Updated April 11, 2024, at 8:42 AM
Tragedy and triumph in clients’ lives can be monumental and life-altering. This article alerts you to three dangerous planning mistakes—and issues that are too-often ignored or treated simplistically—resulting in disaster:
- Failing to plan ahead at all or no formal analysis of the six financial planning areas:
- Current position including cash, budget, and goals
- Risk management including loss exposures and consequences
- Accumulation planning including investment posture tailored to each goal
- Tax strategies and hedging against tax changes
- Retirement planning including income, risk, tax & investment strategies for this goal
- Estate planning including legal arrangements for incompetency during life
- When clients take a “do it yourself” (DIY) approach
- Using financial professionals whose focus is primarily on areas 3-6
Most people know the financial planning analogy of the “pyramid of needs.” A pyramid can crumble if the base, or any support, lacks surety. A weak foundation can be knowingly ignored or just unclear. Even for more advanced-goal levels of the pyramid, guarantees are essential to enable the confident pursuit of sophisticated strategies.
For example, an aggressive strategy in a retirement portfolio could be prudent only if the basic income need is guaranteed (pension, Social Security, and guaranteed annuities), and threats to asset exhaustion are adequately hedged. A protracted market decline and a long-term care (LTC) stay are two such threats. Both the rich and those who can least afford mistakes suffer from failing to integrate guarantees into their financial strategies.
Another example is a surprise halt in group disability payments, shocking a budget (that may now include non-covered therapies, etc.) that stops new contributions to savings and even exhausts them. So, let’s examine the limitations of planning software (both for professionals and DIYers) and some less-than-obvious risk management pitfalls around financial consequences of:
- Disability
- Death
- Guaranteed income
- Exhausting income sources
- LTC expenses
Related: Not All Insurance Policy Reviews are Created Equal
Limitations of Planning Software
Did you know there are key analyses that financial planning software fails to address? DIY and professional packages are particularly limited for decision support. One example is calculating how much term or permanent life insurance your clients need. The need is different pre-retirement versus in retirement and there definitely is a post-retirement need other than for estate tax liquidity.
The reason why these software packages fail to include several key calculations is because of the subjective judgment and difficulties in how to model them. But the effect of their absence can be financially devastating. An experienced professional who understands guaranteed insurance products and how to calculate need is essential. Because of this, insurance must be optimized ahead of any investment strategy (right after budget and cash reserve strategies) because financial security must be reached before taking risks.
At FIG, we use reports, illustrations, and analytics tools to close the gaps in professional planning software. We’re able to give our financial professionals access to numerous financially-sound carriers that directly compete. This is essential to complete diagnostics, planning, and solutions implementation.
Let’s examine areas that should never be placed at risk to fail from market losses or treated in a generic or cursory fashion. For example, most software treats group and private disability the same and merely calculates an amount needed, yet particular policy provisions are crucial to understanding whether your client gets paid during a disability. Despite being an essential tool in financial planning, standard software can blindside clients and financial professionals alike.
Let’s examine some issues and solutions to the risks of income and asset loss due to disability, death, long life, and the expenses of LTC.
Disability Insurance
Disability insurance (DI) is the most important issue during working years. Why? Because savings, paying bills, and insurance premiums all fall into crisis mode without income. Consider that non-covered therapies, paid helpers, and disability aids must be paid for in addition to one’s usual expenses—all while income has stopped or drastically reduced.
One might have DI at work, but what about after a layoff? Some policies are not convertible at termination. What about claim qualification (the definition or trigger) as it changes while on-claim? Yes, it’s possible with all group plans. There can be emotional effects of unexpected halts and reductions in group DI insurance benefits that don’t occur with most personally-owned policies. During the first year (sometimes two) of disability, a group policy pays if your client can’t perform their work; but then the definition changes to the inability to perform any work.
Benefits usually stop even though your client can’t earn what they used to. No software examines this; only gross need minus gross coverage. They simply can’t examine terms of the policies, and instead only look at a few model scenarios of varying durations on-claim.
There’s a similar problem with Social Security. The approval process can take months and disability must be deemed total and long-term. How will your client live while their application grows cobwebs? Private coverage has a supplement that pays until Social Security starts (late). Private coverage is usually tax-free.
