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How to Insure Your Income: Life Policy as Income Source

A life insurance policy usually pays a stated sum in cash on the death of the insured person. However, beneficiaries sometimes need a stream of income more than they need a lump sum of money. The same holds true for policyholders borrowing against any cash value they've built up in the policy.

To meet these needs, most insurance companies will offer alternative methods of settlement when it comes time to pay on a life policy. The most common of these are:

  • interest only;
  • fixed-period installments;
  • fixed-amount installments;
  • life income; and
  • joint and survivor.

Under the interest only option, the proceeds are held by the insurance company -- and the interest earned on the proceeds is paid to the beneficiary according to a predetermined schedule. The minimum interest rate that will be paid is guaranteed in the policy. Usually, the policy also provides that if the company earns interest in excess of the minimum guaranteed, it will pay excess interest on the proceeds, usually on an installment basis.

You can specify that no part of the principal is ever to be paid to the beneficiary; you also can specify that the beneficiary may withdraw the principal in whole or in part or elect another option in the policy. You also may prefer that the proceeds remain on an interest only basis for a stated period of time or until a stated date, and then be paid in cash or under one of the other options.

Under the fixed-period installment option (also referred to as installments certain or time option), proceeds are retained by the insurance company and paid in equal installments over a specified period of months or years. Payments are comprised of both principal and interest. The payments also are established without regard to the length of life of the primary beneficiary. If the beneficiary dies, the payments are continued to a second beneficiary.

The fixed-amount installment option is sometimes referred to as the amount option and sometimes the principal and interest to exhaustion option. It calls for the payment of a fixed, periodic (annual, semiannual, quarterly, monthly) benefit of a predetermined amount until the proceeds (principal) and interest thereon are exhausted. The size of each installment determines the duration of the payments -- in contrast to the fixed-period option, where the length of the income period selected determines the size of the installment. Excess interest will increase the duration of the installments rather than the size of the installment. Fractional amounts are paid in full with the last full installment.

Under the life income option, the proceeds are retained by the insurer and paid in equal installments (monthly, quarterly, semiannually or annually) as long as the beneficiary lives, even if the total paid exceeds the amount of principal plus interest. However, when a life income only option is elected, there is no refund when the beneficiary dies -- even if only one installment has been paid.

To reduce or eliminate this risk, many recipients want to have payments guaranteed for a specified period of time. This can be arranged by electing a life income with period certain option. Under this option, the benefits are guaranteed for a certain period (usually five, 10 or 20 years).

If the beneficiary dies before the end of the period, benefits will continue to be paid to another person for the remainder of the period. If the original recipient lives beyond the period certain, the benefit payments continue for as long as he or she lives.

Finally, some life insurance policies contain a joint and survivor option. (Most companies that do not include this in the contract will grant it as a special settlement agreement.) Under this option, two beneficiaries receive the proceeds of a life insurance policy. When the first beneficiary dies, the second beneficiary (if he or she is still living) continues to receive the proceeds of the policy, in installments, for his or her lifetime (or for a specified period).

One of the principal advantages of selecting one of the various settlement options is freedom from investment concerns. If a beneficiary receives a lump sum settlement of the death benefit, he or she must decide how to use or invest the money.

By electing a settlement option other than a lump sum, you're trusting in the expertise and knowledge of the insurance company to administer the proceeds to provide a stream of income.

However, insurance companies do not provide trustee services. For example, the insurance company would not accept a settlement option under which the company would make payment of the proceeds to beneficiaries "according to their needs" -- since it would require that the insurance company make a judgment determination.

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