Make the Most of your Benefits Package

Make the Most of Your Benefits Package

Many employers offer a benefits package.  The most common benefits are health insurance and a retirement plans, topics I’ve covered in other posts.  Some benefits packages have other features, such as dental and vision insurance, various kinds of disability and life insurance and, in Canada, extended health care.

In this post, I’ll identify the parts of your benefits package for which you might have to pay a portion of the cost.  I’ll also provide a brief explanation of each and what you might consider as you decide whether to purchase them.  Employers often provide other offerings in their benefits packages, such as access to an Employee Assistance Program or medical advisors, at no cost.  Because you don’t need to make an election or pay for these benefits, they are not covered here but you’ll want to be sure you understand all pieces of your benefits package so you can take full advantage of them.

Dental & Vision Insurance in Your Benefits Package

There are many similarities in the coverage under dental and vision insurance.  In addition, the processes for deciding whether to buy them have a lot of parallels, so I’ll discuss them together.

Dental Insurance

Dental insurance pays for preventative dental services (usually two to four cleanings per year), a portion of other dental expenses (fillings, crown, root canals, for example) and sometimes orthodontia. The amounts of these expenses that are covered depend on the deductible, limits and coinsurance.

Every dental insurance plan I’ve had offered by employers has had a very low maximum limit, such as $1,500 or $2,500 a year.  This coverage differs from most other insurance products. Most other insurance products protect against things you can’t afford to lose, such as the injuries caused by a car accident or a tornado that destroys your home, and often have you pay for the “predictable” part through a deductible.

Vision Insurance

Vision insurance generally covers the basics – eye exams related to vision correction, glasses and contact lenses – and doesn’t usually cover more serious eye conditions.  Some eye conditions are considered medical in nature and are covered by health insurance. If you have an eye condition, I suggest contacting your health insurer to see if it is covered as a medical condition.

Networks of Providers

Many dental and vision insurers create networks of providers. My experience is that there are huge differences in coverage in and out of network, so you’ll want to see whether your providers are in the network before making any cost comparisons.

One year, my eye clinic was listed as being in network, but it turned out my specific eye doctor was not. As such, it might make sense to call your eye doctor’s office before selecting vision coverage to confirm that your specific provider is in your network.

Cost Comparison

Because dental and vision insurance have such low limits, they don’t provide much protection against large bills. As such, the decision to purchase them is primarily a comparison of your premium with your covered expenses. That is, you want to answer the question, “Will I recover more from the insurer than I pay in premium?”

Each year, I estimated my family’s dental and vision expenses by type.  For dental, I considered how many family members get regular cleanings, what the visits would cost and whether either of my children had braces. I ignored all other dental expenses, such as fillings or root canals, for this part of my analysis.  For vision, I counted the number of vision exams, pairs of glasses and contact lenses my family was likely to need.

I applied the deductibles, limits and coinsurance to the expenses to get an estimate of what I might recover from the insurer.  I compared that amount with the premium. My post on health insurance provides more information about networks, coinsurance and deductibles.

Other Considerations

Discounts negotiated by the dental insurer with providers are another component of savings.  Similar to health insurance, the cost of dental services provided by in-network providers when you have dental insurance can be significantly less than the cost if you don’t have insurance.  This savings is difficult to quantify initially, but you can estimate it once you have used the same provider under a single dental insurer for a year or two or you can call your dentist and ask about the savings. You can then include those savings in your analysis as a cost covered by the insurer.

You’ll want to research whether your health plan includes basic vision exams for you and your covered dependents.  If your health insurance plan has that coverage (and your provider is in your health insurer’s network which will likely be different from the vision insurer’s network), you’ll want to exclude any recoveries from the health insurer or exclude those expenses from your list before estimating recoveries from your vision insurer.

How to Decide

If the premium and amounts covered by the insurer were fairly close or the premium was less the amount I estimated I would recover (including savings from discounts), I would buy dental and/or vision insurance.  If the premium was significantly more than the covered expenses, I usually took my chances that no one would need any expensive dental work and didn’t make the purchase.   In practice, I bought dental insurance when my kids had braces and usually didn’t buy it otherwise.

As with all other financial decisions, the risk-reward trade-off is an individual one so you will need to decide for yourself how much extra premium you are willing to pay to have a portion of unexpected dental expenses reimbursed by the insurer.  As you do so, remember that there is likely a fairly low cap on the total coverage provided by the insurer, so you’ll want to see how much of that maximum you’ll use up with your preventative and orthodontia expenses in evaluating that risk-reward trade-off.

Many vision insurance plans do not cover anything other than preventative services, glasses and contact lenses.  As such, the decision to purchase vision insurance is often a more straightforward cost-benefit comparison and is less focused on risk and reward.  Of course, if your plan covers other eye issues, you’ll want to take those into consideration in your decision-making process.

