About the Author
David Fulton is a Colorado Springs, CO fee-only financial planner providing Hourly and On-Going Financial Planning and Investment Management. While he works with a broad range of clients, David specializes in working with Active and Retired Military, Federal Employees, and Families with Special Needs Children.
Want to work with David? Get Started⟶
There are probably few topics that are more uncomfortable than discussing insurance. Specifically, life insurance. If you're like most people, it's not that you don't inherently understand the need and value of life insurance, you just don’t want to buy it. Thinking about buying life insurance, discussing the need for life insurance, grappling with the implications of life insurance makes the average person feel…mortal. This is why most people don’t buy life insurance. But here’s the thing, it may be one of the most important things you do as a parent of a special needs child. It wasn’t until my son was diagnosed that I reconciled the true purpose of life insurance and its use in special needs planning.
Why do I need Life Insurance?
It's a contingency plan, a backup plan, the old plan B. What we all hope for is that everyone lives a full and happy life. Along the way you do the right things like developing a budget and plan your finances. You hope to earn more, spend less, invest wisely, and pass along an inheritance for you special needs child to live off of after you pass.
Plan B is a hedge if Plan A doesn’t quite work out the way as planned. If you or your spouse pass early you need life insurance to cover lost earnings that you would have made otherwise. Life insurance reduces the amount of resources available in Plan A in exchange for making Plan B a sufficient and sustainable outcome as well.
The Role Life Insurance Plays in a Special Needs Trust
If you are the parent of a special needs child, then you undoubtedly have heard of a Special Needs Trust (SNT). A SNT is your most important tool to ensure your child is properly cared for after your death. There are many benefits for a SNT. First, they are not subject to probate in most places. This provides a massive benefit to your child because probate can last for years, and funds in a SNT can be available right away.
Second, and most importantly, many people with disabilities depend on government assistance programs, such as Supplemental Security Income (SSI) or Social Security Disability Insurance (SSDI). Without a SNT in place, a payout from an insurance policy, or your estate, will likely affect your child’s eligibility for benefits. If your child’s assets exceed $2,000, they may not receive federal or state benefits until their assets return below the $2000 threshold.
How to exactly fund a SNT is a frequent question many families have. While you can leave assets to a SNT at any time, young families often do not have the resources to both fund a SNT and save for retirement, a house, and college.
For families with a special needs child, life insurance has become a common answer to the question of how to fund a SNT. A life insurance policy can provide a special needs family with the comfort of knowing that even if there are financial setbacks in the future, or one or both parents die early, or their accumulation of wealth is shortchanged, there will still be money in the future for their child. It takes time to grow your savings, and you may not have enough time or savings to make up the deficit.
Additionally, parents don’t need to worry about spending their retirement on themselves, or on what will happen to their child if they require long-term care and drain their savings. They are free to direct their remaining estate and assets to their other children or to leave a larger share for the special needs child and smaller shares for his or her siblings. Once assets are set aside for a trust, they can only be used to meet the beneficiary's supplemental needs and is not accessible to the rest of the family.
*Note: There are many ways to fund a SNT. Since the trust is essentially a bucket that can hold different assets. Many people choose to save and fund a trust throughout their child's lifetime using a portfolio of mutual funds and ETFs, much like their retirement accounts. For the purpose of this blog post we will limit the discussion to life insurance.
How much Insurance do you need?
This is a difficult question. Coming up with a single number is tough. The value you decide on must be tied to your child's quality of life. Be prepared for sticker shock. A lifetime of financial support estimate for a special needs child will be a surprise to most people, often reaching well over a million dollars.
To be able to get an accurate prediction you need to first have a conversation with your child’s doctor to determine potential health care needs now and in the future. Every child's prognosis is different. These are difficult conversations, but are critical. Some children may have a high mortality rate. Perhaps their condition is deteriorating. On the other hand, many children with special needs are relatively stable and go on to live long lives. Ultimately you need to guess on your child’s probable lifespan.
You should consider the cost of where the child will live. If your child can live independently, then there is the cost of living associated with that option. If your child may require special care attendants, a group home, or a special care medical facility, then you need to include those costs in your assessment.
