The 4 Most Common Mistakes with Life Insurance

Hello and welcome again to our Fundamentals of Investing series. These videos are designed to explain important concepts you need to know as you work to secure your retirement and build your personal wealth. I'm Brian Dress, Director of Research here at Left Brain, joined by one of our advisors and our resident expert in financial planning, our VP of Investments, Freddie Garcia. Freddy, thanks for joining us.

Thanks for having me, Brian. You know, you and Nolan have been doing a great job with these videos, so I wanted to do everything I could to participate as well because I know a lot of— I've gotten a lot of good feedback on these things, so I thought I'd join you on a couple of these.

And thank you so much, Freddy, for being with us. In these videos, we do want to answer questions we hear from investors, both clients and others that we speak with. We often discuss stocks and bonds here, but sometimes the most important moves that investors can make is to avoid costly financial planning mistakes. So today we want to talk about life insurance. This is a huge, important topic in terms of financial planning. Freddie's got a lot of experience with life insurance, over 20 years, and today we're going to cover the 4 most common mistakes we see with life insurance. The first question I'm going to ask for Freddie before we jump into those mistakes that we see is, who needs life insurance and why?

Life insurance is a fundamental of sound financial planning. So a lot of times we think if there's different phases in life that we may not need it, but life changes. So it's important to kind of get that basic, basic fundamental of having some form of coverage. That way you have something in place versus nothing. So in answer to that question, it's possibly that everyone can need some type of life insurance. Remember, if you're building up your net worth, it creates an instant estate right away.

That's a good start for us. So again, we're going to talk about the 4 biggest mistakes in life insurance and how you can avoid those. So just as a quick preview, we're going to throw those 4 on the screen. The first is the wrong type of coverage. The second mistake we often see is the wrong amount of coverage. The third we often see is not purchasing coverage when you have it available to you or when you're insurable. And then the fourth problem we often see is problems with beneficiaries or passing the life insurance proceeds down to your heirs and to your loved ones. So we'll jump right in with the first one. So mistake number 1, Freddie, is having the wrong type of coverage. So I guess as a quick backdrop to this, what are some of the types of coverage that are available for investors out there for life insurance?

When it comes to life insurance, there's two classifications of life insurance. You've got your basically term, which is your temporary ones that run for a certain period of time, and you've got your permanent policies. Now amongst the term and the permanent policies, there's many, many different types, but the first thing is understand is there's two classifications, is that do you either want to have one that just runs for a certain time period, or are you looking to have something permanent? Because that's what you kind of build on. And the reality is, is that sometimes people need a combination of both, because sometimes they think they can just buy a policy that covers everything, and that may not necessarily be the case for people. Maybe they have a short-term need, which is what the term policies are for, and they may have a long-term need of trying to leave money behind as a legacy, and that's where you would need a permanent policy. But if your goal in the short term is to maybe just cover a mortgage need or just create an immediate estate, then that term policy will suffice. But it may not suffice for legacy planning or educational funding in the future.

Okay. So can we talk a little bit about some of the differences here? So permanent— there certainly are benefits to having permanent coverage. There's benefits to having temporary coverage. I think the biggest one is price. That's the biggest difference.

One of the things when it comes to life insurance, I've been doing this a long time, and one of the most important factors is you pay on life insurance until you get the benefit. Some of these policies will build cash value and eventually pay for on their own, but you have to be able to afford to pay on insurance. If you can't afford to pay on it, then it kind of defeats the purpose of setting it up. So you want to make sure costs fit in your budget, and costs are a big differentiator between those term policies and those permanent policies. Permanent policies are typically more expensive because they last longer. They build up sometimes some cash values. A term policy has no cash value, but it can give you more death benefit for less dollar amounts. That's why a lot of times when I talk about you may want to have multiple policies to cover different needs. Those term policies, again, they can run 10-year, 15-year, all the way up to 30-year periods. They can also decrease in value as time goes on to save you on money. Those permanent policies, well, the cash that you're paying on those will change as well because they do build up cash values. Now, the way they build up cash values will change. There's some that are fixed investments, some that are index-linked, some that pay dividends. And some that invest in the market. So they're variable policies. All those different types of policies can be quite challenging for customers and clients trying to figure out what they may need. But the reality is they may need a combination of different types of policies depending on what they're trying to accomplish.

