[Editor's Note: This is a guest post from Jon Sycamore CFP®, founder of Physician Wealth Planning. The subject of laying/laddering term life insurance policies has been discussed on this site in the past, but it was over 3 years ago, so I thought it was worthwhile to hit it again. Jon and I have no financial relationship.]
Financial professionals have a bad reputation among consumers. I’m a financial professional, and I agree that it’s not without cause. There are a lot of people swimming in the financial services pool and a lot of them are, well…incontinent. It’s getting better though. You may or may not be familiar with the Department of Labor’s fiduciary rule, but basically, it requires anyone giving advice on retirement accounts to put the client’s needs ahead of their own. I’ll spare you the details, but the point is that the bar is being raised on financial professionals. While there’s still a ways to go, I think the biggest culprit contributing to financial professionals taking advantage of consumers is the sale of commission based products. Many investment advisors have already gone away from selling products to charging a fee for services, but it’s still the standard in the insurance industry.
There’s a saying, “Insurance is sold, not bought”. You, the customer need to watch out for overzealous salesmen who will tug at your heartstrings to convince you to buy as much insurance as you can afford. I mean, you love your children, don’t you?
Jon Sycamore, CFP
I’m not trying to trash on insurance professionals here. In fact, I’ve found that they are raising the bar on themselves despite the DOL rule having no jurisdiction on most insurance sales. I recently attended a webinar hosted by Mark Maurer of LLIS, where he talked about layering term insurance to save client's money. This strategy involves multiple smaller policies of varying lengths that reduce the amount of insurance over time as the client’s need diminishes. Before, you’d probably just be sold a single large policy so the salesman could collect as much commission as possible. Putting your client’s needs first! What a concept!
Determining How Much Term Insurance You Need
Before we go any further, it’s important to understand how much insurance you need over time. There are two approaches you can use to determine how much insurance you need, an important part of buying term life insurance from independent agents.
# 1 Human Life Value
The human life value approach to determining term insurance needs estimates all future earnings, minus taxes and self-maintenance. This is the more straightforward approach as it simply looks at your earning potential and attempts to replace it.
# 2 Capital Needs Analysis
A capital needs analysis is a bit more cumbersome but is more precise. It looks at your needs individually and attempts to fund them. It doesn’t have to get too granular but usually looks at paying off large debts like a mortgage or student loans, funding education, basic living expenses, etc.
Regardless of the approach you take, you’ll end up with a series of cash flows for a given amount of time. Rather than simply adding up all future cash flows to get an enormous number, you choose an investment rate of return you think is realistic, then calculate the present value for each future cash flow and sum those numbers to get the net present value (NPV).
The NPV minus any liquid savings you have is how much insurance you need today. But what about in the future after you’ve had a chance to accumulate more in savings and many of those initial cash flows have passed? The amount of insurance you’ll need is reduced. This is where layering term insurance comes in.
Hypothetical Example
Let's say you’re a 35-year-old female physician in good health and you don’t smoke. Your gross income is $275,000, you pay a combined tax rate of 28%, you max out your 401(k) and make nondeductible contributions of $11,000 into your IRA and a spousal IRA (and convert them to backdoor Roth IRAs). Finally, you determine that if you were to die, your family could live on $40,000 less. This leaves you with $150,713. Assuming your income only keeps up with inflation at a rate of 3% and an investment rate of return of 6%, we can project how much coverage you will need in future years. Is your head spinning yet? Click here for a breakdown of the numbers. As you can see in the chart below, the NPV represented by the blue line starts at $3 million and steadily descends as annual expenses are completed and savings accumulate.
Single Term Insurance Policy Versus Layering Term Insurance Policies
As the chart above suggests, this hypothetical client would benefit from layering term insurance as her need for coverage diminishes. If she purchased a single $3 million, 30-year term policy, that would cost her $2,310 per year, or $69,300 cumulatively. However, If she layers three separate smaller policies as illustrated above, she would pay $1,574 per year for the first fifteen years, then $1,234 for the next five years, and finally $810 for the next ten years for a cumulative cost of $37,880. In total, this strategy provides complete coverage and costs $31,420 less.
Does Layering Term Insurance Apply to You?
You may be saying to yourself, “well that’s great, but that’s a lot of calculating for me to do on my own”. You’d be right. It is. That’s why I’ve included this spreadsheet for you to enter in your own personalized assumptions. For simplicity’s sake, it uses the human life value approach discussed earlier. A capital needs analysis, however, often make an even stronger case because educational expenses tend to keeps the NPV high until after that expense is completed, then it descends at a more rapid pace. Enter your personalized information in the blue highlighted cells and the formulas do the rest.
