Are you concerned about buying the wrong types of life and disability insurance or overpaying for what you really need?
For most people, protecting their lifestyle and that of their loved ones in case of disability or death is a top concern. But most people I meet with are concerned that instead of purchasing exactly the type of coverage they need, they are going to get sold a product by a biased insurance agent who just wants to earn a commission. Or, they are making the huge mistake of simply relying on the insurance provided by their employer.
I wrote this guide to teach people the essentials of life and disability insurance. By educating yourself, you are better equipped to avoid being sold something you don't need, and to be confident that you have the perfect amount of coverage for the right price.
*As an independent, registered, flat-fee only financial planner, it is illegal for me to receive any type of compensation for selling insurance products, or for referring you to someone who does. As part of my planning process, I do analyze insurance coverage needs for my clients, and help them shop for the right coverage, but my compensation is not tied to this aspect of my services. So you can be confident that anything you read below is unbiased.
First Things First: What Exactly Is Life Insurance?
- Life insurance is a contract between you and an insurance company to provide you with coverage based upon your timely payment of premiums.
- Life insurance provides a death benefit to your named beneficiary (usually a spouse) upon your death. When you pass away, your beneficiary files a claim with the insurance company to submit proof (a death certificate) of your passing. The beneficiary will then be issued the death benefit payout which is generally received tax-free.
- There are two types of life insurance: term and permanent (commonly referred to as whole or universal which are types of permanent life insurance).
- I believe that for the vast majority of people, term is a better option because it is a much less expensive way to take care of the financial needs of your loved ones if you pass away.
- The main difference between the two is term has an expiration date and permanent does not. With term, if you pass away while your policy is active, your beneficiary gets the payout. If you pass away afterward, they get nothing. Permanent (whole) lasts until you die and builds a cash value.
Term. Vs Whole (Permanent) Life Insurance
Term is more appropriate for 80-90% of the population. Yet many insurance agents and financial advisors will try to sell you permanent because of the much higher commissions they receive for selling it versus term. This is a big problem in the industry and if you encounter a financial advisor who is attempting to do this, view it as a huge red flag.
What is a level premium term life insurance policy?
- Practically all term insurance policies sold to individual consumers are level premium term policies. This type of policy guarantees that your premium will stay the same for a set period of time.
- For example, let's say a 35-year-old purchases a 30-year level term policy with a monthly premium of $30. Even though as they get older their chances of passing away increase, the insurance company won't raise the cost of the premiums. This is why it's best to purchase a policy at the youngest age that you are in need of one.
- If that same person waited until 55 years old to purchase a term policy with the same death benefit, the monthly premiums would be much higher.
- Another benefit of level-term life insurance is that after completing your initial medical exam when signing up for a policy, you will never be required to undergo another examination to maintain the same premiums.
- Even in a worst-case scenario where you contract a life-threatening illness, your premiums remain the same.
Why do you need to purchase your own individual life insurance policy outside of your employer?
- Employers often, but not always, provide a small amount of life insurance coverage for free, without requiring you to pass a medical exam. Some also allow you to purchase additional coverage that is a multiple of your salary. This is called a group life policy.
- One issue with this is that it's rare these days for anyone to work with the same employer throughout their career. If for whatever reason you stop working altogether, become self-employed, or your new employer doesn't offer group insurance, you would then be forced to buy term insurance on your own. What if this situation arises when you are much older or after you have developed a medical condition? You will end up paying much more for your premiums than if you had just purchased an individual term life policy as soon as you needed it.
- Another problem with group-term life insurance is that the cap on the amount of coverage you actually need may not be high enough.
How much life insurance should you buy?
- Many financial advisors simply recommend purchasing enough coverage to replace 7 to 10 times your annual income.
- But this may lead to you purchasing too little or too much coverage.
- I suggest taking the time to dig a little deeper to understand your true needs.
- The first thing you want to calculate is how much household debt you would want to be paid off in the event of your passing. This could include your mortgage, student loans, auto loans, and credit card debt.
- If you have children and your goal has always been to pay for their college expenses, you will want to calculate what those expenses will be minus what you have already saved for college.
- You may also want to consider milestones. For example, if you have always dreamed of paying for your daughter's wedding or helping your children out with a down payment on a home, you would include these costs in the death benefit you would be shopping for.
- The next step is to add these amounts to the living expenses you expect your survivors to incur that they could not cover with their own income. When doing this, it's up for you to decide how much the survivor would continue to spend on non-essentials such as travel.