Okay, Freddie, that's good information. That's good insight on kind of the types of policies that are out there. So we want to talk about sort of the mismatches and the mistakes that people might make with choosing the wrong type of policies So can you speak to that? You know, what are some of the mistakes you've seen and how can you avoid those?

Yeah. So again, when it comes to insurance, again, it is a fundamental, but you want to make sure you can afford it. So when you're trying to figure out how much life insurance you need, that is one of the biggest mistakes that typically happens. Many times, figure— people figure not enough or they figure too much, or they try to cover it with one specific policy. Financially, it may not make sense for them to do that because they're buying maybe a permanent policy because they need more coverage in the short term. But they may not be able to afford those premiums during the short term. So the policy may what we call lapse because they were paying too much for a lot of coverage. So the answer might be maybe they want to get a term and then a combination of a permanent policy. But as far as figuring out the dollar amount they need, the big mistake happens when you take your essentials as far as what you're trying to accomplish. Is your goal when you're trying to figure out how much money you want to leave behind, are you trying to cover income? Are you trying to cover for educational expenses? Are you trying to leave for a legacy? Well, all these things have to have an order. And the first one is, if someone else is dependent on your income and they will be financially devastated if something happens to you and they don't have that income anymore, then your first goal should be income replacement. So that should be the first coverage amount that you need. Now, the next question is, how long will that income replacement need to be? Because again, say if you're just covering in the short term because your kids are, say, age 15, 16, Maybe you don't need to have 20 years worth of income replacement because these kids are not going to be— well, depending on the kids, right? They're not supposed to be dependent on you for that long. And then maybe if it's a spouse, if someone's a little bit older and your spouse is also able to work, so they're not relying on full, full income replacement. So finding out what the ideal income replacement is, because insurance isn't supposed to make you rich, it's not supposed to leave huge financial windfall behind. It's supposed to replace what you used to bring in. The next thing too is, okay, now that the income replacement's been met, the next thing is, is what about debt you know, whether it be credit cards or whether it be housing, making sure those needs are covered. Because if your income was responsible for covering those needs, whether it be a mortgage payment, whether it be credit card debt, then you want to make sure those needs are covered. Then the other steps kick in as far as, you know, planning for college or planning for leaving a legacy. Those are the last two categories that need to be met. The first two should be those essentials. And again, all those should be based on your budget because you can use permanent policies to cover those if they work in the budget. But term policies in the beginning should cover those essential basics: income replacement and debt, and then of course final expenses.

Okay, Freddie, you sort of touched on this. Well, we're going to move into the second mistake that we see, and that second mistake is getting the wrong, wrong amount of coverage. So you sort of started to touch on this. Can you start to speak to some of the errors you've seen in terms of people getting the wrong amount of coverage and what can go wrong with that?

Well, again, if they're buying too much coverage with one policy, the policy can end up lapsing because they couldn't afford to do it with a permanent policy. So That's a big mistake. The other thing that can go wrong with that is one of the fundamentals a lot of times that people hear, and I believe this philosophy too, is that you should buy term and invest the difference. Well, what if they're buying the term and they're not investing the difference? So at the end of that term period, that policy's done and they have not built up their estate. They don't have anything done yet. So in a sense, they could, you know, 15, 20 years could go by and they still need the same amount of coverage as they did 20 years ago because they never built up their net worth. Because remember, insurance can cover a short-term need, but you also want to start building in that, in that time period. So a lot of times, term and invest the difference— well, if you don't invest the difference properly and never take that step, you could find out that you still have that need later on. The other mistake too is that people don't realize that life changes. They could get remarried, have more kids later on in life, and that need is still there after 20, 30 years. Things can happen. So we want to make sure that we're covering also for those unexpected affected things as well.