Employee Stock Ownership as Part of Your Benefits Package

I have seen three types of employer offerings related to employee stock ownership. I talked about the first, allowing or requiring employees to purchase company stock in their defined contribution plans, in this post.  The second is an Employee Stock Ownership Plan or ESOP which is also a part of a defined contribution plan. The third, an Employee Stock Purchase Plan (ESPP), lets you buy company stock, often at a discount.

Employee Stock Ownership Plan (ESOP)

Under an Employee Stock Ownership Plan (ESOP), an employer contributes company stock to an employee’s defined contribution account.  (For more information about defined contribution plans, see my post on that topic.) The employee cannot sell the stock until he or she resigns or retires from the company, though there are exceptions.

If you want to diversify your company stock holdings, you’ll need to talk to your human resources representative to understand your options, if any.  ESOP contributions are usually subject to vesting (increased ownership by the employee as his or her tenure with the company increases). When the employee retires or resigns, he or she will either receive a lump sum or periodic payments, depending on the terms of the plan.

Employee Stock Purchase Plan

An Employee Stock Purchase Plan (ESPP) allows employees to purchase company stock through payroll deductions.  Many employers offer their company stock at a price lower than is available if purchased through a broker.  The ability to purchase the stock at a discount can be a real benefit, as long as the stock price doesn’t go any lower than your purchase price before you sell it.

ESPPs have varying rules as to how long you have to hold the stock before you can sell it. Also, the tax treatment may be differ depending on how long you hold the stock.   I preferred to have as little of my investments in my employer’s stock as possible. Therefore, I generally purchased stock through the ESPP, but sold it as soon as was allowed to lock in the benefit of the discounted purchase price.

There is a drawback to the approach I took.  If you seek to be a senior executive in a company, company stock ownership is often considered a sign of loyalty and faith in the company.  As such, if this is your goal, you might consider keeping the stock purchased through an ESPP.

Dependent Care Flexible Spending Accounts (US)

Dependent care flexible spending accounts (FSAs) allow you to set aside a portion of your paycheck without paying any taxes on the money. You must use the money to cover out-of-pocket expenses that are related to care of dependent children or parents and are needed to allow you to go to work.  You do not pay Social Security or Federal income taxes on money put into or withdrawn from a dependent care FSA. In many states, you also do not have to pay state income taxes either.

There are restrictions on the types of expenses you can pay from your account. You can generally pay for child daycare (both traditional daycare and nannies), elder care, before-and-after school programs and sick childcare services, among others.  If you plan to use the money for other services, you’ll want to confirm that they are acceptable. This publication from the IRS web site provides lots of details about who can qualify and the types of expenses that are acceptable.

You lose any money you contribute to a dependent care FSA if you don’t spend it in the same year.  For most people, the 2020 maximum contribution was $2,500 if you were single and $5,000 if you are married. That amount hasn’t changed in several years.  If your dependent care expenses are highly likely to exceed that limit, the tax savings make it reasonable to contribute the maximum.  If your expenses are likely to be less, you’ll need to take care in selecting the amount of your contributions so you don’t lose any portion you don’t spend.

Life Insurance Included in a Benefits Package

Many employers offer group life insurance on one or all of the employee, spouse and children.

Coverage

The type of life insurance offered by employers is term life insurance. It pays the stated benefit amount if the covered person dies during the policy period.  The policy period for an employer-sponsor plan often corresponds to a calendar year.

My employers generally provided life insurance on my life (as the employee) with a benefit amount equal to one year’s salary at no charge.  I was able to purchase more insurance on my life and smaller amounts on my spouse and children at my expense.

Exclusions

Group life insurance won’t provide the stated benefit if the cause of death is excluded from coverage. The most common exclusions with which I’m familiar are suicide and murder by the beneficiary.

If these nuances are important to your decision, you’ll want to ask your human resources representative what exclusions exist under your employer’s coverage. Much more importantly, if you are concerned about your mental health or your physical safety, please seek help! There are free crisis lines that will help with either issue or contact your local hospital for mental health concerns or police for safety issues.

How to Decide

Deciding whether to buy life insurance is often a tough decision, as we all like to think we will still be alive at the end of the year. We especially don’t want to think about what will happen if we or a loved one dies.  However, there are many people who should take advantage of this portion of their benefits package.   I offer some highlights of the decision-making process in the sections that follow, but refer you to my post on buying life insurance if you want more information.

How to Decide About Yourself

As you think about your coverage level, whether you have any dependents and, if so, whether they’ll be able to sustain their current lifestyle without your income and personal expenses are important considerations.  If you have no dependents and very little debt, you might not need more life insurance than one times your salary.  On the other hand, if you have children, have some or a lot of debt or are barely covering your expenses, you might want to buy more life insurance to make sure there is money to pay down your debts and/or support your children if you die.

You’ll also want to consider the cost of the life insurance and whether it fits in your budget. For more information on budgeting, see my introductory post and nine-part series with step-by-step details to create a budget, starting with this post.  If buying life insurance means that you don’t have enough money to cover the basics, you might need to take the riskier approach and not purchase life insurance or not purchase as much.

