variety of products and opinions about which to buy.  

The good news is that getting the right life insurance coverage does not have to be expensive or complex. Peloton doesn’t sell insurance, but we commonly advise our clients with respect to obtaining the right terms and levels of coverage. In this article we summarize three principles to address this important but complex topic. Our thought process is not the only correct way but following it should give you peace of mind that you have good coverage for your needs. 

Principle #1: Life insurance is to protect your loved ones against the risk of your early death.  

You don’t need life insurance because you have recently begun your career and being an adult means you should buy some. You don’t need it because a good friend wants to sell you some. You don’t need it as a savings vehicle.  

But when do you need to buy it? 

There is only on reason you really will ever need to buy life insurance: in the event of your untimely death, the people you leave behind would face hardships without it. It is really that simple. Getting married might be a good reason to buy some level of coverage but if your spouse works, it might not be necessary. Starting a family is often a good reason to buy insurance as your children will likely face financial as well as emotional hardships if you die too soon. 

As you approach your golden years, the need for insurance is typically far lower: your children are grown and (hopefully!) self-sufficient and you’ve also accumulated enough wealth to sustain yourself through retirement. This suggests that when you buy insurance, you probably only need it for a certain period. This leads to our next principle: 

Principle #2: Buy life insurance only for the term you need coverage. 

One easy way of classifying the types of insurance is between “term” and “permanent”. Term life insurance is coverage for a specific length – or term – of time. At the end of the term, the insurance will expire. Permanent, or “whole life” insurance is meant to stay in force for a person’s entire life.  Examining permanent insurance is a good place to start. 

Since people are not nearly as likely to die when they’re 40 as when they’re 90, it follows that the mortality cost to the insurance company is much higher for older people than it is for younger. To offer cost-effective, permanent insurance, insurance companies make younger customers pay more than they need to initially. Each premium payment is a combination of insurance cost and an amount of forced savings which will accumulate and be used to pay the rising cost of insurance as the policyholder ages. If the insurance is not needed, they are told, the accumulated “cash value” can be borrowed from the policy, or the policy can be cancelled, and the cash taken out.  

There are a few problems with this forced saving strategy. 

First, if borrowing against the cash value seems appealing, recognize that you are actually borrowing money from your own payments. Instead, you could accumulate that money in a savings or investment account. Or if you own a home you might consider a home equity line of credit (“HELOC”) as an emergency source of funds.  

If you truly cannot save money unless someone forces you to do so, then maybe permanent insurance is the best bet. But you must realize that the cost of doing so is very high, and gaining access to your own cash savings will come with additional fees, taxes, or both. For this reason, we believe that it’s far better for you to purchase insurance in order to insure against risk, and find smarter ways to save your money. 

Instead it often makes sense to buy insurance for the period of years – 10, 20, or 30 – in which both your dependents truly need it and you have not yet accumulated enough wealth for them without insurance. Like permanent insurance, term can be cancelled when there is no longer a need. 

Principle #3: Get enough coverage to fund your wishes for your beneficiaries. 

Beneficiaries are the recipients of the life insurance proceeds when you die. It may be helpful to think of two extreme examples of coverage amounts. Taking the bare minimum approach, you could purchase coverage sufficient to pay for your own funeral and burial – $25,000 would be enough in this case.  

On the other hand, if you want to provide your beneficiaries with a replacement for all of your income forever, you will need to buy a far larger amount. In this case, the easy rule of thumb is to divide your income by 4%. Four percent is a simple estimate of a sustainable annual withdrawal amount. For example: a parent who wishes to replace all her $100,000 income would buy $100,000 / 0.04 = $2,500,000 of life insurance. 

There are also many middle of the road options. You may prefer to make sure your mortgage is paid off or to fund college educations for your children.  

Summary 

Life insurance is made to be complex because often complexity appears to excuse higher fees. But it does not have to be complicated: buy protection for your dependents for the specific length of time they might need it. With a little planning and these principles top of mind, you can determine the right amount of insurance coverage for you. 

Disclosures 

Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal. Diversification may not protect against market risk or loss of principal. The opinions expressed above should be construed as neither investment advice nor a solicitation to buy or sell securities. Actual investor results may vary. 

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