I understand the need for life insuranceand I understand that it is best to buy a term life insurance policy. However, how much should I be insured for? When should I buy such policies? How many policies should I buy?
I am sure you would agree that these are common enough questions … among those who agree that a term policy is not a waste of money!
Let us discuss answers to these questions, which will lead us to an interesting idea: Laddering Term Life Insurance Policies
1. How much should I be insured for?
Thumb rules suck. So let us try commonsense instead.
If I die today,
- My family should be able to meet day-to-day expenses. Perhaps until my spouse dies or until my children get a job to support her
- My children’s education must be accounted for
- Their wedding too perhaps
So my insured sum should account for: day-to-day expenses and long term goals.
2. When should I buy it?
The answer seems obvious, but it is not so.
It seems obvious because most of us learn about the importance of a term policy and take it after we are married and when we have children. In such cases, the answer is obvious: immediately!
What if a 25 year old unmarried guy with independent parents wants to know the answer?
Would you tell him to buy it after he is married? Or should he wait until he has children?
I would tell him to buy it immediately if he plans to get married for as large a sum as he can afford. Why? Read on!
3. For how long?
Again, the answer seems obvious but it is not so.
Typically, those who learn about term policies after marriage and kids, should take a term plan until normal retirement, say 60.
Why? Because their liquid net worth is unlikely to exceed the value ofpolicy before they retire.
Why? Well, typically such folks haven’t invested enough and/or invested right. So they need time.
What about our 25 year old? How long should the duration of his term policy be?
If he has his priorities right, about 20 -25 years, until about age 50.
If does not invest enough, invest right, systematically, he is better off with a policy until typical retirement age.
- The cost of a term policy depends not only on the age and profile of the applicant. It also depends on the tenure. So short termed policies, taken early are lowest in terms of price and highest in terms of prudence.
- The idea is simple: take a short term plan, early; increase net worth systematically; When net worth exceed the value of the policy, get rid of the policy and use the premium amount for further increasing net worth!
- How is increasing net worth related to a term policy? Read on to find out!
4. How many policies should I buy?
I am not referring to the idea of ‘splitting’ the term cover into 2/3 so thatrisk of claim rejection is reduced. I fail to see anything smart about that.
Let us get back to question 1: How much should I be insured for?
A term policy should account for day-to-day expenses and long-term goals.
Day-to-day expenses could range from forever to a couple of decades. That is, until the spouse lives or until the children start to earn.
The duration of other long-term goals can vary quite a bit. For example,
a) My two children are aged 4 and 2. They will graduate from school in 13 and 15 years respectively. So I need money for their college education after 13 years. Let us ignore the two year difference. Assuming I would like them to marry at age 25, I need money for marriage only after 21 years.
b) On the other hand, if my children are aged 10 and 2, I will need money for the first children college fee after 7 years and marriage after 15 years. For the second child, college fee after 15 years and marriage after 23 years.
I can go about buying polices in three ways:
1. Buy a single policy that covers monthly expenses for the family, school fee and college fee for children and their marriage expenses.
2. Ladder the policies
If my the age difference between my children is small, I could
- buy one policy to cover expenses (inflation-indexed) for, say 25 years
- buy a second policy to cover school and college expenses for children, say for 10 years
- buy a third policy to cover marriage expenses, say for 15 years
Buying term policies with different durations that correspond to major long term goals is known as laddering.
Even if the total premium for the 3 policies is more than that for a single policy (not always true. Could well be the other way), laddering them, frees up cash.
Once the policy that covers education has expired, it frees up cash that can be invested or utilized. The same applies to the policy that covers marriage.
If we have just one policy, we would need to keep it active until our net worth is comparable to the policy value.
Laddering can be done in many ways. For example, if the age difference between my children is large I could
- have one policy for expenses
- a second policy for the first child’s education and marriage and
- a third policy for the second child’s education and marriage.
It all depends on the individuals priorities.
Advantages of laddering term insurance policies
- Best suited, if one invests enough for all major long-term goals in a disciplined manner.
- Frees up cash after each major long term goals. Meaningless if not utilized right.
- Possibility of lowering total premium.
Disadvantages of laddering term insurance policies
- If one does not invest enough for major long-term goals, in particular retirement, and dies after a couple of decades with only one policy from the ladder in force, the resulting payout will not be enough for covering expenses. A single policy would fare better in this case.
- Certainly not a simple option. Best to take all policies from the same insurer. If the applicant dies soon after inception, the nominee will have to process all the claims.
- If there is loading involved, laddering may not turn out cheaper.
- Multiple due dates for paying premiums!
Note: After buying a term policy, one or several, it is crucial to invest for long term goals systematically in a disciplined manner. Otherwise, a term plan is pointless.
While calculating the value of the insurance policy, it is assumed that death occurs immediately (well, within a few years!).
That is current expenses are used to calculate the sum required to create an income (inflation-indexed or otherwise). Ifdeath occurs after say, 20 years, the value of the policy will not be enough to cover expenses at that time. There could be a significant shortfall.
Therefore, it is crucial to invest enough for long-term goals so that the value of investments at the time of death minimises the shortfall.
Getting back to our 25-year old, why should be buy a policy for as large a value as possible? Why can’t he get one for covering expenses now, wait until he get a child and then get another for its education and marriage?
Could work that way, but delaying the purchase of a term plan also enhances the chance that it would get loaded due to changes in lifestyle or job profile.
So best to get as much as possible when young if the person wants to marry and start a family.
Laddering works best when all the policies are purchased at the same time.
Term Life Insurance Ladder Calculator
I have modified the comprehensive child planner to include insurance laddering options.
1. the insurance amount need to secure college and marriage expenses of two children
2. the amount need to save for college and marriage expenses
3. insurance amount need to provide inflation adjusted monthly expenses for the family and school expenses for two children
It provides the break-up of the insurance amount needed for above goals with a generic action plan.
With this information, you can create your own insurance ladder.
- Discussions with Kirti from Bemoneyaware on ‘the right age to buy life insurance’
- Comment on laddering strategy by Sanjeev Bhatia in Subra’s post.
Your Say: What do you think? Do you think laddering is a smart idea?