Ladders of Complexity

Laddering level-premium term policies can lower the cost of insurance and help match coverage to need.  But the calculations, and policy features, can be tricky. 

Early in November, I asked my readers to tell me how they were handling their clients’ ever-shifting life insurance coverage needs.  As I dug into the topic, I was struck by the complexity of this seemingly-simple aspect of a client’s financial life.  The cheapest, most direct way to buy term insurance is with a level-premium policy, typically over 10, 20 or 30 years.  But the actual insurance need goes down a bit each year as a client’s future earnings (calculated on a net present value basis) declines, as the client moves one year closer to retirement.  So aren’t you wasting money each year because every year the client is slightly more overinsured than the last one?

For most clients, annual earnings go up incrementally each year, probably a bit more than the inflation rate, making that “overinsured” calculation a bit tricky.  Then, when you factor in inflation, you find that the insurance need is creeping up due to inflation at the same time that it is creeping down due to declining future earnings. 

I asked about laddering policies—that is, buying two or more level premium policies which expire at different times, allowing you to reduce the insurance coverage in steps.  And I asked how you would calculate when and how those reductions should occur. 

Beyond that, what issues should be considered when looking at the policies themselves—in addition to the obvious one of annual cost?

I received many responses, and found myself interviewing two of the most trusted sources of insurance advice in the fee-only marketplace: John Ryan, founder and CEO of Ryan Insurance Strategy Consultants in Greenwood Village, CO (http://ryan-insurance.net/), and Mark Maurer, CEO of Low Load Insurance Solutions in Tampa, FL (https://llis.com/).

In the process, I received the equivalent of a master’s degree in term insurance—which I’ll try to pass on here. 

Alternatives to laddering

The first question to ask is: is laddering really necessary?  The simplest and most flexible approach, it would seem, would be to buy a single policy of yearly/annually renewable term (YRT or ART), where you pay escalating premiums each year, but each year you can re-decide the amount of coverage.  There is no additional underwriting if you continue the coverage.

The problem, as both Maurer and Ryan point out, is that you will pay more, per year, over an extended time period for ART than you would for the same level premium coverage.  “Your ART policy will typically have a lower premium than 10-year term for the first three or four years, and then after that the the cost of ART really overtakes the 10-year cost,” says Maurer. 

“You could say, when YRT becomes more expensive than the cost of a level-premium policy, that you’ll just get a new exam and beat the house,” adds Ryan.  “But what if you fail the underwriting?”

Almost as flexible and simple: simply buy level premium term for the amount of coverage that the client needs at the start of the relationship and then call the insurance company and ask them to reduce coverage as needed.  This flexibility is important to Dion Collins of Collins Advisory in Costa Mesa, CA.  “We have had too many clients over the years end up needing the coverage longer than originally anticipated, and find that they’re uninsurable,” he says.  “By getting a single long-term policy, the client can simply reduce the death benefit when they’re confident they no longer need as much life insurance, which proportionately reduces the premium.”

This is not a perfectly efficient approach, since you end up paying a bit more in those early years than you would otherwise have.  Why?  The level premiums are priced to include the (relatively low) cost of insurance in the early years along with the (higher) cost of insurance in the last years of the coverage.  Those first few years, the client has been paying for coverage today plus an additional portion that reflects the future costs of coverage he is now dropping. 

Collins offered me a real-world example that estimated the additional cost at around $25 a month for a 40-year-old client in good health.

Another problem is that some term life companies don’t allow reductions in coverage, and most limit the number of times you can convert.  Maurer has experienced the process of reducing a client’s face amount—and he says that it can be somewhat complicated.  “Most insurance companies will let you reduce,” he says, “but you may be able to do it just one time through the life of the policy, and sometimes you won’t be able to do it at all in the first five years.” 

Ryan adds that only a handful of companies will allow multiple reductions.  He maintains a list of face reduction guidelines for 23 different major carriers.  A few refuse to allow reductions in years 1-3 and limit the percentage amount of the deduction thereafter, while others allow one reduction for the life of the policy.  Still others permit reductions once a year.