How to Decide About Your Spouse

The considerations for insuring your spouse are similar to buying insurance for yourself.  You’ll also want to consider whether your spouse’s employer provides any life insurance and, if so, compare the face amounts and premiums between the two plans.

How to Decide About Your Children

The amount of insurance available for the death of children is usually relatively low, in the range of $5,000 to $20,000.  I view the primary purpose of buying life insurance on children as covering funeral and related expenses. If you are able to afford a funeral and everyone who “should” attend can afford to get to the funeral, you are less likely to need life insurance on your children.  However, funerals and travel can be quite expensive, so life insurance on your children could cover some or all of those expenses. As always, you’ll want to evaluate whether the cost of life insurance on your children fits in your budget.

Disability Insurance

Disability insurance replaces a portion of your wages if you are sick or injured.  In the US, where workers’ compensation insurance covers workplace illnesses and injuries, disability usually covers only non-occupational illnesses and injuries. In other jurisdictions, it can cover both occupational and non-occupational illnesses and injuries.

Types of Disability Insurance

Employers offer wage replacement in a number of components, including sick time or paid time-off, short-term disability, long-term disability and supplemental long-term disability.

Sick Time or Paid Time-Off

Sick time or paid time off benefits usually pay you 100% of your wages when you are sick. There is often a limit on how many days of sick time you can take. More recently, vacation days are included in the limit and the total is called “Paid Time-Off.”

Short-Term Disability Insurance

After a stated waiting period called an elimination period, short-term disability insurance will replace some or all of your wages.  I have seen short-term disability plans that pay between two-thirds and 100% of wages (excluding bonus) for between 13 and 26 weeks. I have never had an employer charge me for short-term disability insurance, but imagine some employers might do so.

Some governments outside the US, including Canada, offer programs similar to short-term disability.  If your employer requires that you pay some or all of the premium for a short-term disability program, I suggest you research the benefits provided under any government program in your decision-making process.

Basic Long-Term Disability Insurance

After you have exhausted your short-term disability benefits, you may be eligible for long-term disability benefits if offered by your employer.  The basic long-term disability plans I have seen have paid between 50% of salary and two-thirds of the sum of salary and target bonus. Some long-term disability plans provide benefits for only a limited number of years while others will provide benefits until your normal retirement age.  In all cases, benefits stop, of course, if you recover and are able to return to work. I’ve had employers pay the full cost of basic long-term disability and others that required that I cover a portion of its cost. If you pay some or all of the premium for long-term disability insurance, the corresponding portion of any benefits you receive are not subject to income taxes, at least in the US.

Supplemental Long-Term Disability Insurance

Some employers give you the option to increase the percentage of your income that is replaced by long-term disability at your expense.

How to Decide

The decision whether to purchase any optional disability coverage depends on two key aspects of your financial situation. Are you able to support yourself and your family if you are ill or injured for a long time? Does the cost of the disability insurance fit in your budget?

At one (pretty unlikely) extreme, you don’t need to buy additional coverage because you have enough savings for retirement, any children’s education and maintaining your current lifestyle or you can live on just your spouse’s income for an extended period of time.  At the other extreme, you might find it difficult to afford disability insurance. In that case, you probably are also in the greatest need of it as one missed paycheck could be devastating financially. As such, the decision to purchase disability insurance is a balance between your need for the coverage in case you can’t work, your likelihood of having an accident or becoming serious ill, and your ability to pay the premium.

Accidental Death & Dismemberment Insurance

Accidental Death & Dismemberment Insurance (AD&D) provides additional life insurance if you die in an accident. It also pays you a percentage of the face amount of the policy if you lose or lose use of a body part, such as an arm, a leg or an eye.  Many employers offer this coverage. Some charge for it while others do not.

Business travel accident insurance is a form of AD&D that provides coverage only if you are traveling for business when the accident occurs.  Some policies also provide coverage if the accident occurs on the employer’s premises. Most employers do not charge for this coverage, but some may.

How to Decide Whether to Buy AD&D

I generally did not buy AD&D coverage, though obviously didn’t opt out of it when my employer covered the full cost. I had a desk job for my whole career, so could have gone back to work with at least some amount of disability.

If you have a career that is more physical, you’ll want to think about what injuries would make you permanently unable to pursue your current profession. You’ll want evaluate the amount of benefit that would be provided in case of loss or loss of use of a body part.  If your employer’s policy covers accidents in the workplace, you’ll also want to consider whether your workplace is dangerous, such as a manufacturing facility or an oil well, and, in the US, any recoveries you might receive from workers’ compensation insurance. As always, you’ll want to evaluate the potential benefits of this coverage in your specific situation relative to the cost of the insurance and whether it fits in your budget.

Group Legal Benefit

Some employers offer a group legal benefit either at their or the employee’s expense.  Features of this component of a benefits package can include:

  • A discount on legal representation.
  • Telephonic legal advisory.
  • On-line tools.
  • Other free or reduced-fee services.

I’ve never paid much attention to a group legal benefit, as I considered any legal expenses in my budgeting process and have been very fortunate that I have only had very predictable legal expenses (such as writing wills).

