Life insurance enables your loved ones to meet their financial commitments after you are gone. It can be used to pay mortgages, college fees, medical and funeral expenses, personal debts, and ongoing living expenses. The benefits from your life insurance can help your dependents get by and perhaps even achieve financial independence in your absence.
The two main types of life insurance are whole life and term life. Whole or permanent life insurance is guaranteed to stay in effect throughout your lifetime. Term life insurance stays in effect for only the limited amount of time that the policyholder agrees to: a term of 10 years, 15 years, 20 years, or even 30 years, depending on what coverage is needed. The coverage expires at the end of the specified term.
What Is Life Insurance Laddering?
Laddering is a financial concept popular with bond investors. It involves stacking multiple bonds or other financial products with varying maturity terms instead of purchasing one large bond and waiting for it to mature. An investor with a laddered portfolio spreads risk and receives steady income over the years. If anything bad happens to one product, the entire portfolio is not compromised.
In the case of life insurance, laddering involves purchasing several term life insurance policies with different terms instead of a single large whole life policy that stays in effect even when you need less protection. Laddering allows you to pay for only the coverage that you currently need.
How Life-Insurance Laddering Works
Life-insurance laddering is a good idea if your need for life insurance declines as you grow older.
When you’re starting out in life, single with no spouse or children, you have no dependents who will struggle financially when you die (if no siblings or other family members depend on you). The situation changes when you marry, have kids, and assume a mortgage. Your financial obligations increase dramatically. If you die without leaving a safety net for your family, there’s a risk that your home will be auctioned, your kids won’t be able to attend college, and your family will sink into financial ruin.
Under these circumstances, you have every reason to invest in life insurance. The first option is getting a whole life policy that will be in effect throughout your lifetime. This means paying for insurance premiums throughout your life, the cost which adds up over the years and which may not be necessary.
Alternatively, you can purchase a term life insurance policy that provide coverage lasting only until your financial obligations diminish and you have developed substantial savings. However, there’s no telling exactly when you’ll achieve these milestones, and you could end up underestimating or overestimating your life insurance needs.
Say you’ve determined that your family will need about $3 million to live comfortably over the next 30 years. If you die anytime soon, the $3 million will cover the balance of the mortgage and the costs of rearing and educating the children; the family will have enough money until everyone is financially independent.
Instead of purchasing one massive policy with cash benefits of $3 million for a term of 30 years, you can use the ladder strategy. Stack three term life policies of $1 million each for 10 years, 20 years, and 30 years. That means a 10-year life insurance policy of $1 million, a 20-year policy of $1 million, and a 30-year policy of $1 million.
If you die within the first 10 years, all three policies will still be in effect, and your beneficiaries will receive payouts totaling $3 million from the three policies. If you die after 10 years, the first policy will have expired, but your beneficiaries will receive payouts totaling $2 million from the two remaining policies. If you die after 20 years, two policies will have expired, and your beneficiaries will receive a payout of $1 million from the single remaining policy. If your forecast is correct, the financial needs of your family will have declined substantially by then, so that $1 million will be adequate.
Instead of laddering all three policies at once, you could also start by purchasing the 30-year policy and purchasing the rest later.
When Should You Consider Laddering?
Laddering is a good strategy if you understand your current and future financial obligations. The strategy helps you pay only for the insurance protection you need and nothing more. When a policy expires, you no longer have to pay the premiums you used to pay for it.
Laddering life insurance is ideal for meeting life insurance needs that change predictably. If you are afraid that your loved ones may not be able to make the mortgage payments after you die, you can ladder a policy that runs concurrently with your mortgage. You can do the same with respect to the college tuition of your children and other milestones that you can accurately forecast. After your children have completed college and your mortgage has been fully paid, these policies become superfluous.
Pros and Cons of Life Insurance Laddering
Although laddering may make financial sense for people whose need for coverage declines as they age, it is not an ideal strategy for people unsure of their future financial obligations. What are the pros and cons?
Pro: You may save money.
Saving on insurance premium costs is one of the main benefits of life-insurance laddering. Premium rates depend on the term length of the policy, the state of your health, and the amount of coverage you need. Thirty-year term life insurance costs more than a shorter-term policy because the shorter policy poses less risk for the insurance company; in most cases, the policyholder will still be young and healthy during the term. This is a major reason that you save money on premiums by buying life policies with varying term lengths instead of purchasing a single long-term policy.
