Life Insurance

Life Insurance is something to consider usually only if you have dependents – others who are counting on you to provide funds for living expenses. If you’re single - without children or elderly parents to look after - there is probably not a reason for you maintain a life insurance policy.

If you do have dependents, seriously consider life insurance if your existing assets are not sufficient to cover expenses for your dependents. Said another, if you do not have literally millions of dollars socked away, you need life insurance (if you have dependents) - the exception being if your spouse’s income covers all expenses in the absence of your income. 

Now that you know whether you need life insurance, you must determine the amount of coverage required. This requires a bit of math. Briefly, consider the cumulative expenses now through the time your dependent(s) will no longer be dependent. If the dependent is a child, this usually means by the time the child has graduated college. Expenses for calculating total life insurance coverage needs usually include utilities expenses, the cost of groceries, clothing allowances, car payments & maintenance expenses, mortgage payments and college tuition. Over the course of 22 years, these expenses can easily total in the millions of dollars. Consider a case study below - wherein one must spouse must provide for their unemployed spouse and a second child who is a minor (age 17).

Income (cash flows) needs for each period - Proposed
	Readjustment (1 Year)	2nd Child Age 17-18	Blackout Period (Age 49-60)	Retirement (40 Years)
Annual Income Needed	$          85,000	$56,667	$                42,500	$            42,500
OASDI (Social Security)	$          37,200	$10,800	$                         -	$            18,000
Net annual income needed (PMT)	$          47,800	$45,867	$                42,500	$            24,500
interest rate	3%	3%	3%	3%
Years needed	1	2	11	40
PV of net annual income needed	$          47,800	$90,397	$429,700.17	$856,597.58
PV of total annual income needed	$     1,424,495

For a complete assessment of your life insurance needs, consider speaking with a financial planner – and not a financial advisor.

Term Life

Now that you have determined how much coverage you need, know that when it comes to life insurance, they are essentially two types of policies: term and everything else. Everything else goes by numerous names, including Whole Life, Variable Life, Universal Life, but broadly is referred to as Permanent Life.

Term life policies are simple and inexpensive – and worth buying. Consider a term life policy similar to car insurance; the car insurance policy will pay out in the event of an accident; a term insurance policy will pay out in the event of death.

Permanent Life

Everything else besides term life is simply not worth the money. To explain, Permanent Life is sold as a combined life insurance and investment product. With a permanent life policy, paying the policy every month means that you’re not only paying your insurance policy, but you’re also investing. However, with a permanent life policy, you can only benefit from one or the other: the life insurance policy or the cash value of your investments – not both. Why? Because there is no way to be simultaneously alive and dead at the same time. So, with a permanent life policy, you’re paying for two benefits, but you only ever receive one benefit.

But there is another catch: fees. When investing via a permanent life policy – as opposed to making your own investments directly – you’re including a middle man that takes their cut – in the form of a sales commission. This means that had you bought a less expensive, more efficient term policy mentioned above, and then invested the difference (BTID), you would have more money to show for it. Why? Simply because there is no middleman.

It’s simple math. When a commissioned financial advisor takes their cut from a permanent life policy, the policy holder is left with less wealth than had they purchased a term policy and invested the difference.

Many are attracted to permanent life policies because they like the forced savings aspect of the product. But there are much more efficient ways to invest. For those without the discipline or knowledge to invest themselves, consider automatic withdrawals to a Vanguard all-one-fund. Each month, money will come out of your checking account and get directed into a low-cost investment for your particular time horizon – or date when you expect to withdraw your money. If you’re still unsure about investing  yourself, speak with a financial planner (– and not a financial advisor).

 

References

Chilton, D. (1998). The Wealthy Barber. Prima Publishing.

Dalton, e. a. (2011). Personal Financial Planning Theory & Practice. USA: Kaplan Schweser.

Conflicts of Interest

A recent conversation is the inspiration for today’s post – wherein a conflict of interest put a future family member in an inappropriate financial product.

Firstly, lets define a conflict of interest: when one is faced with two or more competing interests. Consider an example we can all relate to: dieting. As someone on a diet, I face a conflict of interest every waking minute. My first interest is my health. This interest supposes that I should eat only leafy greens, fresh fruits, lean meats, whole grains, etc. Further, I should avoid sugars and refined foods – like donuts. 

However, I have a second interest: cravings for unhealthy foods. This second interest pushes me toward eating everything and anything in sight, most especially calorically dense, nutrient-deficient foods. These interests - eating healthy and food cravings - conflict with each other and are mutually exclusive. If I respect one interest, I must deny the other interest – and vice versa. I can never follow both interests at the same time. If I follow my interest to eat healthy, I will not eat donuts. If I yield to my cravings, I will eat donuts.

An extremely high-tech visualization of mutual exclusion

There are many financial services providers that suffer from conflicts of interest. What follows is a list of solutions of how to avoid conflicts of interest in three specific financial services providers.

Insurance Companies

Whether its life insurance or car insurance, certain insurance companies (stock companies) experience a conflict of interest – which is be problematic for you as a consumer. An insurance company that is stock-owned (as opposed to a mutual company, discussed in a moment) sells insurance policies. However, the stock insurance company’s goal is not to provide insurance at the lowest feasible rate; it’s goal is to provide an investment return to its shareholders. Therefore, a stock insurance company will sell insurance at the highest price that the market will bear.

The requirement of providing investment return to shareholders makes for larger premium payments for consumers

Consumers can avoid the conflict of interest in a stock owned insurance company by electing insurance coverage with a mutual insurance company. Mutual insurance companies are not owned by shareholders, but by the insurance policy holders. When a consumer purchases a policy with a mutual insurance company, that consumer becomes part owner of the mutual company. Since the policy owner is now the company owner, any excess profits produced by the mutual company now go back to the owner/policy holder as dividends. Thus, mutual insurance companies are structured to be incentivized to keep policy premiums as low as possible.

Policy owners of a mutual insurance company experience no conflict of interest from shareholders

Investment Services Companies

Similar to the organization structure models above, there are two types of investments services companies: those owned by shareholders and those owned by the individuals that purchase investment products. Not surprisingly, comparable (if not identical) products can be had for lower cost via a client-owned investment services company relative a stock owned company. Consider an example: a S&P 500 index ETF. 

Two companies, State Street Global Advisors and Vanguard offer a nearly identical S&P 500 index exchanged traded fund (ETF). State Street’s fund has a expense ratio of 9 basis points (.09%). The Vanguard fund has a an expense ratio of almost half that: 5 basis points. 

Why the difference for the exact same product? State Street is a publicly traded company that pays dividends to its shareholders. Vanguard has no share holders and therefore no such obligation. Vanguard’s obligation is to provide the best service possible to its clients - the owners of Vanguard funds.

Financial Planning

Certified Financial Planners work with clients to asses client needs before developing a financial plan. Fee-only Financial Planners will charge either a hourly rate, a pre-determined rate for a given level of financial planning, or may include financial planning services when charging a fee for assets under management – money under investment stewardship. Because fee-only Financial Planners are not compensated by selling various products (i.e. insurance policies or specific mutual funds), there is no conflict of interest when working with a fee-only financial planner. You can find a list of fee-only financial planners at the National Association of Personal Financial Planners.

The fee-only Financial Planning model is in stark contrast to the Financial Advisor or broker model. The Financial Advisor is essentially a commissioned sales person. Therefore, the Financial Advisor, or mutual fund salesperson, or insurance salesperson, has a conflict of interest. That salesperson must choose between the product that will net the most commission for themselves versus the product that is most appropriate given client needs.Which one do you think the salesperson is more apt to choose?