If you anticipate that you might need legal advice, it would make sense to estimate the value of any benefits your employer provides and compare them with the cost charged by the employer.  Even having a will written if you have dependent children can be quite expensive, so the value of the discount might be enough to justify the cost.

Extended Health Care Insurance (Canada)

In Canada, many of the basics of healthcare are provided through the government health plan.  However, many important expenses are not covered, including prescription drugs, medical devices (e.g., crutches, wheelchairs and orthotics), various practitioners (e.g., chiropractors, physiotherapists and psychologists) and many other types of medical expenses.

Extended health care insurance covers a portion of these costs, with the portion and specific costs covered varying from plan to plan. Some plans include dental and vision coverage, the portion of ambulance services not covered by provincial insurance, and semi-private hospital rooms.  The insurance includes many of the same coverage features (limits, deductibles, coinsurance) used in US health insurance. If you are considering the purchase of extended health care insurance, I suggest that you read my Health Insurance post, excluding the sections on HealthCare Flexible Savings and Health Savings Accounts.

Acknowledgements

I want to thank Laura Kenney for her invaluable help with making sure I clearly explained these aspects of a benefits package.

How to Buy Life Insurance

How to buy life insurance

Choosing the right type of life insurance policy and its death benefit can be confusing. Not too long ago, I published a guest post from Baruch Silverman of The Smart Investor on the different types of life insurance. In this post, you’ll learn how to buy life insurance.  Specifically, I’ll help you evaluate which, if any, of those types of policies fit your situation and how to select your death benefit.

Why are You Buying It?

The first thing you want to consider is why you are buying life insurance. Three common purposes are:

  • the death benefit.
  • the investment returns.
  • sheltering gifts to your heirs from income taxes.

Death Benefit

If your primary purpose for purchasing life insurance is the death benefit, you’ll want to focus on term and whole life insurance.

Investment Portfolio

Some people use life insurance similar to other financial securities (such as stocks and bonds). Variable life and universal life have investment components to them. In simplified terms, the total amount you pay as premium for these types of life insurance is split between the amount to cover the cost of a whole life policy and the excess which can be invested. As such, the life insurer doesn’t invest the portion of premium related to the death benefit.  Further, the life insurer reduces the excess to cover its expenses, a risk charge and its profit margin before investing it.

Variable and universal life policies include the cost of whole life insurance.  Thus, only people who want the coverage provided by whole life insurance might consider using life insurance as part of their investment portfolio. Even then, the returns may not be as high as other investment vehicles with similar risk because of the additional costs charged by the life insurer.

Tax Shelter

Sheltering gifts to your heirs from income taxes only applies to the very wealthy (those who have more than $11 million in assets). I’m assuming that the vast majority of my readers aren’t in this situation, so won’t address it here.

Other Considerations

All types of life insurance can have an indirect impact on your investment portfolio. If you purchase life insurance in an amount that will cover your dependents’ basic living expenses, it allows you the option to invest your portfolio in riskier assets in anticipation of getting higher returns. That is, the death benefit itself could be considered a low-risk investment.  It reduces your overall portfolio risk when added to the other assets you own.

Do I Need Life Insurance?

Some people don’t need the death benefit from life insurance. In that case, it doesn’t make sense to buy life insurance as an investment security either. In the last section of this post, I provide the details of estimating your target death benefit. People whose target death benefit is zero are those who don’t need life insurance.   Briefly, characteristics of people who have a target death benefit of zero are:

  • Their available assets are more than their debts. Available assets exclude any illiquid assets (such as any real estate or personal property they own), savings for their dependents’ retirement (but not their retirement as they don’t need retirement savings after you die), emergency savings and any savings designated for large purchases.
  • They have enough money to cover their dependents’ education expenses.
  • Their dependents can support themselves on their existing income plus your available assets, including being able to make debt payments as they are due or after using available assets to pay off any debts.
  • They have enough money to pay any end-of-life expenses related to their death.

If you aren’t sure if you meet these criteria, keep reading!

Term vs. Whole

If  you’ve decided that you are buying life insurance for the death benefit, you need to decide whether term life or whole life insurance will better meet your needs. The primary differences between the two options are the length of time you need the insurance and the cost.

Term Life

If you think you will need life insurance for a limited period of time, term life insurance is likely better for you. For example, you might have dependents who aren’t currently able to cover their living expenses and the cost of any debt.  In that case, you might want to buy life insurance that will pay off your debts and support your dependents until they are independent.  If your needs change, many insurers will let you convert a term life insurance policy to a whole life policy without having to provide medical information or have a physical, one or both of which are often pre-requisites for purchasing whole life insurance.

Term life premiums are constant over the term of any policy you purchase. However, if you buy a policy when you are older, the premium will be higher than if you buy the same policy when you are younger.

Whole Life

If you think you will need life insurance for your entire life, whole life insurance is likely better for you. For example, if you have a spouse or disabled children who will never be able to support themselves, whole life insurance could supplement your savings to help make sure they are able to live more comfortably, regardless of when you die.