[Editor's Note: Three comments I'd like to make to round out the topic.
First, I am a strong proponent of the capital needs analysis method of determining how much insurance to buy because it is based on your spending rather than your income. You don't need to replace what you earn, only what you spend. For a good saver, there's a huge difference between those two. So I find that using a human life value approach is much more frequently used by an insurance agent as a method to sell you more insurance.
Second, don't forget the effects of inflation which are hardly insignificant over a 20-40 year career. A 30 year level premium policy is already layered/laddered on an after-inflation basis. In real dollars, both the premiums and benefits are higher in the first few years and lower in later years. Be sure to take this effect into account when determining your term insurance plan.
Third, I am a big fan of this strategy and have two separate term life insurance policies, a $750K policy that ends around age 52 or so and a $1 Million policy that ends around age 57. However, I'm likely to cancel them both in the next few years thanks to reaching financial independence earlier than expected and probably would have been better off buying annually renewable term insurance instead of level premium policies.]
What do you think? Did you layer your term insurance? Why or why not? How much do you expect to save by doing so? Comment below!
I wish I’d known about this method when my wife and I bought our term life insurance policies 20 years ago.
I have to ask, are you sure a lot of financial professionals are incontinent? So sad. Maybe you meant incompetent?
Matt it was a joke about pee in the pool.
No, he actually meant incontinent, but I don’t think he meant it literally. It was a play on the word “pool.”
🙂
I can confirm that it was, in fact, a pee joke. Salesmen are actually very competent, otherwise, they don’t last. However, many can’t “hold back the urge” to sell products that pay out high commissions.
Thanks for clearing the waters on that one, Jon. 🙂
Did not do this on purpose. In fact at our first financial tune up the adviser pointed out a big lack of coverage. We had 15 year term policies (+SGLI on him) expiring about the time the oldest- only at the time- would have college paid for. I had gotten my wish- a second child who was in the oven- and I was working only sporadically so we figured my life needn’t be insured once my first policy expired when youngest was 6 or so. Luckily (though thankfully we never needed it!) adviser pointed out that even if I had no income, my death would leave the kids’ dad needing a nanny, cook, bottle washer, and chaffeur to replace me. So we got another set of term policies on both of us to cover the last kid to driving/ college saved for age.
So in the end SGLI dropping off when he retired when kid2 was 11, and earlier our first term policies ending when she was 6 or so, gave us layering. And here I had been thinking too bad we didn’t get 25 or 30 year term from the get go- but who knew it would take 7 years to convince him to let me have kid2, or that the meandering market would tank and rebound so well in the past decade.
We were done NEEDING term coverage a few years before the policies ended the level term, but we played the lottery for a few years while the price was still low. But truly we didn’t want to be tempted into mariticide too much (when you’re grumpy at each other a half million policy might seem more valuable than a nonearning spouse) so if they’d been a lot higher coverage I’d’ve ended them even sooner.
I always hear that you need to include non-working spouse domestic work into insurance, but it sounds to me like more salesman incontinence. Dishwasher safe bottles cost very little, and I’ve yet to meet a single parent with a cook or chauffeur. Certainly childcare would be an extra expense, but I think the rest are suspect. Your spouse and children’s life would be dramatically altered, but no amount of money could fix that.
Most single parents haven’t gotten a half million or more life insurance policy when they were widowed. In my husband’s case it would’ve given him the opportunity to quit work and stay home with the kids should he have wanted to or get a comprehensive full-time nanny so he could, except for no longer being married and having lost me, have things as easy as it had been before my death. It would also contribute toward the kids college what we had expected and hoped I would kick in by going back to work if they went somewhere very expensive.
Jon, good blog post. Great points. Thank you.
I think I described my approach previously on your site. I intentionally layered a 30 year 2M policy with a 20 year 1M policy. Now about 10 years in to the policies. Would probably have done the exact same way in retrospect.
I agree capital needs preferable–in particular factoring in inflation adjusted college costs.
I purchased a term life policy and did the math comparing laddering policies vs. a single policy, looking at future needs, savings rate, market returns, etc. There were a lot of unknowns, particularly in regards to future savings and returns which made it difficult to confidently project a good ladder policy, and the potential risks imposed by these unknowns were not worth the savings in premiums for me. In the grand scheme of things, the potential savings were relatively minor, and for me the simplicity of ease-of-mind that a single policy could provide was worth it. If I knew for sure what the future holds for me, I could certainly construct an elegant and cost-effective term-life ladder, but I unfortunately don’t.
