For the millions of Americans who get their life insurance through work, it can be easy to gloss over the details around how life insurance works, the types of policies that exist, and how it fits into a broader financial plan. Many others first encounter life insurance products via a sales pitch which may raise more questions than answers.

As fiduciary advisors (meaning we must legally put your interests first), the Revo Financial team looks at life insurance as one part of a holistic financial plan. Members of our team are also licensed to sell insurance, since we want to ensure our clients get the right insurance for their specific needs (and that they understand the fine print). 

To help you understand whether you might benefit from life insurance, let’s review the different types of policies available and the scenarios where they make the most sense.

How life insurance works

At its core, life insurance works like any other insurance contract. The policy holder pays a premium to an insurance company; in exchange, the insurance company agrees to pay a sum of money to specified beneficiaries if or when the policyholder dies.

As you might imagine, there are many ways to structure the terms for this type of contract. For instance, the length of the contract, the rate of the premiums, and various other fine-print details.

Generally, life insurance companies take the premiums paid to them by policyholders and invest the money (versus holding it in cash). Sometimes the way an insurance company handles the funds impacts the terms of the contract.

Term versus permanent life insurance

The most common differentiator between types of life insurance comes down to the duration of the policy.

Term life insurance covers you for a set period or term. This type of policy is common, since it’s often bundled in as part of an employee benefit package. Usually, the term life insurance provided by an employer covers you for the term of your employment. However, you can also buy term life insurance independent of a job. These plans usually extend for a period of 10, 20, or 30 years.

Permanent life insurance covers you permanently, so long as you fulfill the terms of the policy (such as paying premiums). There are numerous types of permanent life insurance, many of which are designed to offer benefits to the policyholder beyond the death benefit.

• Whole life insurance. This is the most common type of permanent life insurance, and the terms are often used interchangeably. In the past, whole life plans included preset premiums and death benefits, but in the past decade or so, companies have come up with new product structures, and many feature more flexible terms. Whole life policies carry a cash value. This value is usually based on the premiums you pay, plus a set interest rate.
• Universal life insurance. These policies are like whole-life policies, but they may allow you (or the insurance company) to change the premiums you pay and/or the death benefit your beneficiaries are set to receive. They also carry a cash value, which may be pegged to a specific index—such as the S&P 500 or a bond market benchmark—instead of a fixed rate or return. This is referred to as indexed universal life.
• Variable life insurance. With variable life policies, you or the insurance company may be able to invest the funds in the plan with more discretion. These investments can impact the value of the cash value or the policy or even the death benefit. It’s particularly important to understand the terms of variable life plans to avoid any potential surprises.

Beyond duration, term and permanent life insurance plans come with several key differences. First and foremost: Permanent plans tend to cost five-15x more than a term plan with similar coverage. This sometimes means people will purchase less coverage (or a lower death benefit) to keep the premiums affordable. That may or may not be advisable depending on your family’s needs.

Permanent life insurance plans may come with more options than a term life insurance plan—namely, you may be able to tap into the plan’s cash value during your lifetime. This can help families cover major expenses like long-term care or even college tuition (depending on the terms of the policy). However, tapping into the plan’s cash value may also impact the death benefit or come with other limitations.

Many of these more complex permanent life insurance plans also come with layers of fees that may impact your premiums or benefits—for instance, a variable life plan that invests the funds may include a managed fee that an indexed universal plan does not. 

Because the “devil is in the details” so to speak, we suggest walking through life insurance plans with a fiduciary advisor—someone who has your best interests at heart. Ask how the insurance company gets paid, which fees and/or benefits are subject to change and which are guaranteed, and make sure you understand the fine print.

Choosing the right life insurance

Which type of policy is right for you depends on your goals and other aspects of your financial picture. And a financial advisor can help you analyze these different factors to make the right choice for you.

In an ideal world, life insurance is designed to cover your family’s expenses if you die unexpectedly. In this scenario, you’d simultaneously build a nest egg through saving and investing. Eventually, when your children have moved out and are supporting themselves, and you’re living off your nest egg, the need for life insurance goes away. Term life insurance is designed for this type of scenario, and a financial advisor may be able to help you build this type of financial plan. But there are other factors to consider.

What are your family circumstances? For instance: Do both spouses work? If so, a term life policy may make the most sense. If one spouse does not work, however, they may need financial support indefinitely to replace not just your income but your lost retirement savings and government benefits. Similarly, think through any relatives you’re interested in supporting. Some families purchase whole life policies as a way to build generational wealth and provide an inheritance for their children; others prefer to use it strictly for worst-case-scenario protection.

What are your expenses? In general, you want your death benefit to cover your family’s expenses. The size of your death benefit may depend on your family’s circumstances, as discussed above, but it can also depend on your family’s budget. If you’re paying private school tuition and a mortgage, you may have larger expenses to cover with a death benefit than a family whose children are grown and whose house is paid off. 

Do you have any debt? When you die, your estate is responsible for settling any debts you owe. Ensuring your death benefit is large enough to pay off any debt can help protect your heirs from having to settle your accounts. If you have debt, think about when you expect to repay it—this can impact whether a term or permanent policy makes more sense.

Do you have a plan in place for long-term care? An increasing number of whole life policies offer accelerated death benefits (ADBs) which can help you cover any health issues you encounter in retirement. ADBs can be particularly helpful if you require long-term care, which generally isn’t covered by health insurance and can cost thousands per year.

How confident are you in your plans? Many insurance policies will allow you to change your mind later. For instance, you may be able to convert a term life policy to a whole life policy, or you may be able to purchase a long-term care rider as part of your whole life insurance policy that’s cheaper than purchasing a separate long-term care insurance policy. Building flexibility into your plan might increase your premiums, but it can also give you peace of mind.

How much life insurance do you need?

The size of your life insurance policy usually goes hand-in-hand with what you need the insurance to cover and the type of insurance you purchase. 

For years, a $1 million policy has been considered the gold standard for policies. In general, a $1 million policy boils down to $50,000 a year for 20 years. However, your family may be able to invest that $1 million benefit. If that investment returned 5% a year, it could generate a $50,000 annual income without needing to dip into the principal. Of course, investments can lose value, too, and a 5% rate of return is simply a hypothetical we used to illustrate how benefits can work in real life. 

If you’re purchasing life insurance primarily as a death benefit, think through your family’s expenses, if they’ll be able to invest the lump sum (or if they’ll need to use it to cover debt), and how long you want the benefit to last. 

If you want to access the policy’s cash value along the way, factor that into your calculations.

While it can be tempting to inflate the size of the death benefit, consider how the size of the payout will impact the cost of your premiums. It’s important to be honest about your ability to pay the premiums, as failure to do so could void the entire policy. 

Nearly half of the people who purchase permanent life insurance surrender the policy within the first 10 years. While you can usually access the money you’ve paid into the account so far, that money may only equal the premiums you’ve paid, and you may have to pay an early termination fee to boot.

Of course, your premiums are impacted by more than just the size of the benefit. Your age when you sign up for a policy, as well as your age, gender, location, health and more factor into what the insurance company may charge. Men tend to pay higher premiums for life insurance than women, for instance. 

Term life policies tend to provide a much larger death benefit for the premium, but the entire benefit expires at the end of the term.

The multiple moving parts we’ve covered in this article help illustrate why life insurance works best when it’s part of a big-picture financial plan. At Revo Financial, we start with the financial plan and discuss insurance as a way to manage risk and protect your savings. If you have questions about whether your family has sufficient coverage, set up a time to discuss.