In addition to the death benefit, whole life insurance gives you the option to borrow money. As you pay premium, life insurers designate a portion of your premium as the cash value. The cash value is always owned by the insurance company, but you are able to borrow an amount up to the cash value at any time without prior approval, any collateral or impact on your credit score. The interest rates on cash-value loans are less than many other sources, particularly credit cards. If you die before the loan is re-paid, the amount of the loan will be deducted from your death benefit.

Cost Comparison

Whole life insurance is much more expensive than term life when you are young, but eventually becomes less expensive.

Probability of Dying

The graph below provides some initial insights into the difference in cost between whole life and term life, as it shows the probability that you will die at each age. I calculated the values based on 2016 data from the Social Security web site.

Probability of dying for each year of age

Not surprisingly, the probability you will die increases at each age. If you buy whole life insurance, it will cover the entire portion of the graph from your current age until you die. As such, there is a 100% probability that the life insurer will pay your death benefit (assuming you continue to pay your premiums). It is just a question of when.

If you buy a 20-year term policy and you are 30 years old, only the deaths that occur in the portion of the graph below highlighted in green would be covered. That is, you will receive the death benefit if you die between ages 30 and 50 and will get nothing if you die after age 50.

Same line graph with blue shading from ages 30-50

The probability you will die is much smaller in this narrow window than the 100% probability you will die at some point.

Present Value of the Death Benefit

There are many factors that determine the premium for term life and whole life insurance policies, but the most important component relates to the death benefit. Actuaries (who help price life insurance) usually base the portion of premium related to the death benefit as the present value of the death benefit expected to be paid, on average, in each year.

One-Year Term Policy

The chart below shows the present value for $1 of death benefit for several sample policies. For illustration only, I have calculated the present values using a 3% interest rate and the probabilities of dying from the charts above.

Present value of death benefit divided by death benefit at each of ages 25, 35, 50

The easiest way to see the impact of the increasing probability of dying is to look at the present value of the death benefit for a 1-Year Term Life policy. You can see it increases from almost zero (actually $0.0015 per dollar of death benefit) at age 25 to $0.042 per dollar of death benefit at age 70 which corresponds exactly to the increase in the probability of dying at each age.

Policies with Longer Terms

There are also increases in the present value of the death benefit for the Whole Life and 20-Year Term Life policies as the age you first start buying the policy increases.

You can also see that the present value of the death benefit at age 25 for the Whole Life policy is much, much larger than the present value for either of the two term life policies. This relationship corresponds to the graphs above which compared the probability of dying in a 20-year period as compared to the 100% probability that you will die at some point.

The difference between the Whole Life and 20-Year Term Life policies is fairly small at age 70, because there is a high probability that you will die between age 70 and 90 – the period covered by the 20-Year Term Life policy. In fact, almost 80% of people age 70 will die during the 20-Year Term Life policy period.  As such, the present value of the death benefit for a 20-Year Term Life policy at age 70 is very roughly 80% of the present value of the death benefit for a Whole Life policy.

Annual Premium

The insurance company collects premium over the full life of the insurance policy to cover the present value of the death benefit. That is, you don’t pay all of your premium to the insurance company in one lump sum, but rather on an annual or monthly basis.

Unless you die during the policy term of the Term Life policy, you will pay premium for more years under a Whole Life policy than under a Term Life policy. Therefore, the differences you see above are larger than the differences in premium payments.

Illustration

The chart below shows the annualized amount of the loss costs. That is, I divided the present values of the death benefits by the average number of years an insured is expected to pay their premium. For example, for the 20-Year Term Life policy, the denominator was calculated as the sum of the probabilities that the insured would be alive in each of the 20 years and therefore able to pay his or her premium.

Approximate loss cost per year per dollar of death benefit at ages 25, 35, 50 and 70

Although these relationships are not precise, they are roughly representative of the differences in annual premium you might pay for the different types of policies at different ages. At age 25, the annual cost of a Whole Life policy in this illustration is roughly three times the cost of either of the Term Life policies. By age 70, the annual cost of a Whole Life policy is less than the cost of 20-Year Term Life policy because, while the present value of the death benefit isn’t all that different between the two policies, people who buy Whole Life policies make more premium payments, on average.

Reality vs. Illustration

It is important to understand that I prepared these examples as illustrations to help you understand the differences between Whole Life and Term Life insurance premiums. In practice, life insurers use different tables showing the probability of dying and different interest rates than I used for illustration, as well as using more sophisticated methods for calculating the present value of the death benefit and including provisions for expenses, risk and profit.

In practice, I’ve seen estimates that Whole Life annual premiums are anywhere from three to fifteen times more than Term Life premium at young ages. As you are looking at your options, you’ll want to get several premium quotes, as they vary widely depending on your age, location, gender, health and many other factors.

