Life insurance as a tool to protect and even build wealth is a concept that is widely promoted by the insurance industry. We even read some things such as life insurance is the secret or one of the real secrets behind the long-term preservation of wealth by some famously wealthy families.
This is actually a ridiculous notion and the fact that some families end up passing on fortunes to one generation to another has little to do with life insurance, although it can help with things like estate management by reducing the amount of tax paid when one passes by a meaningful amount at least.
Money bequeathed is often subject to estate taxes and life insurance payouts do have the benefit of being tax free generally, under the assumption that life insurance benefits are generally more essential to the financial well-being of those who receive it than normal.
This is generally true, and even though it may not be in a given instance, where one is receiving far more money than they would ever need to live very comfortably on independent of the insurance benefits, there are some who do seek to take advantage of the tax advantages anyway.
This is an idea that may be well worth considering in some situations, although we don’t just want to look upon the tax benefits here, as there are some real costs as well. Insurance companies are out to make a profit and do not set us up with policies that we may have the expectation of profit, and the reverse is true actually.
Not only may life insurance be subject to delivering lesser returns than other uses for funds such as investing, life insurance by its nature involves an expectation of financial loss overall, because this is how insurance companies make their money. Their expectation is a profitable one as it must be for them to make sense out of offering it to us, and this profit comes ultimately out of the pockets of their clients of course.
Whatever tax benefits that may accrue to us need to be considered net of this expected loss overall, as whatever we put into a life insurance policy can be expected to result in losses which must be deducted from the tax benefits.
As it turns out, while it is quite sensible to account for tax benefits with life insurance as an additional benefit of it, given that it makes sense already, it rarely makes sense to rely substantially on these tax benefits to justify the insurance. If it makes sense to buy without the tax benefits though or is close to being so, then these added benefits can tip the scales.
Life Insurance to Prevent Wealth Loss
To best understand the proper role of life insurance, we need to think of it as income replacement, not wealth replacement. Life insurance is designed primarily to replace income streams when someone dies and is no longer able to earn.
What it does not do is replace income streams from investments, because once again there is an expected loss overall involved in investing in it so to speak, the life insurance part of it anyway. If we’re looking to grow this amount in itself, we wouldn’t want to be spending on life insurance, because the money we defer from the investments and toward the insurance will lower our returns.
We pay a price for insurance and that price is reducing the value of our portfolios themselves, so at the very least it is not these income streams that we’re protecting.
While we may think that the lump sum payments that our beneficiaries may receive if we die during the life of the policy may help them manage financially, from an investment perspective at least, we’d be better off just investing the money ourselves.
If we already have, say, a million dollars and we’ve decided that we’re going to need two million of coverage, the fact that we are a million short right now ultimately means that we’re protecting against our inability to build this amount further to cover us in the future, not that our million dollars itself needs protecting from an investment perspective anyway.
Of course, if we have a shortfall like this, and we’re accurate in our assumptions, our dependents will end up spending down the principal in time if we do die, to the tune of their only having half of the money that they will need, and that’s a concern for sure. The money can’t look after itself, we’ve decided that, because we’re projecting the expected returns from the money we’ve built up already, so this can only mean that it’s our inability to invest further that is what needs to be protected.
The importance of this distinction lies in the fact that it is not the wealth we’re protecting per se, it’s our future inability to grow it from earning income apart from the returns that our savings will provide.
Someone who is retired for instance and living off of their investments will not therefore be well served to use life insurance to protect their wealth, because insurance doesn’t do a good job at all of doing this, because of the net negative expectation of it. During one’s working years though, one’s income is what we should be seeking to protect, and only the amount that makes the difference between being fine and being short.
From all this, we can see that the primary purpose of insurance isn’t to protect wealth, at least present wealth, it’s to protect us from not being able to contribute enough income to our savings to be able to provide a satisfactory level of financial support.
This concept is already pretty well understood by the insurance industry but those who look to take this further and suggest that we are actually protecting the wealth we already have, independent of our means to grow it from adding investments or savings to it, end up taking the purpose of life insurance beyond its proper use.
People end up buying coverage that they may not need when we don’t understand this properly, and while it is true that most people are underinsured when it comes to life insurance, we still want to make sure that we’re not over-insured either. This happens whenever we spend money on life insurance policies that go beyond our needs and end up paying extra without the proper benefits of doing so.
In our example, we do want to look to make up for the shortfall in our expectations, the million more that we will need should we not live long enough to build this extra wealth, but it’s not the million that we have that needs to be protected, it is the ability to earn this additional million.
We then would look at what it would cost us to do this, and a million-dollar life insurance policy isn’t going to come cheap to be sure, and all this is going to depend ultimately on how much we can afford to spend on the coverage to get the desired level of future protection. The cost of the policy will of course diminish our wealth while we’re alive, and the idea here is to make sure that we’re striking the right balance between the outcomes, what will happen if we die and what will also happen if we don’t over the life of the policy, and select the best mix.
The goal here is to seek to protect only what is necessary to do so, as any excesses will just result in efficiencies, our wasting our money to various degrees in other words. The question of how much future wealth to protect will then come down to comparing what we get with what we give up, and this will allow us to have a good idea of what we can actually afford to spend on this, what makes sense to afford in other words.
Using Whole Life to Protect Wealth
Thus far we have been speaking of the proper use of a life insurance policy itself to protect future wealth, using term life insurance in other words. We do want to look at the actual insurance coverage we receive when we consider how much life insurance we should purchase, as the savings or investment component of whole or permanent life policies need to be considered independently.
The fact is, the savings component of life insurance policies really has nothing to do with life insurance per se, even though they are combined in policies. This side of the policy is merely an investment, no different really than just saving or investing the money ourselves.
So, while we can rightly say that this savings or investment component not only preserves wealth but builds it, it does not do so any differently than with our directing these investments ourselves, so this is not even a material fact when it comes to the ability of insurance to protect or grow wealth.
There are quite a few people who aren’t sufficiently skilled or motivated toward saving enough, and these people can clearly benefit by combining their life insurance and their savings, because these policies to a great degree force us to save.
This is the beauty of whole life really, and even though most of these policies provide very low returns similar to just putting your money in a bank and earning interest, for those who are unable to set enough aside to save, this can be a huge advantage.
What we’re protecting here isn’t wealth so much as the tendency to overspend, and overspending is something that a lot of people do. In cases where they should clearly devote more of their income toward saving, this can be a challenge, and they often decide instead to spend too much or even all of their money rather than saving it.
Ideally though, we would have enough discipline to do this ourselves, although even if we do, we still may want to choose a whole life strategy as long as the investing strategy of the policy matches up with our own. If we are just out to save, then one that saves may be right for us, or if we prefer a more aggressive approach, as long as the returns that the policy averages are competitive, that can be a good choice as well.
We need to bear in mind that these two components are actually competing forces, with the insurance component providing protection against our not having enough money and the savings side seeking to grow our money to the point where we will have more without needing to rely so much on this insurance.
The more we save, the less insurance we will need in other words, and vice versa. The best way to protect wealth, to protect against the deterioration of it by needing to spend it down at some point, is to just have more of it. In cases where we are in a situation where there will be shortfalls if we die, covering this better is what insurance does, and to this extent, it does indeed protect future wealth at least.
Chief Editor, MarketReview.com
Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.
Contact Ken: ken@marketreview.com
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