Life Insurance Basics

In honor of National Life Insurance Awareness Month, it’s time to once again discuss one of the most dreaded, but important financial planning topics. Life insurance is critical when your death would cause a financial hardship for your survivor(s) or when you need to create liquidity upon your death for estate purposes. In its purest form, life insurance is one of the best deals for consumers. You pay a company a small amount every year to make sure that your dependents are protected in the event of an untimely death. Unfortunately, not enough Americans are choosing to purchase an adequate amount of life insurance coverage. According to the 2016 Insurance Barometer Study by Life Happens and LIMRA, one in three households would have immediate trouble paying living expenses if the primary wage earner died. Part of the problem is that people just don’t like thinking about this topic. But another factor is that the industry can sometimes stray from the simple and effective solution, leaving would-be policy owners confused and more importantly, uninsured. The study also found that 40 percent have not bought life insurance -- or more of it -- because they are unsure of how much coverage they need or what type to buy or because it was too expensive. Let’s break down these issues.

How much coverage should you purchase? You need enough to cover living expenses for survivors; the lump sum amount necessary to fund future educational expenses; and/or money to provide for the future retirement needs of the surviving spouse. Years ago, many used “eight to 10 times annual income” to determine the proper insurance amount. But it is now easy to determine your specific needs with an online calculator. If you are using insurance to fund a future estate tax liability, you should use an amount recommended by your estate attorney.

What type of life insurance is most appropriate? There are two basic types: term and permanent. Term is best for those who have a specific insurance need for a defined period of time, like a young couple with kids who have not yet saved a sufficient nest egg to support their survivors in the event of premature death. During the stated term, if the insured dies, the insurance company pays the face amount of the policy to the named beneficiary. Premiums for term policies are often reasonable for those in good health up to about age 50. After 50, premiums start to get progressively more expensive.

Permanent life insurance is a more expensive option, because it combines the death benefit with a savings or investment component and it remains in force until you die. There are three types of permanent: traditional whole life, universal and variable universal. Whole life policy owners rely on insurance company dividends as the source of accumulation inside the policy. Universal and variable universal life holders invest by using sub-accounts, which are akin to mutual funds, inside the policy.

Permanent life insurance earnings grow on a tax-deferred basis, but you don’t have to die to get your money because these policies allow you to borrow against your cash value. The downside is the hefty price tag. High fees and commissions can eat into those beautiful projected returns and eat up as much as three percentage points from the annual return. Up-front commissions are typically 100 percent of the first year’s premium.

If you are weighing term versus permanent, you may want to consult a fee-only financial adviser, who does not sell insurance, but can evaluate your needs, determine the right type of coverage and refer you to a reputable life insurance agent.

Are Greedy Kids Raiding Your Retirement?

“Greedy adult children have become rapacious consumers of their parents’ money!” Those are the stinging words of financial planner, author and speaker Jonathan Pond, who worries that millions of Baby Boomer parents have indulged their children, at their own expense. Of course he was not talking about your kids—your kids are perfect little angels! Although the economy is well into the recovery phase, nearly 63 percent of American families are still providing financial support to their adult children, according to research from insurance and financial services trade association LIMRA. Parents most often pay for their adult children’s cell phone bills, rent, student loans, car loans, credit card bills and even vacations. A separate study last year by the nonprofit American Consumer Credit Counseling found that a higher proportion of U.S. households provide financial assistance to adult children than support for elderly parents.

These numbers may be startling in and of themselves, but it is the next part that makes financial planners nervous: of those parents helping their adult children, 45 percent say it is hurting their retirement savings. Deb Dupont, associate managing director of LIMRA says parents “are providing considerable support to their children at a time in their lives when saving for retirement should be a priority.” Of course these parents know that they should be focusing on themselves, but doing so can be a tangled emotional ride.

Take the case of Joan, a 55-year-old widow, whose 31-year old daughter Mindy went through a nasty divorce and lost her job in 2012. Joan was more than willing to have her daughter move in and she even helped out with some expenses. But three years later, her daughter is creating difficult financial choices for Joan. While Joan would like to concentrate on retirement, she is worried that Mindy will not be able to make it on her own. “I was trying to retire by age 65, but that’s probably not going to happen now. It’s hard for me to draw the line with my daughter.” Unfortunately, Mindy has gotten a little too used to this “temporary” situation and is not clamoring to become financially independent any time soon.

