Do you need to take FEGLI, or are you sufficiently insured between your assets, survivor benefits and social security?
There are 3 core life insurance considerations that will shape the answer to the above question.
- Do you need life insurance at all?
- How much Life insurance coverage should you have?
- What is the appropriate life insurance vehicle:
- Survivor Benefits (based on Federal service and Social Security)
- Term Life insurance
- Whole life insurance
I find that clients who don’t have these questions clearly answered are losing money in their life insurances.
The following steps (and articles) should help you through the life insurance thinking process:
Do you need life insurance at all?
First of all, you must determine if you have a life insurance need at all. The people who need life insurance are those whose death would leave behind an uncomfortable financial situation for their survivors.
(What is considered “uncomfortable?” Only you can define this for yourself. No insurance professional can tell you what your comfort threshold should be!)
Life insurance is not for everyone. If you don’t have people who are financially dependent on your income, or your dependents are now adults and independent, or you have enough assets to self-insure (I’ll explain this below), then you don’t have an insurance need. But if you have dependents that will be financially uncomfortable should you pass– whether children, spouse, or even siblings or parents – then you’ll need to move onto the next step.
How much life insurance should you have?
Answering this questions has a few steps:
Step 1: Define how much of your annual income your survivors need to get them out of their uncomfortable situation. (Your potential survivors should define this, not you! I find it humorous when the insured defines how much money his/her survivor needs. Once the insured dies, the insured doesn’t have to cope with the uncomfortable aftermath; His/her survivors do!) Your potential survivors should be asked “Do I need to replace ALL the insured’s income?” “Will I be clear of a financial hardship with 75% of the income?” “50%?” And so on.
Step 2: Define how long the survivors will likely be dependent. For children, they may be dependent until age 20 or 25 (I’ll let YOU define this one too!). A special needs child may be dependent for many years beyond that. A spouse may be dependent until he/she gets remarried, if they ever get remarried.
- If you have a defined term of dependency (eg. 10 years, or 17 years, or 23 years), then you need term
- If you have an undefined term of dependency, then you may need either whole life insurance or perhaps a “buy-term-invest-the-difference” strategy. (See the technical strategy below and future articles)
Step 3: One you have taken steps 1 & 2, you’ll need to calculate the amount of insurance, and there are two ways to do so:
The simplified way: Take the dollar amount you defined in step 1 and multiply it by the length of time (in years) that you defined in step 2. For example, if you defined $40,000 in step 1 and 30 years in step 2, then multiply $40,000 x 30 = $1,200,000. But what if you had an indefinite term of dependency? Now we gotta get fancy (and technical).
The technical way: This is very technical, so brace yourself.
You’ll notice in my example above that the $1,200,000 will provide $40,000 a year for 30 years even if the $1,200,000 never grows or appreciates in value. What would happen in the $1,200,000 is invested and does grow? Well, it should last beyond 30 years, right? If you do the math you’ll notice that $40,000 represents 3.333% of $1,200,000. What this means is that if you can grow your investments at a rate of 3.333% per year, you should be able to generate $40,000 a year forever, so $1,200,000 really can last you well beyond 30 years.
Now that’s important to know because if you have a survivor who will be financially dependent for 30 years, they may not need to multiply $40,000 by 30 (which equals $1.2 million). Instead, they can reverse engineer the whole insurance calculation to look something like this:
$40,000 = __________% of $_________________
Ask yourself this question: What rate of return do you feel confident you can get from your investments? If you answered 10%, then you won’t need $1,200,000. All you’ll need is $400,000 because
$40,000 = 10% of $400,000.
If you answered 5%, then all you will need is $800,000 because
$40,000 = 5% of $800,000.
So, $1,200,000 is the maximum amount of insurance you’ll need if you don’t try to grow the death benefit. If you grow your death benefit, you will be able to get by with less.
“How low can you go?”
If you answered 3.33% then you’ll need $1,200,000, right?
Not exactly. Remember, in our example we’re trying to generate $40,000 a year for how long? Forever? Nope, just for 30 years. If you invest $1,200,000 and annually yield 3.33%, you’ll get $40,000 forever without ever touching the principle!
So, if you didn’t grow it at all, then the principle alone should last you for 30 years. If you grow it too much, then you will never touch the principle. If you have slight growth, you will touch both the growth and the principle.
As you can see, this alternate way of calculating the insurance death benefit can result in a lower death benefit which will save you on your insurance premiums. This alternate calculation can be used for both term insurance, and especially for whole life insurance where the cost can get quite high.
More technical points:
Taxes: Life insurance principle is not subject to income tax. (It is possibly subject to estate tax. See my previous article on “How Federal Benefits Impact Your Estate.”) However, the growth on that principle is subject to income tax. This, in turn, will affect how much growth you need to compensate for taxes.
Inflation: Your income needs will likely rise over time, so assuming a fixed amount of income is not accurate. You will need to factor in a growth rate needed to compensate for inflation.
What is the appropriate life insurance vehicle?
Before discussing the insurance vehicles that you need to pay for, let’s review the insurances that are FREE. As a federal employee your survivors may be entitled to a survivor death benefit, as well as Social Security survivor income. These don’t “cost” anything (they really do, but the cost is swept into your retirement system contributions (FERS or CSRS) as well as Social Security tax).
- CSRS survivor death benefit: A CSRS employee who dies in service entitles their spouse (or former spouse, by court order) to receive 55% of the CSRS employee’s accrued pension. This is received as a monthly benefit.