Related: Life Insurance Needs in Less Than a Minute
As with all insurance types, delay in getting covered is both risky and costly: a change in insurability could occur and premiums are locked in at application. An example could be a high-earning prospect who balked in obtaining proposed DI and life coverage. If he or she got lung cancer, it can take two years to qualify for Social Security, during which he or she could only work part-time (not yet qualifying for group DI). This would result in a family slowly descending into near indigency.
Special riders are diverse and proper counseling is essential to avoid wasting premiums to get needed coverage. Indeed, budget analysis is necessary with your professional help because the right cash management strategy will enable one to build a reserve for contingencies like long waiting periods for benefits. A long elimination period dramatically reduces premiums.
Disability Policy Decision Support for Businesses
Often times, businesses need disability policies, and not just to help employees replace their income and pay for non-covered medical and therapy expenses. Businesses need to at least temporarily replace the lost talent or revenue associated with the affected employee or owner. Imagine returning to your business after two years of disability only to find it at a severe competitive disadvantage, if not defunct. As mentioned earlier, a buy-out policy can provide an owner with a fresh start while preserving everyone’s jobs.
Life Insurance
Tax-Free Income (Effectively)
If overfunded (up to IRS limits), life insurance can become a way to diversify against income tax changes that are reducing tax-favored options. This is a strategy that most software ignores, but can be important for someone expecting a mid-to high-tax bracket after retirement. Growth is tax-deferred but can effectively produce tax-free income, and the deferred tax is essentially forgiven when the death benefit is paid.
Survivor Benefits Clients can Rely On
Neither NaviPlan nor any comprehensive planning packages perform survivor benefit payment (SBP) analysis, otherwise known as “pension max” calculations. Here’s the concept, first with pensions, later with Social Security: Providing for a pensioner’s potential widow or widower to have some continuation of pension (SBP) requires a pension reduction from its inception. This is because paying over the length of two lifespans is far more expensive to a pension plan than paying over one.
Since 1987, spouses have had the right—waivable only by the spouse—to at least half of a retiree’s pension. The reduction in a pension depends upon age and sex difference, about 8% for half continuation and 16% for full continuation for same-age couples. Think about this: Payments upon death is a death benefit, and a pension reduction is a premium. That’s a guaranteed-issue life policy. Newer mortality tables enable carriers to compete with SBP, if not on premium, then as to other value pension SBP lacks. The potential widow surrendering the right to SBP must be the owner (controller) of the delivered policy; an exchange of rights avoids surprises in case of divorce.
Put yourself in the shoes of a married retiree, but your spouse (for whom you had reduced your pension to avoid the budget shock of pension cessation) dies first. You ask the administrator, “Please refund my pension reductions since there’s no survivor to pay.” That administrator will look at you as if you have two heads! Irritated, you now ask, “Okay, please increase my pension to the single-life amount.” The administrator will look at you as if you had three heads!
That’s why it’s so important to calculate the amount of privately-owned coverage to pay as much as the pension’s SBP would have, you’d have at least been able to cancel the policy and halt premium payments, or used it for tax-favored income, tax-free LTC, or a legacy or charity.
This pension max strategy doesn’t have to be used for all of the SBP. Most pensions now require that a retiree retain at least 10% of the SBP in order for the spouse to access health benefits. For Social Security, no reduction for survivorship happens. But survivors do lose the lower of the two payments. What will replace that in a budget? It’s essential to have this analysis for both Social Security and SBP well before retirement.
This analysis shouldn’t be assumed useless (as it might have been when mortality assumptions drove higher costs) or postponed until one nears retirement. Pension max is just one of several uses for lifelong coverage, calling into question the buy-only-term assumption.
Related: Finding the Right Indexed Universal Life Insurance Policy
Policy Configuration
For the popular “flexible universal life” solution, software fails to support the decision between Option A (level death benefit; declining actual insurance as cash value grows) and Option B (death benefit is the total of cash value and insurance). A co-worker’s client loved his Option A variable universal life policy (where securities drive cash value, rather than guaranteed rates). The carrier competently hired and fired money managers, and his cash value grew impressively. He deposited a bonus well over $25,000 into it, then died weeks later. His widow received the same death benefit as if no deposit had been made.
Another situation was common for variable life policy owners during the last recession: Receiving a letter stating that the cost of coverage within the policy, combined with market losses, caused the policy to head for a lapse unless premiums were drastically increased.
Configuring coverages and costs is crucial, as are guarantees: conversion to income, interest crediting, immunity to market loss and lapse in policy (for income or LTC options, too).
