Dumbing Down Insurance Licensing Exams

The Wall Street Journal reported on April 25, 2011 that Primerica is pushing to make state insurance licensing exams easier so more of their potential agents can pass.

I have limited experience with state insurance licensing exams. In the mid-1980s the company I worked for brokered annuities for its small pension clients as a way to mitigate mortality risk. Since I was responsible for the folks who made those sales, I decided to become licensed myself.

I had to go to required classes—not exactly onerous—although it was a long Saturday because the class was B-O-R-I-N-G. I had to pass both the state licensing exam and a couple of NASD licensing exams since I was to sell annuities. I did read the suggested material for the state exam since many of the questions related to specific New Jersey requirements (including all the stuff about what happens to you if you don’t follow the rules). My study for the NASD exams consisted of taking one sample exam. I don’t recall my scores, but I had absolutely no problem passing and thought at the time that the minimal requirements New Jersey imposed didn’t make me feel comfortable that a state-qualified broker could give the best advice to the Aunt Bessies and Uncle Jakes of the world.

And now Primerica wants to make the tests easier? Insurance products have not become more straightforward in the last 25 years. If people can’t pass the tests, Primerica should change its recruiting so it attracts people who can. Primerica carps about an unsatisfied need because of the lack of brokers. The public, they say, is not being well-served.

If Primerica can’t attract people who can qualify under the current system, they need to change their ways. Perhaps they should look at their unique compensation structure that pays agents for bringing in other agents in addition to actually selling insurance products. Maybe if agent compensation was aligned with public needs, they would find qualified individuals, as their competitors do.

Oh, did I mention that if you want to join Primerica’s agent training program, it will cost you $99?

~ Jim

Annuity or Lump Sum Payment? (Part II)

In the previous post I asked you to think about the risk you should be trying to mitigate as you consider the lump sum vs. annuity issue.

Most people’s greatest risk is outliving their money and relying on Social Security. Annuities can mitigate that risk, but not eliminate it. Life annuities will continue for as long as you live, but most pensions do not adjust benefits for increases in cost-of-living. You've lessened, but not eliminated your risk of outliving your money when you choose an annuity over a lump sum. This risk of outliving assets applies not only to the person receiving the annuity or lump sum, but also to a spouse or partner.

If you are married, you can take your annuity as a joint and survivor form to allow continuation of some or all of your pension after your death. The payments will continue as long as your spouse lives. Your benefit is reduced to pay for this insurance. All other things equal (although they rarely are), I suggest the joint and 75% or 66-2/3% options because one person cannot live well on half the income two had. For example, if you own a house or rent an apartment, you’ll need more than half the space if you decide to move and if you don’t move, your rent or real estate taxes stay the same.

If you have an unmarried partner, you have the same considerations, except many corporate pension plans will not allow joint and survivor benefits. Then you need to look carefully at what happens when you die, and how much income needs to be continued. Perhaps a life annuity will be fine because the partner has sufficient retirement assets to take care of himself. If not, then either you can take the lump sum (see the third blog in the series for problems with lump sums) or some portion of the monthly benefits will need to be set aside to take care of the partner.

Let’s say the partner needs to have the equivalent of a 50% of the pension annuity income continued after the annuitant dies. To use an example, let’s say the annuity is $2,000/month and if you were allowed to take a joint and 50% survivor benefit, your benefit would be reduced to $1,800 to cover the cost of the survivorship benefits. Actual reductions depend on the age differences between the partners and pension plan specifics. If that option isn’t available, you can look at how much life insurance you can purchase on your life for $200 a month. (To simplify I am ignoring taxes here.)

Purchasing guaranteed renewable term insurance might be a good way to fill in the gap, essentially buying the survivor benefits from an insurance company instead of from the pension plan. It’s not as efficient, but it can work.

I should mention that if the need for post-mortem income is limited to a fixed period of time, plans often allow optional benefit forms of 5-, 10- or 15-years certain. Under those annuity forms, if you die before the end of the certain period, the benefits will continue for the remainder of the guaranteed 5, 10 or 15 years, as elected. Note: these forms of benefit are only useful if there is some need of finite years (for example a child’s education) that you are trying to protect. Do not use a years-certain option in lieu of joint and survivor options for a life-income need.

How can you handle the issue that most annuities do not have inflation protection? It takes discipline, but here’s one approach: Determine (you can do this online or have your friendly insurance agent or financial advisor get the information for you) how much your annuity would need to be reduced to get inflation protection. It’s rare for an insurance company to provide full protection, so you may need to settle for a proxy to determine an estimated cost – such as using an annuity that automatically increases benefits 3% or 4% a year.