I prefer the “auto layering” based on inflation. Having lots of policies makes it harder for family to track them down. Don’t have any real issue with this approach though. You just need to realize it’s cheaper bc you have less coverage when you are more likely to die.
Actually 6 years in to those policies. 10 years ago I purchased a single 1M 20 year policy (influenced by Dave Ramsey). Then came to realize I was under-insured both in amounts and over time but also that 20 years out I could likely self-insure 1M of the 3M goal.
Great Post….Those who are young and not close to FI should keep it in mind!
Generally, Life insurance rates are coming down as people live longer and survive major medical events. Why buy excessive coverage now? I am not interested in making my spouse and/or kids multi-millionaires.
These products seem to require knowledge of the unknowable. I hate shopping for this kind of insurance. I want a simple product that I can buy once and forget. 20 or 30 year term seems about right.
Complexity favors the seller.
Not a lot of complexity there. I technically have layered policies. A 20 year that runs out at 53 and a 30 year that runs out at 58. The 20 year is significantly cheaper.
I wish I had thought of this strategy earlier too. I have $3 million in term life between 2 policies. One strategy I had debated was decreasing the policy amount (allowed under my current policy) of one policy from $2 million to 1 million once I have hit a certain amount of savings/net worth. Then a few years later, removing the policy altogether. That would leave me with another $1 million policy until I hit FI. The overall cost may be slightly higher, but I have had the policy for 5 years and hopefully can cancel it in the next 5.
A lot of companies will do that since you paid more when you were less likely to die. This decreases their risk and is better than a lapse which would require a new commission to some agent if you bought another policy instead.
“You may or may not be familiar with the Department of Labor’s fiduciary rule”
This rule has been delayed by the current administration and is not currently in effect. For what it’s worth, financial planners like the author are still legally allowed to put their own interests first. I intend no offense, and I’ll read the rest of the article, but there’s some misdirection here from the start.
“If you assume that every financial professional you interact with is a hardened criminal, you’ll do okay.” -William Bernstein
There is at least one reputable company (forgetting name — Banner?) that will sell a laddered policy as a single policy so you don’t have to purchase multiple policies to make this work. It makes the paperwork and payments easier. Larry Keller or someone else should be able to tell us who that is.
I explored this a few years ago and decided against it. However we’ve now had our 3rd kid and have an 8 year spread between the oldest and youngest, and we haven’t changed our policy. I’m going to explore again whether laddering will be worth it so I can front load the major benefits over the first 10-20 years and decrease it over the final 10. It’s not for everyone and not necessary for everyone, but certainly worth considering.
I can confirm this. Bought two laddered policies from Banner right out of fellowship, and it was as simple as buying one policy; premiums have been the same way since. I just had to run the numbers on terms4sale.com, confirm it made sense, and tell the agent what I wanted.
I did a similar thing with less money but it was 30 years ago. Very simple.
I had 3 kids, I bought $600,000 of term insurance.
As each child graduated from HS I dropped $100,000, when they finished college I dropped another $100,000.
When the last finished college, I dropped the last of the insurance
By that time there were enough assets for my wife to be ok for the rest of her life.
Gordon
New favorite quote: “There are a lot of people swimming in the financial services pool and a lot of them are, well…incontinent.”
I think a lot of people end up layering if they are appropriately insuring capital needs all the way along. I had no life insurance until I got engaged. My wife had a good paying job with benefits, so I got a 750k 20yr term policy to pay off our mortgage (which would have been a bit tough for her to afford on her own) and give her some financial flexibility. I was just finishing training and I’m fat (life insurance is basically priced by the pound), so this filled our needs without breaking the bank.
A few years later, a positive pregnancy test changed the picture. In addition to child-related costs, my wife went from full-time to freelance to have more time at home. The nature of her work would make it difficult to return to her pre-baby compensation very quickly, even without the practical considerations of a single parent. This prompted a 2M 30yr policy which will sunset about 13yrs after the 750k policy when there are no more college bills to pay.
In retrospect, splitting the second policy into a 1M 20yr and a 1M 30yr would have better matched our needs and saved some money, but we’re still pretty close to the right track. Of course, if I had become uninsurable before that second policy was written, our situation would have been more challenging.
We have a single policy – 20 year term with 8 years left. BTW, we also did a first-to-die option. So we have a single policy that covers both my wife and me. Sure, if one of us dies the other no longer has a policy, but at that point it wouldn’t be needed anyway because of the payout. That’s sort of the point.
How much more was the first to die policy than just a policy on one of you?