Costs change over time. Inflation degrades the value of the dollar. Inflation, while it has averaged 3.22% historically, is uneven. The costs of housing and medical care typically advance at a faster rate than other goods and services. Which means, expenses will probably increase over time. Additionally, costs will change during major life transitions such as the change from Early Intervention to School Aged Services, the transition from school to adulthood, and the transition that happens when parents or care givers are no longer around when the trust is designed to do all the work. A financial planner who works with Special Needs Families should be able to help you determine this lifetime needs assessment.
What Kind of Life Insurance Should I Buy to Fund the SNT?
Before deciding what type of insurance to purchase, you need to think long and hard about the purpose of the policy. You can quickly get caught up in the marketing associated with these plans. Often you will get offered different bells and whistles called riders which will increase the cost and complexity of the policy.
It is usually best to buy insurance for the reason it exists; to insure against a loss and provide income replacement. All the extras that are hyped by insurance salesmen, to include being used as retirement savings mechanism, almost always comes out worse than if you just invest in a properly allocated index portfolio. Don’t buy into the hype…just buy insurance to be used as insurance.
The first type of insurance you should consider is Term Life Insurance. Term life insurance is the most simple and straight forward type of insurance. Term provides coverage for a defined period of time, normally the time in which premiums are paid. A term policy pays a benefit should the policyholder die within the period covered under the policy. The premiums for term policies typically increase each year as the insured gets older or are level for a specified number of years, such as 10, 20, or 30 years. Insuring later in life after your initial term will face steep increase in premiums at the end of the guaranteed term.
Term is appropriate for most people. You should have a term policy on yourself and your spouse to account for lost wages or cost of caring for your children if your spouse where to die. Many people choose to self insure over time. That is, they buy as much term insurance as they need for as long as they need it until their assets appropriately accumulate to cover the difference. Family needs will also presumably decrease over time. Your kids will grow and leave the home, they will have attended college, and you may have even paid off your home. As you approach retirement, you don't need insurance because you have self-insured.
Term Life Insurance is appropriate if your child’s prognosis is poor, or his or her life expectancy will not likely exceed the end of the term. Additionally, If you are still in debt, or do not have a cashflow strategy to fund your retirement you should only consider term insurance. As cold as it may sound, you need to focus on yourself first before you can properly take care of your child. Ensure you get convertible term. This allows you to "upgrade" from term insurance to permanent insurance at a later date without having to get fully re-approved and without having to go through a full medical workup again. This is especially important to prevent future health issues from effecting your insurability. The other smart move is often to get what is called return of premium term. You will pay more, however, in the event you do not need to use it and you come to the end of the term you will get your premium you paid during the life of the term policy back tax-free. You can then turn around and use it to buy a permanent policy at that time. If you are in good financial shape and have saved and budgeted appropriately, then you may be in a position to consider a permanent life insurance policy to fund your child's SNT from the beginning.
Unlike term insurance, a permanent life insurance policy lasts for the policyholder's entire lifetime and provides both death benefit protection and cash value. Part of the premium paid by the policyholder goes into a cash account which accumulates over time. You may withdraw money from your permanent policy as a loan. The policy holder is typically obligated to pay back the borrowed amount with interest. Permanent insurance comes in many flavors like Whole Life, Universal Life, and Variable Universal Life. The cost of a permanent policy can be cost prohibitive. They are flat-out expensive.
Another issue with permanent life insurance, is they often lapse with annual lapse rates in the first 5 years as high as 12% per year with well over 50% in the first 10 years alone (source). Letting a permanent life insurance policy lapse is so common, that more than 250,000 policies with a combined face value of more than $57 billion are lapsed and surrendered back to life carriers each year. The average face value of those policies is approximately $225,000 (source).
You can’t blame a product for making a choice to lapse, however, If you are going to use permanent life insurance to fund a SNT, you need to have a realistic plan to cover the premiums throughout the remainder of your life or you are just throwing good money after bad.
For parents of a special needs child, there is another type of insurance called a survivorship life insurance product that is ideal for funding an SNT trust. A survivorship or “second to die” policy is a type of joint permanent life insurance that pays out upon the death of the second parent to die, which is presumably when the child will need the money.