Yes, it sounds like, Freddie, is one of the things you need to do if you have life insurance is on a periodic basis do, do some sort of review on the policies that you're holding in order to make sure that what you have is covering what you need to cover. So as you said, life does change. Children get older, you might have new children, things along those lines. So it's definitely important to get with somebody, a financial professional, and do those reviews on a periodic basis, make sure you've got the right the right policies. We've seen a number of people come in with policies from 10 and 20 years ago that just aren't appropriate for them anymore. So definitely make sure you're not falling into that category.

Yeah, that's very true. I would recommend that you do those periodic insurance reviews with a CFP professional. Remember, they will act as a fiduciary on your behalf because you do want to do insurance reviews because life changes. And then, you know, also the other issue we run into, and this is probably your last mistake, is people don't update these policies. I've been doing this 26 years and I've seen beneficiaries is listed of people who've passed away and they're listed as people's beneficiaries on there. Or people get remarried and they may have the former spouse still listed on there as their beneficiary. So it's very easy to let these things slip through. Um, and then when it comes to beneficiaries, you also want to update but also let somebody else know if they're your beneficiary how to access that. And companies change names over time, so discard old policies that no longer apply because you could be leaving your heirs a ton of work where they're going through policies and there may not be anything there anymore. So discard old policies, keep everything updated, do periodic reviews with an advisor and make sure beneficiaries are all updated. And somebody knows— they don't have to know how much, but somebody knows how to access or where to go. And that where-to-go person could be that trusted advisor that has everything updated for you.

We'll get a little bit more into the beneficiary side of things here in the, in the last point. The third point, though, is the third mistake that we see is not purchasing insurance when you're insurable. So Insurance companies go through a process called underwriting when you try to buy a policy, an insurance policy. So it considers your age, your health, a lot of other factors. So of course, the younger you are, the cheaper it's going to be to cover you. Freddie, can you talk about some instances in your career when you've seen someone not purchase insurance when they could and then when they needed it, they didn't have coverage?

Yeah. Again, when we talk about one of the first questions you asked is who should buy insurance? And the reality is everyone, because you may have someone who was a bachelor and then all of a sudden 15 years later they get married. But during that 15-year period, they could have came up with something that maybe they became diabetic or developed, uh, MS or some kind of chronic health issue that now it makes insurance a little bit more tough. Even if you buy that permanent or that term insurance in the beginning just to make sure you have coverage, you can always convert that to a permanent policy. So that's one of the things that people forget about is that maybe if you bought that extra amount, you're not spending a lot in the beginning because you're younger, because remember your rate's locked in at a young age. So later on as your health changes, ages, you can always lock that coverage in and make it a permanent policy. One of the things we forget too is we tend to procrastinate as people, you know, that's, that's a common thing we do. And we're only one second away from something happening to us. And over the past couple years, this whole COVID situation taught us that our health can change drastically within a moment's eye. Somebody sneezing and coughing, and all of a sudden the next thing you know is we got a fever and we're out 7 days, right? Then we're thinking the worst. Well, Things do happen and we can't control those things. So everyone is only just one instant away from not being insurable. There's also been changes too with policy coverages. People that weren't insurable before, because of modern medicine, there's treatments available that have now extended life. So insurance companies may not have covered someone previously because, you know, the disease may have not been treatable, but due to modern medicine, they're able to. And then one more aspect to throw on that is that workplace plans— I always encourage people to get those because if you do have insurance issues where you're, you, you would be a high insurance risk, one of the benefits of a workplace plan is that it's group coverage. So I would recommend someone— and that's the benefits of working with advisors, we can discuss those types of issues— if you have a workplace plan available, max out that coverage because a lot of times there are very minimal health requirements for those. And the last thing is many companies also have what they call guaranteed issue plans. Guaranteed issue plans, the premiums are higher and the coverages are going to be smaller, but they can at least meet some expenses versus not having anything.

Okay, Freddie, I think kind of the bottom line is there's an urgency here. No, no matter kind of what your life situation or what your age is, the older you get, you know, the more likely you're going to have health problems. And obviously age plays into it as well. It's going to get more expensive. So stepping in and doing something today is definitely advisable here. And then let's move to the fourth mistake. You started, started to touch on this, and that's problems with beneficiaries and trusts. What are beneficiaries, Freddie, and how do you go about selecting and changing the beneficiaries on your insurance policies?