Sorry, I don’t remember. I barely remember yesterday – let alone 12 years ago. 🙂 It was a lot less than two separate policies though. They lower their exposure since they only have to pay once. (Actually, they pay on us BOTH if we die from the same incident within a few hours of each other.)
Was looking at term4sale.com and plugging in the numbers die my wife. 38 years old in exceptional health for a 750k 15 year term vs a laddered policy of 250k 5, 10, and 15 year policies. Surprisingly, the 15 year 750k term policy was significantly cheaper. Was sure I would find the opposite
That is weird. Obviously you want to run the numbers because strange things do happen with insurance pricing.
I layered $1M 15 year and $500k 20 year in my late 30s (replacing other insurance). Price of each policy was nearly the same. Throw in the workplace policy for another $300k as long as I’m employed (or want to overpay out of pocket when I quit) and this ended up meeting our needs very well.
“die my wife”? I hope that’s not a Freudian slip ????
Like Arthur, I have done a little bit of layering on both ends (a pyramid approach, if you will). I bought one term policy when I got engaged (my wife would have needed my salary replaced, at least in part) and another for a different duration when we started planning to have kids. The first policy will expire 10 years before the second, and my employer’s life policy will expire the day I retire.
Years ago, even though I was single, I ended up with a level term 30 year policy through work as a fully reimbursed benefit.
When I changed companies, I lost the reimbursement benefit, but decided to keep the policy anyway. Even though I did not have a risk to cover, I felt I had put lots of work into my career, and my two siblings could use any benefit that came their way. The cost seemed de minimis at the time.
Today, I am quite sure I would counsel against getting coverage for a risk that does not exist. However, I do have some empathy for young people that may make an initial insurance mistake.
KJF
Me too. I certainly made several.
Jon:
Great article on an important subject. Way, way too many people just figure out how much insurance they need today and buy one term insurance policy to cover the entire need for the next 20-30 years.
I have a similar spreadsheet that I use for this same kind of analysis and I have a few suggestions/comments that you should feel free to dispute:
1) Check your NPV calculation in column J. For instance, cell J3 is calculating the NPV as if the first cash flow of $155k is happening at the end of year 1. It’s actually happening at the end of year 2 and so the NPV in column J is inflated for all years except the first year. This calculation error becomes more pronounced the further into the analysis you go.
Think about the $335k NPV in cell J31. You’re discounting a cash flow of $355,164 at 6% in 30 years from now. The NPV of this cash flow is really only $61,838 – not $335,060.
Notably, the NPV of future income cannot increase. It is at its peak today and then goes down every day into the future (unless your opportunity cost/discount rate is negative in which case you have bigger issues).
2) I would consider whether you really want to subtract “Savings” from the needed coverage. The amount of savings you need at each point in the future is inherently built in to the NPV by the discount rate. If we assume that the future income is all necessary for retirement (whether saved or spent), then by subtracting savings from the NPV, you’re effectively double-counting the savings and understating the amount of needed coverage.
Just my two cents. Happy to discuss if you or others disagree with this logic.
This is a very good article and one that I think most people need to read and think about. Having purchased policies through two different insurance agent at a time when I was financially not as knowledgeable as I am today, I realized that I was not given the right kind of guidance and service. I was recommended only a 15 yr term convertible whole life and then a few years later told to buy one more policy similar to first one. Was given a similar recommendation for my wife which I ended p converting whole life due to other reasons and out of no choice. In hindsight, we should have purchased a 3M policy in the beginning and then dropped each policy as our financial condition was improving.
What I have realized is that the financial services industry is filled with either incompetent or insincere folks who don’t have the best interest of their clients. Being able to assess a personal situation and recommending a plan catered to individual needs is an important aspect of financial planning. However, this approach takes time and leaves very little opportunity to profit for the service provider. It is a business that is driven by volume and so the best way to make the most money for financial professionals is to come up with a cookie cutter approach and sell the plan. This is not just for insurance but also retirement plans. Unfortunately, this gives a bad reputation even for those few professionals who are sincere in this industry.
Great post on something not many people think about. Most people would plug in their financial information into a calculator and use the result to buy a single term product, but as mentioned, your life insurance needs should be decreasing over time, so the entire amount won’t be needed for the entire term.
Not sure how policies work in the States, but in Canada, you can construct a layered term policy by using a term-30 as the base coverage and adding term-10 and term-20 as riders. That way, you only pay a single policy fee and you can benefit from rate banding.
It seems the spreadsheet is no longer available. I swore I downloaded a copy but can’t seem to find it :(.
I guess we should have gotten a copy and kept it on the WCI servers.