Why would reducing the face amount be so complicated?  “This is not an easy calculation for the insurance company,” explains Maurer.  “You bought a $1 million 20-year term contract when you were 40, and now you’re 52 and you want to reduce it to half a million dollars with eight years left.  What does the insurance company charge for that next eight years?”

Even though the face amount decreases by 50% after 12 years, the premium amount will not go down by 50%—again, because the client is 12 years closer to death, and therefore costs more to insure.  There appear to be exceptions, however.  On Ryan’s list, Prudential will allow face reductions down to the product minimum ($100,000), and new premiums are based on the issue age of the original policy, not attained age.

Finally, if you want to keep things really simple, Ryan suggests that some clients might want to simply buy the full amount of coverage for the 20 or 30 years until retirement.  The annual cost is not dramatically greater (as you’ll see shortly) than a fancy laddering strategy. 

“If they get to the end of that 20 years and they’re not healthy, they might really regret letting go of half a million dollars in coverage,” Ryan says. 

And he adds that this policy does represent decreasing term.  “Because inflation is eroding the value of that $1 million face amount,” says Ryan, “it will be worth roughly $500,000 in 15 years.  I ask advisors, would you rather be in control of that drop in 10 or 20 years?  If so, there is a price to that.”

Banding discounts

How much can you save by laddering rather than simply buying and holding on for the full period of level premiums?  Using round numbers, Maurer estimates that a client might pay $600 a year for a million-dollar term policy with 20 year level premiums, compared to roughly $300 a year for a $500,000 20-year contract and $150 a year for a $500,000 10-year policy.  [All numbers in this article are somewhat hypothetical, since the actual prices depend on age and rating of the client.]  The client with the two-policy ladder is paying $150 less per year than the single 20-year policy would cost—essentially saving some of the higher cost of insurance in the client’s years 10-20 that is built into the 20-year term’s yearly premiums.

The downside with laddered term contracts, as Greg Miyashiro of Kahala Financial Advisors in Honolulu, HI points out, is that each individual contract will come with its own policy factor fee, often roughly $50-$75 per year.  “That money could be used to buy a lot more term life,” he says. 

Another drawback, he says, is the banded rates: you pay less per dollar of coverage for larger policies.  So if you split $1 million of total coverage among two $500,000 policies, you might not get the discount associated with a larger face amount.  “Almost everybody has a price band at $500,000 and almost everybody has one at $1 million,” says Maurer.  “So laddering usually doesn’t make sense if you’re combining smaller policies.  Instead of buying five $200,000 policies over various time periods, it can be less expensive to buy $1 million of coverage over the entire time.”

Maurer says that some insurance companies will do a package deal.  For instance, Banner Life will let a client buy 10-, 15-, 20 and 30-year term (or various combinations) all at once with a single policy factor fee charged on the longest term policy.  “You’re buying at a discount compared to buying four standalone policies,” he says.

Need estimates

Elise Foster, of Harbor Financial Group in Boulder, CO, helps her clients stagger 10-year and 20-year level-premium term policies whose expiration coincides with key financial milestones, like the children finishing college and clients reaching retirement.  “Of course, we monitor savings progress toward these goals,” she says, “reminding clients that the insurance is due to expire.”

Mike Searcy, of Searcy Financial Services in Overland Park, KS, and Norm Boone of Private Ocean in San Francisco have been creating term insurance ladders for years. Searcy will typically combine a 30-year, 10 year, and either a 15- or 20-year level premium policy for clients, while Boone prefers to combine 20- 15- and 10-year policies that term out when the last child is expected to finish college or become self-supporting. 

This starts to get to how you calculate the future insurance need, but you might need something closer to a crystal ball than a spreadsheet if your goal is to be precise about this calculation.  As Ryan pointed out, Searcy has found that coverage needs don’t always reduce as clients accumulate more assets.  “Lifestyles and costs can increase, which increases client needs,” he says.  “Divorces, business changes and dependent situations can change the amounts needed.”  Advisors who are currently using sophisticated spreadsheets (or crystal balls) might be comforted to know that MoneyGuidePro is introducing a new “tile” in its software which models laddered life insurance options in the context of the full client financial plan.