Survivorship life insurance is almost always cheaper than insuring the same two individuals with individual single policies. Due to the fact that the life insurance policy does not pay out until both the insured individuals die, they are less risky for the insurance company and the premium paid for the second to die policy is considerably cheaper. Another benefit of a survivorship policy is the life insurance underwriting process is usually easier because the insurance company will usually focus on the youngest or healthiest of the two insured individuals.
The downside of a survivorship policy is that the surviving spouse does not receive any benefit from the policy, which means it should only be counted on to provide a benefit for your special needs child. If you are concerned about maintaining a quality of life for your surviving spouse and their ability to support your child, then you should consider buying a separate policy to cover the difference in your income. A term insurance policy would be best used by the surviving parent to support the child, and when the second parent dies, the survivorship policy would pay out for the special needs child. So what types of survivorship policies are there to choose from?
Guaranteed Universal Life
The first type of survivorship policy to consider is a Survivorship Guaranteed Universal Life Insurance (GUL). The GUL is a hybrid between term insurance and permanent life insurance, and it offers its purchasers the ability to take advantage of the best features of both and can be an attractive choice for funding a SNT. GUL policies are priced similarly to a term life insurance policy because it does not have the cash value accumulation and you can simply lock in the rates at your current age. The absence of a cash value means that guaranteed universal life policies can be significantly less expensive than other permanent alternatives. They essentially act as term life insurance that extends until you reach whatever age you wish to specify in the policy.
One knock on a GUL policy is the inevitable erosion of the death benefit over time due to inflation. Because the purchasing power of the dollar is reduced every year, in the future when you expect to need the proceeds of the policy, they will be worth less than if it was paid out today and should be taken into account when you determine how much insurance you ultimately need to purchase. If you have done your homework, you will already have taken inflation into account on your needs projections.
Another problem with GUL policies is that they are inflexible. If you pay less than what’s necessary, pay after the grace period, or skip a payment, these actions may affect the guarantee. You must be disciplined to use it. Unlike a Universal Life policy that may have more flexible payment options.
The second type of survivorship policy to consider is a Survivorship Whole Life policy. This type of policy is more expensive than the GUL, but does offer some additional benefits that may be worthwhile. The Whole Life policy works much the same way in that you must determine the death benefit you wish to purchase. The death benefit is guaranteed by the insurance company just as with the GUL. However unlike the GUL, inside the Whole Life policy is a cash value component that grows over time based on a dividend rate. The cash value grows over the life of the policy, and in many cases can grow into a sizeable amount. This cash value is what gives this type of policy some attractive benefits as a tool for funding a SNT.
After paying the premiums for a number of years, the cash value can be used to increase the death benefit to account for loss of purchasing power due to inflation. Unlike the GUL or a Term policy, where your death benefit will slowly erode in value over time, this increasing death benefit feature of a whole life policy can be especially beneficial.
A secondary use of the cash value is to use it to pay the remaining premiums over the life of the policy. This feature can be helpful when the policy owners are reaching retirement and may not have the income and cashflow to continue paying premiums. With enough accrued cash value, the policy essentially becomes self-funding and will stay in place without any additional payments from the policy owner.
Lastly, perhaps the biggest benefit to a Whole Life policy is the return of cash value when the policy holder chooses to cancel the policy. Why is this such a nice feature? Because, life happens. Your need for permanent insurance may not always be there. Sadly, many parents may outlive their special needs children and would no longer need to fund a SNT. The Whole Life policy will return the cash value to the policy owner, which will often offset the premiums paid over the years, making this a low risk option for many families with an unknown future.
This post is by no means a compendium on insurance. There are no easy answers here. It is typically best to discuss your options with a financial planner who specializes in special needs planning and can lay out the pros and cons of each option. Your financial planner can also help you find a reputable insurance salesperson and ensure the product you ultimately purchase meets your families needs. Because each family is different, you will need to decide on which type of insurance is best for your situation and how much you will need to purchase to fully account for what could be a lifetime of care for many.