How Much to Buy

As with any financial decision, there are two conflicting factors that will influence the amount of the death benefit you buy on a life insurance policy – your budget and your financial needs. In the section, I will talk about how to estimate the best (i.e., target) death benefit for your situation. Once you’ve selected an amount, you can get quotes from several insurers to see whether the premium for that death benefit will fit in your budget or whether you will need to find the best balance between premium affordability and death benefit for you.

Rules of Thumb

Not surprisingly, there are some rules of thumb for guiding your selection of a death benefit. Some of the ones I’ve heard are:

  • Three to five times your salary
  • Ten times your total earned income (i.e., salary, value of benefits and bonus)
  • Ten times your total earned income plus $100,000 per child for college

Rules of thumb like these can provide some insights, but they, by definition, can’t take into account your personal circumstances.

Tailored Approach

A better approach for selecting a death benefit is to analyze your own finances and goals for buying life insurance.   I suggest calculating your target death benefit as the total of the amounts needed to meet your goals, considering the following components.

Debt

If you have debt, you’ll want to consider whether your dependents will be able to continue to make the payments on the debt out of their own income. For example, if your spouse’s earned income is high enough to continue to make your mortgage payments, along with all of the other expenses he or she will need to cover if you die, then you might not need to include the remaining principal on your mortgage as a component of your target death benefit. On the other hand, if you are concerned about your dependents’ ability to continue payments on any debt, you’ll want to include the outstanding principal on those debts as a component of your target death benefit. I’ll define this amount as “Debt Principal to be Pre-Paid.”

Final Expenses

When you die, your dependents will incur some one-time expenses. These expenses can include your funeral or memorial costs and professional expenses to settle your estate. I’ll call the amount of these expenses, “Final Expenses.”

Net Future Living Expenses

The next component of your target death benefit calculation is the amount you need to cover your dependents’ future living expenses.

Current Expenses

Start with your household’s total expenses from your budget. This amount will include monthly expenses for everyone in your household, the amounts you are setting aside each month for your designated savings and any amounts you are setting aside for your spouse’s retirement. To be clear, it will exclude any amounts you are saving for your own retirement.

You can eliminate any monthly expenses or amounts for designated savings for things that are only for your benefit. For example, if you spend enough money on clothes for your job to include it in your budget, you can eliminate those expenses. Similarly, you can also eliminate any expenses related to a vehicle that only you drive or designated savings to replace it.

Earned Income

You then need to calculate your dependents’ monthly earned income. This amount may be calculated in two parts – current monthly earned income and future monthly earned income. For example, your spouse may currently work part time as you are relying primarily on your income for support. If you die, your spouse may be able to work full time to increase his or her earned income. Alternately, your spouse may need some education (discussed below) to get the qualifications needed for his or her desired profession.

Extra Expenses

Next, you’ll need to calculate the amount of any expenses that your household will have because of any changes in your spouse’s availability to provide household services. For example, your spouse may work part-time while your children are in school and provide childcare after school. If your spouse starts working full time after your death, you will need to add after-school care expenses to your budget.

Time Periods

The last factor that goes into this calculation is the length of time until you think your dependents will become self-sufficient. For children, you might assume that they will become independent after they turn 18 or graduate from college. The ability of your spouse to become self-sufficient will be a function of his or her skills, education and/or need for more education and household responsibilities (e.g., childcare or elder care).

I suggest splitting the calculation of this component of your death benefit into three time periods – short-term, medium-term and long-term. For each time period, you’ll calculate your net living expenses as expenses minus income. For any periods for which income is more than expenses, set the difference to zero.

  1. Short term – During this time period, you’ll use your current monthly expenses, excluding your personal expenses, and your dependents’ current monthly earned income.
  2. Medium term – During this time period, you’ll use your current monthly expenses with adjustments for extra expenses for services currently provided by your spouse and your dependents’ future monthly earned income.
  3. Long term – During this time period, you’ll assume that your children (other than those who will always be dependent on you for care) are self-sufficient, so can eliminate all expenses related to children and their care from your expenses. You’ll use your spouse’s future monthly earned income. In many households, income in this period will exceed expenses so there may not be a need for death benefits to cover expenses in this period.

You also need to estimate how many months each of these three time periods will last.

Net Future Living Expenses

Your Net Future Living Expense amount for each time period is calculated as the number of months it will last multiplied by monthly net living expense amount. You can then calculate your total Net Future Living Expenses as the sum of the three amounts you calculated for the three time periods.

For those of you who like to see formulas instead of words, you will calculate:

  1. Short-term Net Expenses = Greater of 0 and Current Expenses – Current Income
  2. Medium-term Net Expenses = Greater of 0 and Current Expenses + Extra Expenses – Future Income
  3. Long-term Net Expenses = Greater of 0 and Future Expenses – Future Income
  4. Net Future Living Expenses = (number of months in short-term period x Short-term Net Expenses) + (number of months in medium-term period x Medium-term Net Expenses) + (number of months in long-term period x Long-term Net Expenses)

You could refine this amount by considering inflation and investment returns. Depending on your investment strategy and the time until the funds are used, your investment returns, on average, can be more than inflation. As a conservative first approximation, I suggest using the total without adjustment for inflation and investment returns.

