Most of my previous posts highlighted the importance of budgeting, managing debt and investing to secure a better financial future. You're never too old or too young to secure your financial future. The sooner you start, the greater the results. Planning for the future takes on a whole new dimension when marriage and kids come in the picture. College planning, paying closer attention to health insurance benefits and the dreadful thought of a spouse dying forces you to build protection around your lives by way of life insurance. Several of my friends and I have recently or are currently going through the process of obtaining life insurance and seem to differ in our perspectives over the options that are available. I wanted to share my perspective about the 3 most popular life insurance options.
Whole life insurance is a form of permanent insurance that offers protection through the entire life time of the insured individual and creates a cash value that can be borrowed against in the event of an emergency or that can be taken upon surrendering the policy. Whole life requires the policy owner to pay a fixed monthly premium for the rest of their life, and upon death, the company will payout the face value of the policy (death benefit) to the beneficiary. It's important to note that the company is the sole determinant of the dividend rate payout which makes up your cash value.
If you've ever received quotes for Whole Life policies you'll know the premiums are incredibly high for relatively low coverage. Whole Life is a combination of 2 products: life insurance and an investment, indicating that you're protected with some growth. The cash value element is usually the point of attraction that convinces most people to purchase this product, for which you can borrow against at anytime. This is a supposed benefit, however any loans taken against the policy must be repaid with interest. If the loan isn't repaid, your death benefit will be reduced. If you had a $200,000 death benefit with $40,000 in cash value and you withdrew $20,000, your resulting death benefit would be $180,000.
So it must be smart to purchase a policy with cash values? According to ConsumerReports.org, the annual rate of return on a whole life policy is about 3.5%, rendering this product a poor investment. If you read my post on How to Approach Investing then you're aware that inflation is about 3%, which means that the returns on the whole life are being undercut by inflation. I was quoted monthly premiums of about $200 for a $250,000 policy. If I purchased and kept this policy for 10 years and died in the 11th year, my beneficiary will ONLY receive the face value of the policy ($250,000), NOT the cash value that accumulated because that DIES with you. Essentially I would've paid north of $24,000 in those 10+ years and the payout is only $250,000. Simply put, Whole Life Policies are just an expensive form of insurance with a Savings account. If you think about the purpose of a savings account - do you really need a middleman telling you to repay yourself after borrowing your own money with interest? NO THANK YOU!
One more thing to note about cash values....the first few years of a Whole Life policy yields no return because of fees and the cost of insurance and you start to see some positive returns around year 8. It will take a several more years after that for the returns to finally look somewhat promising. By the way, a portion of those fees happen to go to the person who sold you that policy and that money is not invested on your behalf. The company takes their profit, a portion goes into a pool to pay death benefits to those who die, the salesman gets their percentage and the remaining goes into a conservative investment. You can invest your money YOURSELF.
INDEXED UNIVERSAL LIFE
Index Universal Life is similar to a regular whole life policy in that it's comprised of permanent life insurance and and a cash value account. The cash value portion is directly linked to the performance of the stock market. I was quoted $125 in monthly premiums for a $200,000 policy. Not as expensive as Whole Life, but again, I would be way under-insured than I'd like to be. The main selling point for an IUL is that in the event the stock market has a terrible year, you won't lose because there's a guaranteed payout of 0% to 3% payout. If the market has higher returns, you can experience gains as high as 13%.The high return would be part of their cap rate which is anywhere between 10% to 15%. It sounds nice to be getting a minimum guaranteed return, however this is just another fancy selling point to get you to fork over your cash. This begs the question, WHY WOULD I PAY AN INSURANCE COMPANY TO INVEST MY MONEY, TO THEN DETERMINE HOW MUCH RETURN TO PAY OUT? The cap rate poses a major issue because when index funds posted returns in excess of 30% In 2013 , the insurance company would've only paid you a maximum of 15%. The other 15% gain is kept by the company to pay for the cost of the insurance and massive fees. This doesn't seem to pass the common sense test.
So what's the alternative?
BUY TERM LIFE AND INVEST THE REST
Term life provides a level premium and a death benefit protection for a set period of time. This is usually a good fit for younger individuals or families who are concerned about replacing loss of income. Term insurance doesn't build any cash value and has no value upon expiration. Term life provides bargain-price protection that pays out a large sum to the surviving beneficiary upon death during the 20 to 30 year life of the policy.
I'm currently waiting for approval for a 30 year term life policy for $1,000,000 that will cost me about $55 a month for the entire life of the policy. Once approved, this will replace the current policy I have that costs $45 monthly but has increasing premiums as I age. In the event I die before the policy expires, my beneficiary won't get $200,000 like the permanent insurance options discussed above, but he will get $1,000,000 CASH. Now that sounds more like it and I won't be financially burdened to pay this policy.
The sales people selling Whole and IUL's, will tell you term isn't a good option because most people outlive their policy and there's no cash benefit. This is true but let's give that some context. I've had my car insured with Geico for 6 years now at about $170 a month which today totals over $12,000 paid in premiums thus far. I haven't had to file a claim yet. Should I call Geico and demand that they pay me back a portion of that money? NO. That's what insurance is for. Protection. If I got into an accident and severely hurt someone, Geico would pay them up to $250,000 in bodily harm damages not to mention the cost of repair to their vehicle. I certainly couldn't afford that out of pocket. So $12,000 over a 6 year period to have protection against the results of a potentially tragic accident is well worth it. Term Life works the same way.
It seems most sales people will argue that Whole Life is a great way to build wealth. Life Insurance isn't a vehicle meant to create wealth. It can jump start your beneficiary's future in the event you die prematurely. But since most people outlive their term policy, how can you build wealth? The Best and Only way to build wealth is to:
- Live Below your Means
- Reduce DEBT
- INVEST Early
Paying insurance companies via a Whole Life or Indexed Universal Policy to build wealth can leave you and your family short changed in the event of death. If you implement all the personal finance principles I've highlighted in my previous posts, you will effectively create wealth. If I happen outlive my term life insurance, I can still pass down wealth to my son from the money that will be in my retirement accounts.
If you're still not sold on Term and think permanent insurance is best, it might be because you don't have the discipline to "save" or the risk tolerance to invest. If you like the built in security of accumulated cash value even if the returns aren't great and don't mind paying the high cost to get it, then permanent insurance might be right for you. If you are risk averse and prefer "guarantees" and don't mind paying the high cost then permanent insurance might work for you. If you've been in your whole life policy for a while and like the cash value you see, then it might be worth keeping. It's always a good idea to explore all the options available but I'm confident that for all the reasons I mentioned, Term life will be the clear winner.
If you plan to be Financially Independent, buy Term Life and invest the difference so you can be wealthy enough to be self-insured against your death.
Do you have your life insurance policy in place? Which option best suits your family's needs?