Time period life insurance coverage in retirement revenue planning
Term life insurance provides a death benefit if death occurs during the contractual period, if the premiums have been paid and the policy remains in effect. When life insurance is not viewed in the context of retirement planning, term life insurance offers the lowest premiums for meeting the household’s human capital replacement needs. Other types of life insurance are a combination of term life insurance and savings vehicle. It is therefore important to start the discussion with a clear understanding of how term life insurance premiums are calculated.
Figure 7.1 shows the basic mechanisms for determining the premium payments required to support a term life insurance policy that provides a tax-free death benefit payment of $ 500,000. Insurance costs relate to the risk of mortality during the contract period. Therefore, insurance premiums will vary based on age, gender and health status as determined during the subscription process. This example is provided for a forty-year-old male using the US average mortality rate for Social Security participants born in 1980 with no adoption accepted. In practice, non-smokers in good health receive preferential status with lower premiums, while others with medical conditions may not even be eligible for life insurance. If all else is equal, as the age of the policy increases, as the death rate increases. Life insurance is also cheaper for women than for men, as women live longer on average.
As in the previous discussion of income pension pricing, Figure 7.1 uses some simplifying assumptions to help understand the basic structure of how term life insurance works. These simplifications relate to interest rates, mortality and fees. I simplify interest rates to assume that fixed income assets will make 3 percent forever and forever. Interest rates won’t change in the future, and we don’t worry about other fixed income assets like corporate bonds that could offer higher returns while increasing credit risk. Since interest rates do not change, there is no interest rate or reinvestment risk. The insurance company can determine the prices with certainty and know what interest rates will apply in the future. Therefore, in the event of an unfavorable fixed income investment environment, no additional reserves need to be created to support future claims.
For mortality data, I use the 1980 Social Security Agency cohort life, which is the closest available life table for current forty-year-olds. This table contains mortality data including projections for the total population of Social Security participants born in 1980. My assumption is that there is no risk of unexpected changes in mortality so that the insurance company can determine the rates without having to hold excessive reserves to support claims in the event of adverse surprises.
This mortality data source is a cohort life table and not a period life table. Cohort life tables capture mortality for the same person over time. If a sixty-five year old turns eighty-five in 2019 in 2039, his or her eighty-five death rate will most likely be lower in 2019 than that of an eighty-five year old in 2019. A cohort life table uses projections of future mortality improvements when calculating life expectancy. Even if the projections are incorrect, they are more likely to be accurate than the assumption that mortality will not improve at all. Cohort life tables predict longer life span and are certainly a better choice for considering longevity when creating a retirement plan. The Social Security Administration also provides cohort life tables for Social Security participants born at different times in the past.
As mentioned earlier, most insurance companies use underwriting to further classify their clients based on mortality risk. Some may not qualify for life insurance, while others who are in good health and have a lower risk of mortality may get better insurance rates. I am assuming that there is only one life insurance policy for the entire population of the same age and gender and that anyone can qualify without underwriting. This makes my simulated pricing more expensive for those who might otherwise qualify for preferred categories. Another implicit assumption is that no one will lose their insurance policy. It is assumed that all policyholders retain their insurance policies for the entire term.
Finally, I am assuming that the insurance policy offers actuarially fair prices without subtracting the cost of running the insurance company. This will aid direct comparisons in the later analysis between investments and insurance, where both are treated as free of charge. Later in this chapter, I’ll describe the effects of changing these assumptions.
Appendix 7.1 Pricing of term life insurance for a forty-year-old man
Are you looking for more information? Click here and subscribe to the Retirement Researcher for my weekly newsletter. Receive additional articles, resources, and exclusive invitations to upcoming webinars!
* This is an excerpt from Wade Pfau’s book Safety-First Retirement Planning: An Integrated Approach to a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now from Amazon AMZN.