Education

There are two types of education expenses that you might want to include in your target death benefit calculation:

  1. The portion of the cost of education for your children that you want to provide. Some people suggest $100,000 per child for college. This amount may or may not be the right amount depending on how much you expect your children to contribute to their educations, how many years of college education you want to support and what type of school they attend. Prestigious colleges can cost as much as $75,000 to $80,000 a year currently (2020), while in-state tuition (assuming your children live at home while attending college) can cost as little as $15,000 a year in some states. Other children may not go to college or may attend a trade school.
  2. The cost of any education your spouse needs or wants to allow him or her to work in a profession he or she enjoys and allows him or her to earn enough money to increase his or her independence.

Target Death Benefit Calculation

You can now calculate your target death benefit as follows:

Debt Principal to be Pre-Paid

Plus        Final Expenses

Plus        Net Future Living Expenses

Minus   Savings in excess of your real estate and personal property assets, emergency fund, designated savings and spouse’s retirement savings

Plus        Education Expenses

Minus   Amounts in existing college funds

Minus   Any amounts included in your Net Future Living Expenses designated for college

If you are single with no debt, this amount could be zero indicating that you might not need to buy life insurance. If you are married with no children, don’t have a lot of debt and have a spouse who can increase income or decrease expenses to be self-sufficient fairly quickly, you may need only a small death benefit. At the other extreme, if you have several children and a spouse who won’t be able to be financially independent for many years or ever, your target death benefit could exceed $1 million.   As you can see, the specifics of your financial situation are very important to setting a target death benefit and a rule of thumb may not work for you.

The Different Types of Life Insurance

Life Insurance.: Understanding the Terminology

The life insurance landscape is confusing, to put it lightly. One can get lost in the different types of policies and terminologies, such as whole life, term life, cash value, variable life, and a lot more. If you want to purchase life insurance, you need to first understand the different types, how they work, their cost and which type is right for you and your lifestyle. They fall under four basic types: term, whole, universal and variable.

But how do you make sense of all the different types to ensure that you are picking the correct and best one? Here’s a quick breakdown of the four most common types of insurance policies.

Types of Life Insurance

There are two time-frames over which you can buy life insurance – a stated term or the rest of your life. Insurance that provides benefits over a stated term is known as term life. Permanent life policies provide benefits for the rest of your life (as long as you continue to make premium payments). There are three common types of permanent life insurance – whole life, universal life and variable life.

Term Life Insurance

Term life protects the insured for a pre-determined number of years which is usually any period from 10, 15, 20 or 30 years. The length of time the insurance is in effect is the “term” of the policy. When the term ends, the policy can be renewed on an annual basis as long as the premium is paid. Most insurance companies allow the policy owner to renew until the age of 95, after which point the probability of dying is so high as to make the cost of the insurance almost the same as the death benefit. The life insurance offered by employers is usually term life with a term of one year.

Term life is the most popular type of life insurance and the most affordable. Many financial advisors recommend that you buy term life insurance instead of whole life insurance and use the money you save to invest. But remember that this is a piece of general advice and not specific because you should first consider your own needs and personal situation. What product is most appropriate for you will depend on many things.

Here are the main strengths of term life insurance.

Flexibility

Life insurance will provide cash for your beneficiary so your family can deal with the negative financial consequences of your death. Term life insurance policies are very flexible in that they easily adjust to the policyholder’s needs.

Death Benefit

Beneficiaries do not pay income taxes on death benefits from life insurance. If the policy is properly owned, the death benefits can also be free from estate taxes.

Whole Life Insurance

When you buy traditional whole life insurance, the death benefit and the premium stay the same throughout the term of the policy. As indicated in the name, the term of a whole life is your entire life or until you stop paying the premium.

As you get older, the probability that the death benefit will be paid increases leading to increases in the amount of premium needed to pay for the death benefit (as would be seen in the premium increases you would pay if you bought a series of one-year term life insurance policies). You can imagine that the cost gets very high if you live to 80 years old or more. The insurance company could just assign a premium for term life insurance that goes up each year but it will come to a point that it will be very expensive for people at advanced ages.

Under a whole life policy, the insurance companies keep the premium level by charging a premium that is higher in the early years. This premium is more than what they need to pay claims when you are younger so they invest the money and use it to help pay the cost of insurance as you get older while keeping the premium level.

The main advantages of whole life insurance are as follows.

Lifetime Guaranteed Insurance

With whole life, the insurance company guarantees a premium amount that you have to pay. This means that this amount will stay the same for the rest of your life and will not increase. You can also rest assured that your loved ones/beneficiaries will receive a guaranteed, lump-sum payment at the time of your demise. You may also choose your business to be a beneficiary if you want.

Cash Value Accumulation

Aside from having life insurance for life, whole life also allows you to build a significant cash asset, as the insurance company sets aside a portion of the premium in an account. What’s more, your cash asset under a whole life policy is not going to be dependent on the ups and downs of the market at any time. You can also borrow against the cash value portion of your whole life policy. So, in case you need money for other things in the future such as payment for a home, college funding or a business loan, you’ll have a ready source of borrowing.