Yeah. So with an insurance policy, one of the things you're going to do is designate who gets the money and that's who you list on there. The nice thing is that you can designate multiple people. You could designate spouse, you can designate children, you can give equal percentages, you get to choose. You also get to put contingency plans on there. You'll have a primary beneficiary, but you can also have a contingent beneficiary. So you want to make sure those are up to date, and it's people that you want to have the money go to. So if your goal is to make sure that this person, whether it be a spouse, whether it be a child, whether it be a relative, whether it be a charity, you can designate that all very simple with an insurance policy and it will not go through probate by listing proper beneficiaries on there. If you have something a little more complicated set up where you want a trust listed down as the beneficiary, you can do that as well. But you want to make sure that's properly done. Also, insurance can escape, like I said, probate tax. It can also escape estate tax too, if it's done properly. Depending on your thresholds, it may hit those amounts. That's why reviewing those beneficiaries are an important thing to do because those are going to change over time. Remember, your financial plan and your estate will keep changing over time. Looking at those beneficiaries and making sure they avoid probate, making sure they avoid estate tax is going to be a key thing to review with your advisor.

I agree, Freddie, and I also like what you said about letting the beneficiaries know that they are beneficiaries and what to do in the case of your passing so they know what is going on if something happens, because obviously the last thing you want to think about is financial affairs in that sort of situation. So And can you talk about any kind of horror stories you've heard about beneficiaries and what can really go wrong here?

Well, again, if I had— I had a client once who, they didn't have any children, but they had listed their siblings down as their beneficiaries. Well, they listed all their older siblings who had passed away long ago. So in a sense, the person died without any beneficiaries on their policy, which means it typically goes through intestate. So the state then gets to determine who gets that money. So those are the kinds of things we want to avoid. The other things too I've seen, because people didn't update their beneficiaries or they updated and forgot to notify people, it can lead for a lot of confusion. Remember, when a policy is issued, it'll show who the beneficiary is. But when you update the beneficiaries, the original beneficiaries you had on there are still on the original policy. So if all you have listed somewhere in that safe, you have some— or wherever you store your original policy, you have the original beneficiary listed on there, that person might be thinking, okay, I'm the beneficiary trying to make a claim and they cannot, and they won't even be told who the next beneficiary is. If you do do an update on your beneficiaries, it's important to tell that person because you're going to get a separate notification from the insurance company that a beneficiary has been changed. And if you don't put that together with the policy or update it, that person's not going to know and the insurance company won't list it. All they'll tell that, that the person trying to make a claim, whether they are the beneficiary or not. But they won't say who it is because there's a privacy issue. So those are some of the things I've seen.

We're going to close it down here. Just, just as a quick recap, you know, there are a few mistakes we want to avoid. Life insurance is important for pretty much everyone. Also wanted to throw in here, we didn't mention life insurance proceeds are not taxable at the federal level. That's certainly something to consider, that it's a good vehicle for passing down money that avoids estate tax. So for folks especially who have large estates, certainly want to consider doing something with life insurance. But the mistakes we want to avoid are, number one, having the wrong type of coverage. Number two, having the wrong amount of coverage. Number three, not purchasing insurance when you are insurable. And number four is problems with beneficiaries and trusts. Freddie, any parting words as we bid adieu to the viewers this week?

Don't procrastinate. Again, we're all guilty of it, but don't procrastinate. And there are plenty of qualified advisors out there that can help you with this topic. I wouldn't recommend trying to do this alone because I stated fairly quickly the number of types of policies, but there's many different segments within those policies. So you want to find out what's right for you and what works for your budget. So work with an advisor and don't procrastinate.

Thank you, Freddie, for that. That's really a good parting word for us. We want to thank the viewers for being with us. Definitely don't procrastinate. Get this all under control with life insurance. Before the year ends. We've got a few months, but it's a good time, as good a time as any to take care of these, of these issues. Really one of the most important things that you can do for your family. With that, we will see you again next time. And thank you for being with us on Fundamentals of Investment.

Thank you.