How Long Should You Have Life Insurance?
- Most term life insurance companies provide terms in five-year increments — i.e., 10-year term, 15-year term, and so on, up until 30 years.
- Your financial obligation probably doesn’t fit exactly into one of those term lengths, so your best bet is to round up.
- A common mistake I see people make is they purchase a 30-year policy when a 20 or 25-year policy would suffice. Let's say your premiums would be $60/month. Adding an extra ten years on a policy when you don't need them would cost you $7,200. This is exactly why rules of thumb should not be used when determining how much coverage to have and how long it should last.
How To Shop For Life Insurance:
- Once you determine how much life insurance you need, it's important to shop around for your policy. I recommend working with an independent agent who is able to obtain quotes from multiple companies.
- Ideally, they work on salary only and they should always be willing and able to explain in a simple manner the pros and cons of your various options.
- It's not necessary to work with someone local.
How Does Disability Insurance Work?
- Social Security disability benefits are almost always inadequate which means you may want to make sure you have additional coverage from a personal policy.
- Rarely would you need to rely on a policy for short-term coverage (since you should have an adequate emergency fund) so your focus should be on a long-term disability policy (LTD).
- LTD is an insurance policy that protects an employee from loss of income in the event that he or she is unable to work due to illness, injury, or accident for a long period of time.
- Anyone targeting an early retirement should have their own policy.
- The question is whether you need additional coverage above and beyond what is provided by your employer. We will discuss this further, but first...
Long-Term Disability Key Terms You Need To Know
- Elimination Period: How long it will take for your funds to be paid out. For LTD this can be as soon as 90 days but some policies require waiting up to 360 days. The rule of thumb is the longer the wait, the lower your premium.
- Definition of Disability: The criteria used by the insurance provider to determine whether you are disabled and therefore eligible for disability payments. Your policy will use either an "own occupation" definition or "any occupation definition"
- Any Occupation: Avoid this. This type of policy is less expensive BUT you can only receive benefits if you’re unable to do any form of work whatsoever, including jobs you have no interest or experience in. It’s very difficult to qualify for any occupation benefits because most people who become temporarily disabled can technically do some form of work.
- Own Occupation: Own occupation disability insurance pays out when you are no longer able to perform the specific job you had before your injury. Whether you get a new job in a related field or end up working in an entirely different occupation, you’ll still receive disability benefits because you can’t execute your previous responsibilities. You need to make sure any policy you purchase has any occupation language written into it.
- Guaranteed Renewable Policy: Your insurer can't cancel your policy as long as you pay your premiums BUT they can increase your premiums as long as the increase affects an entire class of policy holders and doesn't single you out.
- Non-Cancelable Policy: Your insurer can not cancel your policy OR raise your premiums. The premiums on this type of policy may be about 20% higher than one that is only guaranteed renewable, but in most cases if you are still young and buying your first policy which you will then own for 20 plus years, the extra cost of non-cancelable is worth it.
- Rider: A supplemental agreement attached to and made a part of the policy, providing additional features to your coverage (usually for an additional premium.)There are many types of riders out there but the three listed below should always at least be considered when purchasing a policy:
- Partial/Residual Disability Rider: This kicks in when you develop a condition that doesn't prevent you from working the same job altogether, but forces you into a reduced workload or number of hours.
- COLA (cost of living adjustment) Rider: This rider is designed to help your benefits keep pace with inflation after your disability has lasted for 12 months. This can be a big benefit if you develop a condition that lasts for a number of years but it can add close to 10% to the cost of your premium so you have to decide if its worth it. You may be better off purchasing the highest monthly benefit available to you even if that means having to cut out the cost of the COLA rider.
- Future Increase Option/Benefit Increase Rider: This is where you pay a premium in order to have the ability to increase your monthly benefit, up to a predetermined maximum, regardless of your health, as your income rises. This can be especially beneficial to younger healthcare professionals such as physicians who expect their incomes to rise significantly in the coming years.
Disability insurance through your employer Vs. purchasing your own individual coverage
- Just like with term life insurance, it's generally best to purchase your own LTD coverage in addition to what your employer provides. While the employer coverage may be less expensive, or even be paid for by the employer, there are key drawbacks to be aware of.
- Generally, individual LTD insurance provides more comprehensive coverage and is more flexible. The biggest difference is most employer LTD doesn't provide own occupation coverage which is crucial.