Term life insurance offers a death benefit if death occurs during the fixed period covered by the contract, when premiums have been paid and the policy remains in force. When not viewing life insurance within the framework of retirement income planning, term life insurance offers the lowest premiums to support the human capital replacement needs of the household. Other types of life insurance are a combination of term life insurance and a savings vehicle. This makes it important to begin the discussion with a clear understanding about how term life insurance premiums are calculated.
Exhibit 7.1 shows the basic mechanics for determining the premium payments required to support a term life insurance policy providing a $500,000 death benefit received on a tax-free basis. The costs of insurance relate to the mortality risk during the period covered by the contract. As such, insurance premiums will vary by age, gender, and health status as determined through the underwriting process. This example is provided for a forty-year-old male using average mortality in the United States for Social Security participants born in 1980 without any assumed underwriting. In practice, nonsmokers in good health will get a more preferred status with lower premiums while others with medical conditions may not even qualify to purchase life insurance. All else being the same, premiums rise with the policy starting age as mortality rates increase. Life insurance is also cheaper for women than for men, since women live longer on average.
As with the previous discussion about how income annuities are priced, Exhibit 7.1 uses a few simplifying assumptions to make it easier to understand the basic structure for how term life insurance works. These simplifications relate to interest rates, mortality and fees. I simplify interest rates to assume that fixed-income assets always and forever earn 3 percent. Interest rates do not change in the future and we do not worry about other fixed-income assets like corporate bonds that may offer higher yields accompanied by greater credit risk. Since interest rates do not change, there is no interest rate risk or reinvestment risk. The insurance company can determine prices knowing with certainty what interest rates will be in the future, so there is no need to accumulate additional reserves to support future claims in the event of an unfavorable fixed-income investing environment.
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For mortality data, I use the 1980 Social Security Administration cohort lifetime, which is the closest available life table for current forty-year-olds. This table provides mortality data including projections for the total population of Social Security participants born in 1980. I assume that there is no risk about unexpected changes in mortality so that the insurance company can determine pricing without holding excess reserves to support claims in the event of unfavorable surprises.
This mortality data source is a cohort life table, rather than a period life table. Cohort life tables track mortality for the same individual over time. When a sixty-five-year-old in 2019 turns eighty-five in 2039, his mortality rate at eighty-five will most likely be lower than that of an eighty-five-year-old in 2019. A cohort life table uses projections for future mortality improvements when calculating life expectancies. Even if the projections end up being wrong, they are probably closer to being correct than assuming no mortality improvements at all. Cohort life tables will project longer lives and are surely a better choice for considering longevity when building a retirement income plan. The Social Security Administration also provides cohort life tables for Social Security participants born at different points in the past.
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Also, as mentioned, most insurance companies use underwriting to further classify their customers by mortality risk. Some may not qualify for life insurance while others who demonstrate good health and a lower mortality risk can obtain better insurance rates. I assume there is just one life insurance policy for the whole population with the same age and gender, and everyone can qualify without underwriting. This will make my simulated pricing more expensive for those who could otherwise qualify for preferred categories. Another implied assumption is that no one lapses on their insurance policy. All policyholders are assumed to hold onto their policies for their full term.
Finally, I am assuming that the insurance policy provides actuarially fair pricing without expenses deducted for operating the insurance company. This will support direct comparisons in the later analysis between investments and insurance where both are treated as not having fees. Later in the chapter I will describe the implications of changing these assumptions.
Exhibit 7.1 Pricing a Term Life Insurance Policy for a Forty-Year-Old Male
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*This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon
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