Hybrid Life & LTC Insurance
Additional aspects of life insurance requiring professional examination, yet not treated in software for decision support, is whether and how to capture the advantages of the new hybrid life and LTC solutions. Some existing life policies can have a free or minimal cost rider added that allows the death benefit to be accessed during life for LTC expenses—tax-free. Your clients will most likely look for help with essential questions:
- How much of the death benefit can be accessed? Is more needed anyway?
- What underwriting is required?
- Are benefits triggered by institutionalization or by the inability to perform activities?
- What does the rider cost, and what’s the cost to take more than the cash value?
- Even if the rider is free, is the old policy’s mortality charge still competitive?
- Could the existing policy, or its LTC rider, require an extra premium to avoid lapse?
- Are there guarantees against policy lapses and against LTC rider lapses?
Variable vs. Fixed Indexed Life or Annuities
During market downturns, a policy owner may get a notice requiring higher premiums than first illustrated—with a warning that income or LTC riders may be compromised. This is because the internal expenses come from the cash value, which can have dramatic market losses; the premium is not the cost of coverage. Also, the fine print for variable products allows the carrier to cancel guaranteed income and other riders by merely refunding charges for them.
However, there are fairly new solutions: fixed indexed universal life (FIUL) or fixed indexed annuity (FIA) policies. The riders on these policies can only be dropped by the owner. Fixed indexed policies credit interest that, historically, has been higher than other fixed-rate bank and insurance products. These fixed policies credit interest based upon the performance of several choices of market indexes, and they guarantee against market loss.
No software exists to aid in deciding between variable versus fixed indexed solutions, nor for riders. However, FMOs “shop the market” to enable financial professionals to clearly show guarantees against market losses, guarantees of income, or guarantees of LTC benefits (along with possible higher benefits if the underlying indexes perform better than the guaranteed levels).
You should compare identical death benefits and options for your clients, as well as premium and return rate assumptions. Then, you can help find which policy has the greatest cash value at a given late age (or possibly highest death benefit).
Related: What are the Charges Deducted from Indexed Universal Life Policies? [Infographic]
Business Uses of Fixed Life & Annuity
Employee Benefits Planning
Companies that are unable to provide an actual pension can be competitive with larger employers by offering fixed-rate and FIAs in or alongside a qualified retirement plan. Employees want more than a few low-risk or fixed-rate options in their retirement plans, and fixed annuities solutions can provide that. Non-qualified plans, such as deferred compensation, can differentiate among employment classes. An employer can’t assume fiduciary duties for planning support, but you can with the backing of a strong and ethics-driven FMO.
Business Disposition and Key Person Planning
Fixed life and annuity products make sense for businesses, enabling a buy or sell and supplemental retirement contracts and other calculation-supported needs to be met. For example, imagine that a business broker values a multi-owner business and an attorney draws up a share-purchase commitment for buy-out when an owner dies or has a protracted disability. If a triggering loss occurs, wouldn’t the failure to fund cause a sudden credit crunch, lawsuit, or even allow an incompetent heir or spouse to become an owner? What would happen if your business lost key talent without the guarantee of being able to promptly fund replacement?
Annuity Decision Support
DIY and professional planning packages don’t distinguish between minimum income needs and lifestyle income needs. Prudence requires that guaranteed income (like a pension, Social Security, or annuity income) is matched to “must-pay expenses.” So, the minimum that must be placed into an annuity to assure that the minimum income need is funded usually isn’t calculated. Nor do these packages analyze any phased income needs; they don’t match bond and annuity maturities to those phases.
Annuity Needs Analysis
For almost everyone, there’s a minimum amount that must be in a guaranteed annuity versus at-risk investments. You might object, “There’s no ‘must.’ There’s only my preference!” But experience responds, “Oh, contraire, my friend!”
Budgets include expenditures that clients are guaranteed to incur: HOA fees and maintenance, various taxes, food, medical, and out-of-pocket amounts (and many other necessities). Budgets also include entertainment, travel, cell phones, and subscriptions—items that you could forego if your clients’ investments crashed for a protracted period.
Prudence suggests that you match “guaranteed to incur” expenses to “guaranteed to receive” ones, such as a pension, Social Security, and fixed annuity income. If the total income your clients need exceeds the income they’re guaranteed to receive, only a fixed annuity (and some life policies) can provide for that shortfall. At-risk investments are best used for other income needs and to hedge inflation. It’s the seasoned and well-trained professional, not some online robo-planning suite, who can help your clients avoid exhausting income sources.