Let’s just say your original $2,000 per month annuity must be decreased to $1,333 per month in order to provide full COLA protection. In year one, you will need to invest the $667 monthly difference between your standard annuity and what it would be with future COLA adjustments. In year two, the annuity will continue to pay you $2000, but let’s say there was some inflation and the $1,333 would have grown to $1,375. In year two, that’s the amount of your pension you can spend and the rest ($625/mo.) you will invest. (Again, I’m ignoring taxes.)

At some point the $1,333 increased by cumulative COLA differences will exceed the $2,000; let’s say it is $2,025. Then you are taking the entire annuity and making up the $25 difference by dipping into your savings.

Will it work perfectly? Not at all. On average, for a very large number of people it might work out well, but some people will die before they exhaust the savings made up of “scrimping” in the early years. For some, inflation will be less than expected and they too could have spent more in their earlier years. For others the opposite will be the case. Perhaps inflation runs higher than expected – or you live much longer than average. In both cases you should have spent even more in the very early retirement years, and now you will have to cut back in your later years.

Not a perfect solution by any extent, but at least with the life annuity, the nominal payment is guaranteed for as long as you live. For lump sums, the issue is even worse.

Next up in Part III, what happens when you take the lump sum instead of an annuity.

~ Jim

Types of Life Insurance

In the previous article I suggested most of us have the wrong amount of life insurance. That said, many of us may have the wrong kind as well. Currently you can buy four major types of life insurance: Term Life, Whole Life, Universal Life and Variable Life. They are not totally separate species so they interbreed and produce subspecies like Universal Variable Life.

Term Life     This is the pure insurance form. For a specific number of years (the term) you pay a specific dollar amount to purchase a specific face amount of life insurance. If you pay your premiums and you die during the period, the insurance company pays the full face amount. Terms can be as short as one year and as long as twenty. During the term period the life insurance company can’t cancel the policy or raise their rates, even if you are on death’s door. Each year we age, life insurance becomes more expensive because more people in our age-cohort are expected to die. Consequently, whenever the term is greater than one year, the rate you pay is an average rate to cover the whole term. You pay a bit too much in the early years and are getting a break in later years. On average the insurance company is still making money.

Whole Life     Think of this as term insurance that lasts your “whole life.” AS with term insurance, for whole life policies the insurance company can’t cancel the policy as long as you continue to pay premiums on time, it pays off whenever you die and your premium remains constant.

Because the premium will last your whole life (usually they stop when you reach a defined age, like 100) the amount you pay in the early years far exceeds the cost of pure insurance. To make that attractive, the policy calls for investment of the “excess” premium in a Cash Value Account. The cash value account grows, often based on arcane formulae related to the insurance company’s investment earnings and typically has a low minimum guaranteed interest rate. Over time, the policy may pay dividends that you can apply to reduce the premium or (preferably from the insurance company’s standpoint) increase the amount of life insurance.

Starting to get confusing right? Whole Life is a combination of Term Life and an investment product. Depending on interest rates, tax policy, and a host of other characteristics it can be a good investment or a bad investment, but it is important to realize it is an investment. Life insurance companies understand this and they pay their brokers a lot more commission to sell you a Whole Life policy than a Term Life Policy.

Universal Life     Think of Universal Life as a life insurance policy with the extra advantage that you can make additional contributions to the Cash Value Account, which will earn market interest rates based on the insurance company’s investments in bonds and (often) mortgages. You can apply returns on the Cash Value Account to reducing future premiums, building up extra cash values or purchasing additional insurance.

As you can see, this product moves farther away from pure insurance and more toward an investment. Under current law, tax advantages are available, but periodically as Congress looks for ways to cut deficits, these tax “loopholes” come under fire.

Variable Life     For the first three types of life insurance, the amount of insurance remained fixed, unless you use policy dividends to purchase additional insurance. Variable life changes that dynamic. You pay premiums that are invested in investment vehicles you choose from a selection that includes stocks and bonds. Your Cash Value Account can decrease as well as increase and the amount of life insurance you have in effect depends on the value of the account. This product is mostly an investment tail wagging the life insurance dog.

What else?

Oh gosh, I haven’t touched on the ability to borrow from your Cash Value Account and the myriad ways that affects your death benefit, or future premiums, or how some policies allow you to automatically increase coverage at certain periods in time and … There is nothing simple about life insurance products once you move away from Term Life. That’s how insurance companies try to differentiate themselves and brokers justify their commissions. If everything were transparent insurance companies would have to cut their profits to compete on costs and service. Well, that’s a rant for another day.

