People who invest in certificates of deposit are used to the concept of "laddering." They buy CDs that mature on different dates to avoid being locked out of their cash or locked into a low interest rate for too long.
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You can build a similar ladder with life insurance, planning extra coverage for when you'll need it the most and tapering off coverage when your needs won't be as great. This approach can save you money.
You can ladder life insurance two ways:
- Buy policies with different term lengths at the same time: for example, one policy with a 30-year term, one with a 20-year term and one with a 10-year term.
- Buy one policy now and additional policies later. You might buy a 30-year policy early in your career or marriage and ladder on a 10- and/or 20-year policy during your peak earning and debt years, after you have children, buy a house or incur other financial obligations.
Life insurance needs can go up and down
Laddering is great because most people probably don't need much life insurance at the start of their careers, says Mike Piper, a certified public accountant in Manitou Springs, Colorado.
"After they get married, have kids and/or get a mortgage, suddenly there is somebody who would be in financial trouble if they died. So they need life insurance," adds Piper, the author of several personal finance books and blogger at ObliviousInvestor.com.
Later, that need for life insurance should decrease as your savings grow, your debt balances shrink and children leave the nest. By reducing the amount of life insurance during that stage of life, a policyholder could save hundreds of dollars a year in premiums, Piper says.
Potential sources of savings
Laddering shorter-term policies not only is a good way to bulk up coverage during key times of your life, but it also saves on premiums, says Greg Sanders, founder of Peachtree Insurance Advisors in Marietta, Georgia.
The annual premiums on 20-year and 10-year policies would be lower than for a 30-year policy in the same dollar amount because coverage on the 10- and 20-year policies ends while the policyholder is younger and presumably in better health, he explains.
At the same time, big policies don't necessarily bring big savings. Buying one $5 million, 20-year policy instead of two $2.5 million, 20-year policies saves only $85 a year, Sanders says.
Laddering example No. 1: Lou, 30
Here's how laddering would work for a 30-year-old man we'll call "Lou." He is a nonsmoker in average health and lives in St. Louis.
If Lou were to buy a 30-year, $1.5 million term-life insurance policy, he might pay $2,050 a year in premiums, Piper says.
But with laddering, Lou might buy:
- One 30-year, $500,000 policy with an annual premium of $730.
- One 20-year, $500,000 policy with an annual premium of $475.
- One 10-year, $500,000 policy with an annual premium of $310.
Those premiums add up to $1,515, saving Lou $535 a year during the first 10 years for the same $1.5 million in coverage, Piper says. That's $5,350 for Lou, in addition to potential interest or investment returns.
As the two shorter policies expire, after 10 and 20 years, Lou would save even more because he would no longer be paying those premiums. But he would have less coverage.
Too young to ladder?
An argument might be made against life insurance laddering for people in Lou's younger age bracket.
"If you're 27 years old and need $1 million worth of insurance, just buy a 30-year term policy," says Sanders. "Don't try to split it up. You might save a little bit of money, but the savings won't be worth it."
He adds: "If you get into your 30s and 40s and don't need that much coverage, you can always call and reduce your death benefit, and the insurance company will reduce the premium."
But the laddering strategy can work well for those in their mid-30s and older who are buying life insurance for the first time, Sanders says.
Laddering example No. 2: Stan, 43
Consider the example of another consumer we'll call "Stan." He also lives in St. Louis, is 43, doesn't smoke but is overweight and takes medication for blood pressure and cholesterol. He also would be considered in "average" health, Sanders says.
Buying a 30-year, $1 million life insurance policy could cost Stan $3,221 a year, he says.
Instead, Stan could use laddering to purchase:
- One 30-year, $250,000 policy with an annual premium of $912.
- One 20-year, $750,000 policy with an annual premium of $1,522.
Those add up to annual premiums of $2,434, which would save Stan $787 a year for the same $1 million in coverage during the first 20 years. That's a total savings of $15,740, which Stan would enjoy on top of any interest or investment gains, Sanders says. But, like Lou, Stan would have less coverage in the later years.
But needs may not change
A laddering plan presumes that life insurance needs will shrink, but unexpected issues often arise -- such as boomerang children returning to the nest, a mortgage refinance that increases housing debt or the purchase of a second home, says Craig DeSanto, senior vice president in charge of life insurance for New York Life.
"What they initially thought they would need ends up changing over time," he says. "If you're going to execute a strategy like this, it's really important that you buy term insurance from a carrier that allows conversions to permanent insurance to give you the option to keep the policy in place if your needs have changed."
If you find yourself wanting to replace laddered policies with longer-term coverage that's potentially more expensive, you might reduce your benefit to save on premiums, DeSanto says.
Don't forget your policies
Let your heirs know about your life insurance ladder: how many policies you have and with what companies. "It's important that they know all of the policies you have in place," Piper says.
Finally, don't forget you have more than one policy when it comes time to pay the bills on them. "You wouldn't want to let one policy accidentally lapse by missing a premium payment thinking, for instance, that you already paid the life insurance bill last month," he says.
Copyright 2014, Bankrate Inc.