Tax Benefits

Whole life insurance carries with it numerous tax benefits, one of which is the tax-advantaged buildup of cash value. Also, many whole life policies provide dividends representing a portion of the insurance company’s profits that are paid to policyholders. Whole life insurance dividends may be guaranteed or non-guaranteed depending on the policy. The good thing is that even if you are accumulating dividends on the policy, you can defer paying the tax for them. This feature is one of the reasons that make whole life slightly more expensive than both term and universal policies. But take note that the policy is not flexible like the others.

Universal Life Insurance

Universal life falls under the umbrella of permanent life insurance options. It provides more flexibility than whole life.

There are three main components of universal life.

Death Benefits

You can choose from 2 options when determining how you want the beneficiary to receive the death benefits:

• Type A Death Benefit or Level Death Benefit. It’s up to you to pick a level of the death benefit, one that starts off as a single amount and stays level or the same for the life of the policy, regardless of its cash value.

• Type B Death Benefit: The other option is a combination of a specific death benefit and then the insurance company adds the cash value accumulation feature that accumulates over the life of the policy.

The Cash Value Portion

The insurance company allocates a portion of your premiums to an interest-crediting strategy of your choosing. In the basic form of Universal Life, interest is credited at a fixed rate by the insurance company. Some policies, known as Variable Life as discussed below, allow people to invest in mutual funds.

Flexible Premiums

The owner of a universal life policy has the option to pay as much or as little premium above a stated minimum. Although this flexibility attracts many insurance customers, a good percentage find it confusing at the same time. In term life insurance, you pay a certain amount every month or every year and you already know what the death benefit will be. But here, the shifting balances of premiums and death benefits are more complicated than what the majority of people need. Plus, it comes with the same extra costs as other permanent policies.

Another major difference between universal life and whole life policies is that policyholders of universal life can pay the premiums as they desire. However, in order to remain active, the policy must have sufficient available cash value to pay for the cost of insurance.

This isn’t something that you can do with a whole life policy because you can’t change the premiums to suit your present economic situation.

Variable Life Insurance

Variable life is similar to whole life with a different treatment of the cash value component.

In whole life and universal life policies, the fund managers keep the cash value component in a savings account. Although the growth is small when compared to other investment options, there is an assurance of the minimum rate guaranteed by the insurer. The insurance company also makes dividend payments from time to time.

Investment of Cash Value

When it comes to variable life, you’d imagine that it is some type of investment vehicle. The funds are in a mutual fund-like sub-accounts where there is potential for bigger growth. But there’s also the possibility of losing money depending on how the market behaves. The insurance company places the cash value in the stock market. Unlike universal life insurance policies, the insurer of a variable life insurance policy does not guarantee that your cash value won’t decrease.

If you are seeking higher, tax-deferred growth, variable life insurance policies are better investment options than whole life policies because they are like a “super-IRA.” However, you can only invest in the sub-accounts that are available through your policy. You don’t have the option to choose from the wide variety of mutual funds that are on the open market.

While premiums for a variable life can be lower than whole life, it is riskier since the company invests in the stock market. Many people don’t know much about the stock market and don’t know how to properly manage the funds to adjust to the market conditions. An average person won’t have the necessary skills or experience to do it effectively. These features limit a variable life insurance policy as an investment option and as a life insurance choice. The limits on investment choices is common to all permanent policy types.

Cost Comparison

The premium for a term life insurance policy is less than the premium for a whole life policy in the first several years you own it.  As you get older, you are increasingly likely to die so the premium for term life insurance increases and eventually become more expensive than if you were paying for a whole life policy you started buying when you were younger.

Cost of Term Life Policies

You might think that it is a disadvantage to choosing term life. After all, you have to die first to receive money (which does not go to you at all). Every year you will have to keep paying insurance premiums so you can protect your family. The premiums are affordable so you won’t have problems making the payments. But here is where some people can’t reconcile the cost and the benefit: when the 20 years go by and the insured is still alive. The insurance company does not give back anything. The truth is, this is a fair deal because the low premium you are paying only accounts for the death benefit you will get in case you die during the term of the policy.

Cost of Permanent Policies

In contrast, if you had purchased a permanent policy, you could keep it forever. And if you opted to stop in 20 years, the insurance company would likely give you back a portion of the premiums you have paid. When you account for the dividends you’ve received, there is a chance that you’ll get back all your premiums at that point. There is no guarantee that the policy will pay dividends so the insurance companies will not include them in their projections.

In the early years, permanent policies are more expensive than term policies so you would have to consider how much you are able (or are willing) to pay when you choose your life insurance.

About Baruch Silvermann

Baruch Silvermann is a personal finance expert, investor for more than 15 years, digital marketer and founder of The Smart Investor. But above all, he is passionate about teaching people how to manage their money and helping millions on their journey to a better financial future.