From the previous post we saw that our insurance needs do not remain constant over our lifetimes. Only by great luck will one policy be a good fit all of your life. Many people end up cancelling their Whole Life or Universal Life or Variable Life policy because they don’t meet their needs. This is an expensive proposition because you’ve paid your insurance broker much of his commission from the first years’ premiums.

If you need life insurance, buy term. If you want investments, choose the best one. Sometimes, because of tax advantages, an insurance product may be the best investment vehicle. Sometimes. My money is mostly sitting in mutual fund companies.

As you can guess, your local insurance broker isn't sponsoring this blog.

~ Jim

How Much Life Insurance?

I would be willing to bet that most people either have too much or too little life insurance. Before you read this post, what’s your gut feeling about the level of your life insurance?

I also want to note that I don’t sell insurance, am not affiliated with any organization that does, and frankly couldn’t care less who you buy insurance from. I’m only interested in helping you understand how to determine the right amount.

Term Life insurance (the pure form, not with some accidental death and dismemberment benefit and not where you are investing in the policy by paying more than for pure insurance) only pays off if you die. Life is a binary proposition. You are either alive or you are dead. (Again, we’ll ignore the missing person cases where things are in limbo for a few years.)

Here’s the thing: actuaries (and I used to be one of them) are pretty adept at estimating what percentage of a large group of people will die at each age. What they can’t do is tell which ones. (Although there is a rumor some Sicilian actuaries have the inside track – it’s a joke—pause for groans.)

Dying, however, is not necessarily a financial risk.

I am an example of someone who does not need life insurance. I have sufficient assets to cover all my debts and take care of funeral related expenses. My children are grown and no one is counting on me for their living expenses, or college education. (At least they shouldn’t be.) In fact, some charitable organizations would benefit from my death.

I could purchase life insurance to increase the size of my estate, but if I do, I’m not buying insurance; I’m buying future gifts for my favorite people or charities. I’m making a choice to invest in a bet on when I die rather than give them the money directly for them to invest. That’s not eliminating any financial risks of my untimely death.

When I first started working, I was in a similar position regarding life insurance to where I am now. The modest life insurance policy I got as a benefit from my employer more than covered my obligations. However, as soon as I had my first child everything changed. With that blessed event, my death was no longer just my bad fortune. My death would eliminate a future income stream that I expected to use to take care of my child through college and take care of my wife during the time she couldn’t earn full wages because she was taking care of our child. The ante increased with child number two.

I think at that time my employer-provided policy was three times my pay. It was woefully inadequate. To do a quick estimate of how much life insurance you might need, figure out a year’s worth of living expenses for all your dependents. Multiply that by the number of years you need to support your dependents and then add on college expenses (if you were planning on paying for them), credit card debt, student loans, etc. (not your mortgage payment because that should be part of your annual support number.)

Fancy Dan investment folks will want to develop present value numbers that recognize the time value of money and future cost increases and all kinds of stuff to make your head spin.

This isn’t an exact science and the method I’m suggesting implicitly assumes your dependents can invest the money to earn the same rate costs will increase in the future.

Here’s a simplified example:

Alice and Joe have two children, ages 8 and 6. They both work and each earns $40,000 per year. After taxes and savings they spend $60,000 per year or $30,000 from each paycheck. If either of them dies, they want the surviving family members to maintain their same lifestyle.

It will be 10 years before child 1 is out of the house and each year the family will be $30,000 short, for a total of $300,000. The second child will be in the house an extra 2 years at (say) $6,000 a year. (An extra $12,000). You want each child to attend college and you’d like for them not to have to take student loans since you won’t be there to help them out afterward. If you die, private college may be out; but even at a decent public college, tuition, room and board, a car, books, fees, etc. adds up to a bundle. You figure $20,000 per year (so $10,000 for each parent) for eight years (Totals $80,000).

Grand total = $392,000. Put another way, each parent should be carrying insurance of almost ten times their gross pay.

What other things might you consider in determining the life-style risk? If the surviving parent will have to cut back on employment to take care of children, life insurance will have to pick up the slack. You may be subsidizing elderly parents and need life insurance to cover that need.

You know your personal situation better than I. The good news is that pure term insurance, guaranteed renewable for 10 or 15 years is very affordable. A 35-year old healthy male can get a $500,000 policy for a little over $20/mo.

The internet has lots of calculators to help you define how much insurance you need, and can also be used to price insurance. I suggest you go explore them. Maybe in a future post I’ll check a bunch of them out and let you know which ones I like.

So, do you have the right amount of life insurance?

Next up, different kinds of Life Insurance.

~ Jim