For instance, the premiums for a 10-year term life policy with cash benefits of $500,000 cost $565 yearly, those for a 20-year policy cost $625, and those for a 30-year policy cost $715—with each policy having the same cash value. The total annual premiums are $1,905 for the three policies, and their cumulative cash benefit is $1.5 million. That’s in contrast to a nearly $2,300 annual premium for a single 30-year policy with a cash benefit of $1.5 million. Also with laddering, you save money whenever a term life policy expires.
Pro: It’s easy to adjust coverage.
Nobody can forecast his financial needs for the next 10, 20, or 30 years with perfect accuracy. After 20 years, you may realize that you did not adequately factor in in the effects of inflation or that you otherwise underestimated what the financial needs of your family would be after you die.
Insurance providers require you to you cancel your existing policy in order to buy a new one with the benefits you need. With laddering, however, most insurers allow you to easily modify your coverage to fit your new estimates. You can purchase riders to your primary policy, pay a little more, and ensure that your loved ones are sufficiently covered.
Pro: Separating coverage improves protection.
Having separate policies for different coverage needs enables you to stay on top of your family’s financial needs at all times. You can assign a purpose to each policy and easily keep track of fulfillment of that purpose.
For example, if your kids will be attending college in eight years, a 10-year policy dedicated to their college fund is best; for settling your mortgage, a 20-year policy; to meet the more general needs of your spouse and family, a 30-year policy.
Con: You have to manage multiple payments.
If you ladder policies, you must make several payments each month instead of just one.
If the payments are not synchronized, you may forget to make some payments and risk being penalized or, worse, having the policy lapse if you don’t receive timely warnings. Fortunately, you can make arrangements with your bank and insurance provider to synchronize your monthly payments and have them deducted automatically from your bank account.
Con: Carrier restrictions apply.
Insurance carriers restrict the extent to which you can ladder your life policies. Usually, there are no legal restrictions on the number of life policies one can own as long as you can afford the premiums. But life-insurance laddering is restricted to individuals who are 70 years old or younger, and coverage limits are set between $100,000 and $8 million.
Within the set range, these coverage limits can be adjusted during the term of a policy to reflect your changing coverage requirements. A medical examination must be conducted every time you need to amend your policy, which can be tedious.
Con: Perfectly matched coverage isn’t always guaranteed.
Unless your provider offers customized laddering packages, it’s not easy to find coverage that perfectly matches your needs—no matter how many ladders you stack. Fortunately, most insurance plans are flexible, and you can adjust them as necessary.
How Much Life Insurance Do You Need?
Everyone has unique financial needs. However, most experts suggest purchasing an amount of life insurance equal to six to 10 times the size of your annual income. If you earn $108,000 a year, then, you should get a policy that ranges between $648,000 and $10.8 million.
This rule of thumb may not be optimal in every situation. How much life insurance you need really depends on how much money you want to leave your dependents when you die. If they’re getting benefits from your pension plan, Social Security, or your savings, you may only need to make up the projected deficit.
Make this decision based on your own circumstances. If it’s practical, you may even choose a policy that is 20 or 30 times the size of your income. More money won’t hurt your loved ones.
Is Laddering Cheaper Than a Single Policy?
Laddering is often cheaper than a single policy, but not always.
If you correctly predict your family’s financial needs and ladder strategically, you may save thousands in the long run. But sometimes laddering is more costly. For example, if your financial needs increase rather than decrease over time.
If you neglect to factor in such possibilities as having to battle expensive long-term illnesses, having to deal with adult children who return home for financial reasons, or having a disabled child who depends on you longer than you anticipated, you may underestimate the amount of insurance you need. Adjusting your policy during old age could mean paying so much more in premiums that the extra expense cancels out the money you saved by laddering. You might even have done better to purchase a single policy. So which strategy is preferable really depends on circumstances, not all of which are necessarily easy to predict.
Life insurance laddering is a great idea if you are sure that your financial obligations will decline over time. If you can’t be sure whether they will, you are better off going with a single policy all along instead of switching to a whole life policy down the road. To help avoid costly mistakes while laddering, consider seeking the counsel of a qualified financial advisor.