Ryan recommends that, in the absence of these fancy calculations, most clients simply round up.  If the calculation says they need $800,000 in coverage, he will recommend $500,000 over 20 years and $500,000 over 10—and if the policies are covering alimony or a loan, where there is a decreasing balance over time, he’ll look for a company that allows multiple reductions that would coincide with the reduction in debt. 

But for clients who are insuring their future income, he doesn’t see many people decreasing face amounts.  “You just don’t have people saying, hey, I have $1 million and I want to reduce to $500,000,” he says.  “That’s not a common request.  Because of inflation and people wanting to do more later in life,” Ryan adds, “it seems like the need doesn’t actually decrease over time.”

Maurer says that if a client needs $1 million of coverage at age 45, with 20 years of work ahead of her, then the right amount of coverage will almost certainly not be $500,000 after ten years.  “I have put into my 401(k) for 10 years,” he says, “and I’ve saved for my kids college.  But factoring in inflation and changes in lifestyle, the insurance need will probably be closer to $650,000 in ten years, instead of all the way down to $500,000.”

Has he seen anybody try to model this precisely?  With all the variables that Searcy has pointed out, there seems to be no spreadsheet solution.  Maurer suggests that perhaps the declining future need should look more like an amortization schedule on a mortgage than a linear reduction.  “This is where the art comes in, as opposed to the science,” he says.

Convertability

Searcy also looks for term policies that can be converted to a permanent form of coverage—because he has had cases where a client contracted a serious illness near the termination of the term policy.  “In those cases, they will always convert to permanent,” he says. 

Andrew Komarow, who practices in Farmington, CT, uses Protective Life’s term policy built on a universal life chassis for exactly this reason.  Clients will buy a policy with a 20-year level premium, he will recommend decreasing the face amount in the later years, and if the client’s health deteriorates, the contract can be converted to a universal life policy with half the face amount and the same premium.

Advisors who simply look for the cheapest term policy will inevitably wind up with a contract that doesn’t have the conversion option—and might regret it if they have a client on her deathbed.  For instance, Haven Life, which is affiliated with Mass Mutual, doesn’t have a conversion option, which allows the company to charge 5-10% less on its term policies and show up very competitively in a web search based strictly on premium cost.  Other policies will only allow conversion five years or more before the day the level premium term ends, so you have to read the contract carefully.

Ryan affirmatively weeds out companies that don’t have a conversion option at the end of the term, so if you go to his website—AdvisorTermQuotes.com—you can price shop without worrying about selecting a cheap policy that is cheap because it doesn’t include the features he believes are important.   

What would the conversion look like?  Again, the numbers will vary with client circumstances, but Maurer says that somebody who reaches the end of a 20-year level premium term contract, at age 62, might see yearly premiums jump from $600 a year of term to something in the $4,000 to $5,000 a year range for the same face amount of permanent coverage. 

This, of course, is a good option only for a small number of clients who suddenly find themselves in a hospital bed at the end of their term coverage.  “These conversion options are a last resort for those who are uninsurable and can’t re-qualify for a new term policy once the old one loses its rate guarantee,” says Ryan.  “But for that situation, they can be worth their weight in gold.”

Finally, in response to my original request, several advisors mentioned a new company called Ladder Life, which was created specifically to offer the purchase of term insurance (at zero commissions!) and scale it back incrementally.  I was not able to score an interview with Jeff Merkel, CEO of Ladder Life, but here’s the company’s website: https://www.ladderlife.com/.  If you routinely build term life ladders, or are thinking about starting, then it might be a good resource to consider alongside Ryan and Maurer.

The bottom line is that laddering term contracts to fit client needs for coverage is far more complicated than I had imagined.  The variation in policy features, the complexity of modeling how that need will change over time, and things we haven’t covered here, like the way different companies handle various underwriting issues—all make this an area of your practice that begs to be outsourced to experts.  But if you can oversee or provide this service, you can almost certainly save clients some money, and help them navigate a part of their overall financial picture that few laypersons are equipped to handle on their own.