A Necessity for Fixed or Fixed Indexed Annuities
Imagine that your clients are drawing income from their investments, and a recession depresses their share and bond value. Is it prudent to keep liquidating securities for income when their portfolio loses half or more of its value for protracted periods? You might draw less, lowering your living standard, but you still must take a sizable income throughout this period.
Even if your average return long-term is well above your draw rate, extraordinary losses cause your clients’ portfolio to deplete. It could get a better return in a recovery, but they’d have fewer shares getting that return. That’s how people exhaust nest eggs when their draw rate is below the average return: They assume all will be fine. Again, you can see a great long-term average return but liquidating in a downturn leaves your clients with not enough shares or bonds that benefit from recoveries!
Fixed-Rate vs. Fixed Indexed Annuities
How might you decide between fixed-rate and FIAs for your clients?
It’s possible for a guaranteed interest rate in one annuity to be higher than that offered by a second one, yet the second annuity guarantees a higher income at a given age than the first. It boils down to accumulation and payout rates. Although an FIA pays no interest if the index suffers a loss, there also can’t be a market loss. FIAs have historically credited higher interest than bank- or fixed-rate-only annuities.
Long-Term Care
Most people know someone whose finances—even relationships—were devastated by LTC expenses, yet few people hedge correctly. And don’t look to software to provide decision support for asset-based (single deposit or hybrid) and ongoing premium solutions. LTC costs are examined in scenarios of one or both spouses needing at-home or institutionalized care. The process also identifies which assets would be exhausted to pay for care.
If Medicaid is an option, then you can help clients decide between an ongoing premium (stand-alone) policy that qualifies to protect assets from Medicaid recovery and the more competitive single-premium hybrids of life and annuity policies. You can also examine pooled benefit policies of both stand-alone and hybrid varieties, and clarify scenarios in which life or annuity benefits are reduced by using LTC benefits.
Stand-alone policies are subject to premium increases if the carrier becomes stressed and there may be waiting periods for benefits. These policies are being eclipsed by the newest single-premium FIA and FIUL policies, however. That’s because these new asset-based policies are guaranteed to not lapse and aren’t subject to extra premium demands. They also have no waiting periods. If no LTC expense occurs or a spouse is lost, such policies can convert to paying annuity income.
Life insurance hybrids provide higher LTC benefits than underlying death benefits and more than annuity hybrids. But annuity hybrids do provide a good multiple of the premium for LTC. Stand-alone policies and asset-based hybrids are medically underwritten.
Bottom Line
Your clients deserve the most complete financial security possible. And that requires a complete analysis, expert decision-making, and competitive choices from you and your firm. The most effective financial planners don’t treat fixed insurance challenges in a cursory fashion.
At FIG, we enable planners to examine issues that standard planning packages don’t treat, and we can help you lay bare the end result of guaranteed solutions. Can a robo-planner or DIY package do that?
Keep Reading: CAR Program: Life Insurance Concepts
Disclosure: Please note that the views, information, and/or opinions expressed in this article are solely those of the author(s) and do not necessarily represent those of Financial Independence Group, LLC, its principals, and/or employees. The content within this document is for informational and educational purposes only and does not constitute legal, tax or investment advice. Customers should consult a legal or tax professional regarding their own situation. This document is not an offer to purchase, sell, replace, or exchange any product.
Insurance company products and any related guarantees are backed by the claims paying ability of an insurance company. Insurance policy applications, such as long-term care and life insurance policies, are vetted through an underwriting process set forth by the issuing insurance company. Some applications may not be accepted based upon adverse underwriting results. Some types of permanent insurance may require consistent premium payments, or the policy may risk lapsing. Unpaid policy loans decrease future death benefits paid to beneficiaries. Excessive policy loans may cause the need for future premium payments. If a contract lapses due to excessive policy loans or if a customer surrenders their policy, one may be subject to tax payments for policy loans that exceeds the premiums paid. Excessive premium payments may cause the policy to become a modified endowment contract. Policies classified as modified endowment contracts may be subject to taxes when a loan or withdrawal is made.
Insurance companies may set certain interest earning limits on the indexed products they issue. These limits may be referred to as crediting rates, indexing methods, caps and/or spreads, and all vary by product and insurance company. Customers should carefully review all product information with their financial professional prior to purchase.