Life Insurance Annuity Coverage

Annuity contracts are agreements between individuals and insurance companies, in which individuals pay money to the companies in exchange for the promise of lifelong income. Annuity contracts very commonly include a provision for payment to a beneficiary or beneficiaries in the event that the contract holder dies. A contract issued by an insurance company and including a death benefit sounds a lot like life insurance – and annuities are indeed issued by life insurance companies. It is logical to wonder whether, or to what extent, an annuity might substitute for life insurance.

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The Concept Of Life Insurance

An example recalls the basic notions of life insurance to mind. Consider a logical candidate: a young breadwinner with a spouse and a child. The stock of household financial assets is meager, but the family sets out to accumulate wealth while providing for the unexpected. One possibility – a gruesome one but necessary to contemplate – is that the breadwinner might die, leaving the family without its major source of income. The family may well wish to insure against this possibility by paying money to eliminate the risk associated with the breadwinner’s premature, unexpected death.

If the breadwinner’s annual income is (say) $60,000, then the insurance policy should carry a face value sufficient to allow the family to live on interest earned off the death benefit. A $1,000,000 policy would allow the family to draw $60,000 in annual income from the principal if a safe, conservative investment return of 6% is available. This is close to the historical average return on high-grade, long-term bonds, so a $1,000,000 life-insurance policy on the breadwinner would be reasonable.

The family’s objective is purely and simply to protect against risk. Consequently, a term insurance policy would be best. Whole life insurance, which includes an investment account and accumulates a cash value, is much more expensive than term insurance, whose price reflects only the actuarially-determined risk of insuring the breadwinner’s life, plus the costs of administering the policy. Rather than treat life insurance as a combination investment/risk mitigation exercise, it would be better to eliminate the risk at the lowest-possible premium cost, then invest the extra amount of money that would have been spent on whole life insurance. One of the most famous slogans in personal finance is “buy term and invest the difference.”

Why Not a “Life Insurance Annuity?”

In this context, a “life insurance annuity” would not substitute for the purchase of life insurance outright. True, the family could take the money used to pay the life-insurance premiums and instead invest it in a deferred annuity carrying a death benefit, but this would be wrong on virtually every count. Buying life insurance gives the family $1,000,000 worth of protection immediately in exchange for payment of policy premiums. The annuity death benefit, at minimum the sum of purchase payments minus any partial withdrawals, would be far less than $1,000,000 during the accumulation period of the annuity. Not only that, but the annuity is very likely the wrong investment for the family – a fixed annuity would be too conservative, while a variable annuity would carry expenses that could be avoided in alternative investments such as mutual funds, particularly if the investment were made in a qualified plan.

A Counterexample

Change the context of the example. Consider a middle-aged couple in their mid-fifties, whose children have left home. The breadwinner’s income is $60,000, the same as in the previous case, and they carry a $1,000,000 term-insurance policy on the breadwinner’s life. Suppose that one of their parents dies and leaves them $1,000,000. Now it would make sense to purchase a “life insurance annuity” with the inheritance. Actually, the annuity would be an investment for the couple’s retirement, but it would see double duty since the death benefit would be sufficient to offset the breadwinner’s mortality risk. The couple could then either drop the term life insurance or not renew it – the premiums would have become fairly expensive by this time – and add the money formerly paid out in premiums to their retirement-investment funds.

The example of an inheritance may seem contrived, but it would have been equally apt to assume that the couple’s investments had grown to reach $1,000,000. That is how most millionaires are made – not by sudden windfalls but by slow, steady savings. This is the time of life when couples invest in annuities in order to solidify their prospective retirement income. The fundamental purpose behind life insurance is to replace income lost due to premature death. At retirement, that income is lost anyway, and the rationale for continued life insurance goes away with it. The life insurance would have been dropped soon anyway; by dropping it now that the couple’s net worth allows them to “self insure,” they can take money formerly devoted to paying premiums and devote it to investing for retirement instead.

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The Moral

The moral derived from these two examples is not to buy life insurance when young and shun it when old, although it often works out that way in practice. The moral is that neither avoiding risk nor building wealth is the only goal in life. We have multiple goals and our success in meeting them depends on our available means and our particular circumstances.

Specialized Cases

This moral becomes clearer as we review some special cases involving life insurance and annuities. Even though the paradigmatic view of life insurance is that the need vanishes at retirement, people sometimes continue to hold it until death. Estate considerations are one reason for doing so. Growth in an annuity accumulation account is tax-deferred but taxes are due upon distribution – and this applies to heirs as well as the original annuity holder. In contrast, life insurance proceeds are taxable only insofar as they form part of an estate that may be subject to estate taxation.

Another reason for continuing to hold life insurance is to cover final expenses using a small whole-life policy. (Since the date of death is uncertain, permanent insurance must be used rather than term insurance.) There is also a possibility of accessing the cash value of whole-life policies prior to death, by borrowing against the policy value and repaying the loan out of the death benefit.

Even if we confine the analysis to an insured and one beneficiary (a spouse, most likely), the comparison between life insurance and “life insurance annuity” can become complex. If the survivor survives the insured by a substantial interval, the annuity payout will probably exceed the interest income available on a life insurance death benefit. If, however, the survivor’s demise follows closely upon the insured’s, then the higher cost of the annuity death benefit will drag down the net benefit to the survivor, making life insurance preferable. If the beneficiary dies before the insured, it is easy to change the beneficiary on a life-insurance policy, but the extra cost associated with the death benefit in an annuity contract was, in effect, wasted.

Not surprisingly, there are counterexamples favoring the “life insurance annuity,” such as the requirement of a survivor annuity in order to retain eligibility for the Federal Employees’ Health Benefit Program. Some people cannot obtain life insurance or have preexisting conditions that drive premiums sky high. For them, “life annuity insurance” can represent a “second best” solution that mitigates some of their risk at an affordable price while promoting their investment goals at the same time. For those who find term life insurance less and less affordable as they age, a “life insurance annuity” represents a mixed strategy that allows them to combat mortality risk by increasing their “annuity coverage” and decreasing their life insurance coverage.

Life insurance incurs cost to reduce risk. Annuities are a retirement-oriented investment. In principle, these objectives are clear and distinct. Nevertheless, the degree to which each contains elements of the other is a source of fascination and potential confusion, even to experts in both fields. Remember the basic principles underlying each and don’t feel compelled to worship one to the exclusion of the other.

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