- FERS survivor death benefit: A FERS employee who dies in service entitles their spouse (or former spouse, by court order) to receive:
- Basic Employee Death Benefit (BEDB): This amount equals ½ the employee’s final salary (or hi-3 average, whichever is higher), PLUS a lump sum amount, roughly around $33k.
- Return of FERS contributions: With interest. This return only applies to FERS employees who dies with less than 10 years of service.
- Survivor Annuity: A FERS employees who dies with more than 10 years of service entitles their spouse to 50% of the FERS employee’s accrued pension. This is received as a monthly benefit. See HERE for more details.
- Social Security Survivor Benefit: Here, too, surviving spouse, former spouse, and eligible children can get a monthly benefit. The amount of this benefit depends on Social Security benefit accrued to the decedent. See HERE for more details.
Life Insurances that cost you money:
We return to the core issue – spending money on insurance. If you’re gonna spend, spend wisely!
Survivor Benefits at Retirement & Whole Life insurance: These require a much lengthier discussion, which is scheduled for a later question in this series.
Federal Employee Group Life Insurance (FEGLI):
The following information can be found on OPM’s website:
“If you’re in a FEGLI-eligible position, you’re automatically enrolled in Basic life insurance, it is effective on the first day you enter in a pay and duty status UNLESS you waive this coverage before the end of your first pay period.
You do NOT get any Optional insurance automatically – you have to take action to elect it.
You have 60 days from your entry date to sign up for any Optional life insurance. If you do not make an election, you are considered to have waived optional insurance.
The Federal Employees’ Group Life Insurance Program offers:
- Basic Life Insurance — equal to your annual basic pay, rounded to the next higher $1,000, plus $2,000.
Plus three types of optional insurance:
- Option A, Standard — in the amount of $10,000.
- Option B, Additional — in an amount from one to five times your annual basic pay (after rounding up to the next $1,000).
- Option C, Family — provides coverage for your spouse and eligible dependent children.”
Why NOT FEGLI?
FEGLI may not be the vehicle of choice for a number of reasons.
Firstly, the maximum coverage you can get in FEGLI is 6x salary (1 Basic + 5 Option B mulitples). As mentioned above, you may be looking for 10x, 20x or 30x salary.
But, the real reason FEGLI is not ideal, is because FEGLI doesn’t address your insurance need. Remember, in step #2 above I mentioned that if you have a life insurance need at all, you either have a term-life need or a whole-life need, meaning you either expect your insurance need to go away (term) or you don’t expect it to go away (Whole life or Survivor).
FEGLI is neither term nor whole life. FEGLI is not like term simply because FEGLI can last your whole life, while term usually lasts for a specified term of years. Because FEGLI can last beyond your term need, you will almost always be paying more for FEGLI than you would with term insurance. I have found that FEGLI is often 2x or 3x more expensive than term.
However, FEGLI is not like whole life for two very important reasons:
- The cost of FEGLI doesn’t remain fixed, unlike typical whole life insurance. Instead FEGLI rates keep rising even through retirement. You can easily spend more in FEGLI premiums than you will eventually get as a death benefit from your FEGLI policy!!! (This is a negative rate of return for those who remember from the class.)
- FEGLI does not build cash value, unlike typical whole life policies which do build cash value. Cash value is a monetary benefit of your whole life policy that you can access even while you’re alive for whatever purposes you’d like. Should you ever decide to cancel your whole life policy (for example, the person who you were protecting pre-deceases you) you can get all your cash value. Should you ever cancel FEGLI, there will be no cash value.
There are a couple of situations when I feel FEGLI is worthwhile to keep:
- FEGLI is appropriate is when a person has poor health and is not going to get private insurance without paying a hefty premium.
- Also, FEGLI has an option called “Basic” which will become free (at the later of retirement or age 65). For someone who is near retirement, it is often wise to just hold onto your FEGLI Basic and let it become free. The other FEGLI options (“B” and “C”) don’t become free.
TERM Life Insurance:
Term insurance is insurance that covers you only for a limited term (ex. 10-years, 20-years, 30-years, sometimes longer), but after the term, the insurance coverage lapses (or renews for exorbitant premiums).
For someone with a term need, term insurance is often the best option. It provides a large death benefit for relatively little cost.
But can term insurance substitute for a Whole Life need?
At first glance, it cannot by definition! If someone has a whole life need, then how can term satisfy it?
Term cannot substitute for a whole-life by itself! But one can buy the cheaper term insurance as part of a savings strategy to become self-insuring after the term is over.
Let me explain: Suppose a person needs $400,000 of insurance. But they haven’t yet accumulated $400,000 of savings. Term insurance can buy them $400,000 of coverage for the short term, and provide them the time needed to save $400,000 on their own! After the term expires (ex. after a 20-year term), the person can now self-insure! The way to use term-life for a whole-life purpose is essentially to use it as bought time to become self-insured!
First define your insurance need; is it term or whole life? FEGLI often is inappropriate for either. Term life is obviously the best for a term-need but can also be used as part of a self-insuring strategy. You may get to the point where instead of carrying insurance, you have accumulated enough savings to self-insure. At that point you may not even need a survivor pension, nor whole life insurance! Survivor Pensions and whole life insurance have pros and cons which we will explore in a later article.
Diversifying your life insurance (meaning getting portions of each type) may be an appropriate strategy, but requires you to weigh the pros and cons of each form of insurance, and then structure the appropriate balance.
If you need help with these calculations, send me an email!
All the best!