The steps necessary to wean an adult child off of a parent’s gravy train require tough and often emotional conversations. Ideally, Joan would have had “the talk” before Mindy moved in, but that never happened. Now it is important for Joan to discuss her needs and expectations going forward. Maybe something like, “It’s been three years since you moved in and I was happy to help you out during this major transition in your life. But I think that you are more than capable to take control of your financial life and I want to help you develop a plan to help you get there.”

As Joan works on the plan with Mindy, she will likely have to ease her into full independence. That might mean that if the goal is to have her move out in six months (she must choose a concrete date), she will have to develop a budget, which winds down the payment of expenses over time. Joan should reiterate that she will help guide Mindy through the process, but not to finance it. While she’s having these difficult conversations, Joan should also define when it's appropriate to ask for help in the future (a medical crisis or a job loss), but it must be an emergency, otherwise she risks getting caught up in the cycle again.

To accurately reflect the agreement, the plan needs to be in writing, it should be specific and both sides need to stick to it. I’m not saying that you shouldn’t help out your children in need, but you should be smart about the financial assistance you provide. Financial independence is a marker of adulthood - help and generosity differ from unhealthy dependency.

401(k) Fee-Asco

A Yale professor is providing a perfect follow up to this year’s PBS episode of Frontline called "The Retirement Gamble." That program detailed America's retirement crisis and the financial services industry’s feasting on high fees inside of many employer-sponsored plans. Professor Ian Ayres has recently completed an exhaustive analysis of company-sponsored 401 (k) plans and found that many charge excessive fees. But Ayres has taken the research to a new level by sending about 6,000 letters to companies, saying he would disseminate the results of his study next spring and would specifically identify and expose those companies with high-cost plans.

The concept of reeling in retirement plan fees gained a bit more momentum last year, when the Department of Labor put new rules into effect, which required 401 (k) sponsors to disclose fees and performance data to plan participants. The first round of the more detailed information was sent in November 2012 and, despite all of the media hype, those disclosures did not make much of an impact.

According to the EBRI 2013 Retirement Confidence Survey, about half (53 percent) of defined contribution plan participants reported having noticed these new disclosures, and only 14 percent of those who noticed (7 percent of all plan participants) said they made changes to their investments as a result.

This data gibes with findings from consulting firm LIMRA, which found that half of plan participants do not know how much they pay in plan fees and expenses. In fact, about a fifth of all participants think they pay nothing for their retirement plans.

To review, there are a bunch of fees that participants pay, including administrative, trustee and investment fees. The average plan costs about 1.5 percent, with larger company plans coming in at closer to 1 percent and small to medium sized ones sometimes costing in excess of 2 percent.

You may think that a half of a percent does not seem like a big difference, but that fraction could cost you hundreds of thousands of dollars over time. As a baseline, if you were to start with $100,000 and invest it over 50 years at a 7 percent return (compounded monthly) with no fees, you would end up with approximately $3.2 million.

If you apply the average plan fee of 1.5 percent, the future amount is more than halved to just over $1.5 million. But if you are in an expensive plan and the fee is 2 percent, your future value drops to $1.2 million at the end. That’s $300,000 that could be falling to your bottom line! 

What should you do if your retirement plan is more expensive than the average? One benefit to the disclosure rules is that plan participants can be empowered to effect change. The first step is to review the disclosure that was sent. If your plan costs more than the average of 1.5 percent, gather as many co-workers as possible and lobby your boss for a cheaper plan. It may surprise the boss to learn that he or she could find cheaper alternatives. But it is notoriously difficult for smaller companies to get the best plans. The reason is that the financial services industry likes scale. It takes a lot of money to provide all of the services necessary to operate a retirement plan, so financial companies like to land the big fish.

If you hit a brick wall on a new plan, then at the very least, try to have cheaper investment options added to the current plan. Index funds, which carry much lower fees, can make a big difference. I recently helped a radio caller navigate her 401 (k) plan investment options. By shifting from costlier actively managed funds to index funds, her cost of investing dropped from over 1 percent to just 0.25 percent.

It can feel burdensome to stay on top of all of these issues, but hopefully the long-term benefit outweighs the short-term work involved.

© 2013 TRIBUNE MEDIA SERVICES, INC.