In Part 1, we reviewed the fundamental differences between Term and Permanent Life Insurance. Basically Term is cheaper but it expires and gets more expensive as time goes on. Permanent life is way more expensive, but it lasts forever and has the potential to build up cash value.
We concluded with me learning a fact about life insurance that made me question my Variable policy. I’ll explain below what exactly that was and how it caused me to request two new quotes so I could crunch the numbers to determine whether the Term or Variable Life Insurance policy was truly the better deal.
The Deal Breaker:
About 5 years after I purchased my Variable Life Insurance Policy, I was reading the book “Your Money Ratios” by Charles Farrell. When I got to the chapter about life insurance, there was something very valuable I learned:
• With a permanent life insurance policy, when you die, the amount of coverage is actually subtracted from your investment account before the life insurance company kicks in the rest. For example: If you have a $500,000 policy and your account is at $400,000, your family would only receive the $400,000 + $100,000 from the life insurance company; NOT $900,000. In other words, at some point, you may be paying for your own death benefit!!!
This was a big shock to me because I thought that the death benefit was IN ADDITION to the cash value that was building inside my investment account – which at the time seemed like pretty good deal because let’s face it – I am going to die someday. However, I was wrong. And this meant that if I were to pass away, my family would receive much less than I had originally believed they would receive.
After reading that, I immediately emailed my insurance rep and he confirmed that that was indeed true. He said there were special policies where the two things could be separate, but they (of course) cost even more than what I was currently paying.
Why This Revelation Was Important:
So in theory if I lived long enough and built up my investment account with the insurance company, I could have eventually turned over more money to the insurance company that what I would eventually get paid as a death benefit. Therefore, the insurance company would actually have to pay nothing. If that is true, then why even bother with having lifelong guaranteed coverage in the first place??
The New Quotes:
I decided in light of this new information, I should revisit my insurance needs and request two new quotes for a $750,000 policy: One for a 30-year Term and one for a Variable Permanent Policy. One way or the other, I was going to get a minimum of 30 years of coverage. The question is which one would be better for my finances?
Here is what my rep came back with:
• Option A) Variable: $250 per month
• Option B) Term: $58 per month
Now let’s crunch some numbers to see which one is better:
Option A) Variable / Permanent Life Insurance Policy at $250 per month.
In this option, we pay $250 per month indefinitely for as long as the account is in good standing. The account will grow to have some cash value (more on that below).
Remember that one important factor is the fact that we’ll be paying for our own death benefit if our account grows too large. So rather than speculating what the insurance company is going to do with our $250 per month and how much our account will grow, let’s instead ask the question like this:
• How long would it take to grow $250 per month to more than $750,000 if we invested the money ourselves?
Using Microsoft Excel, we do some quick math to find the answer. If we assume an 8% average annual return, we find the following answer:
• It would take 38.2 years to build up $750,000.
So in other words, if you died in less than 38.2 years, then this policy would make sense in terms of paying out more than what you paid into it. However, if you live beyond 38.2 years (and I hope we all do), then you would have been better off (in hind sight) having invested the money yourself because you’d have exceeded your own death benefit.
Option B) Term Life Insurance Policy at $58 per month.
In this situation, the math is very straight-forward. We’re going to pay $58 per month for 30 years ($20,880) and get absolutely nothing in return as long as we don’t die. Out of curiosity, what is the future value of $58 per month with an 8% return over 30 years? $86,441. In both situations, this is incredibly cheap compared to the Variable plan.
But remember that we are comparing the two options. So how much money would we save by going with the Term plan over the Variable?
• $250 (Variable) – $58 (Term) = $192 per month saved.
So now I get to pocket $192 per month AND I get to have $750,000 worth of protection for the next 30 years.
Suppose that I invest that extra $192 per month over this 30 year period and assume an 8% return, it would grow to $286,149. That’s $286,149 that you would have forfeited to the insurance company had you went with the Variable policy (and not passed away).
But Isn’t the Variable Policy “A Wonderful Investment Opportunity” – That’s What the Insurance Rep Told Me!
So in reality, let’s say we went with the Variable Life Insurance policy. Would we really have $750,000 in our account after 38.2 years of paying $250 per month? Absolutely not! Every month when you make your payment, the insurance provider deducts the fees for the insurance itself as well as the administration fees (which were pretty ambiguous from the statements I use to receive). Whatever (small amount) is leftover is invested however the insurance company sees fit.
This is why it is difficult to accept insurance as being “an investment” rather than just insurance. The high costs and fees eat away the majority of your returns. As an investment, how can you do much better than a low cost index fund or ETF that only charges 0.20 to 0.50%?
Let me share with you a personal example. When I finally decided to cancel my Variable Insurance plan in favor for the Term, it had a cash value of around $300. That’s right, after almost 5 years of paying $117 per month (about $7,000 altogether), my “wonderful investment opportunity” only had a total cash value of about $300.
Want to add insult to injury? The insurance company had an “exit redemption clause” that said that they would deduct up to $500 from any cancelled policy upon refund of the cash value. So my “wonderful investment opportunity” net me $0. Pathetic!
So assuming we don’t die in the next 30 years, here is a snapshot of where we’d be at the end of year 30:
• Option A – Variable Policy: We’ve paid $90,000 to the insurance company (which has a future value of $372,590 at 8%). The cash value of our policy is God-Knows-What (and probably no where close to $90,000). And in 8.2 more years of continued payments, we would have theoretically paid our own death benefit.
• Option B – Term Policy: We’ve paid $20,880 to the insurance company (which has a future value of $86,441 at 8%). Our policy has now expired and has no cash value. BUT, because we are disciplined savers, we invested the extra money we saved from not taking the Variable policy and built up our own investment portfolio of $286,149 that we can now use for retirement or whatever we see fit.
I declare the Term Life Insurance Policy the winner!
• For the same 30 years of coverage and death benefit, the Term option had the lowest costs.
• Even though the Variable plan had an investment associated with it, we’ve shown that you could probably do better by investing the money you’d save by going with the Term plan.
• Recall in Part 1 that I said that life insurance is intended to replace your “working income”. Hopefully in 30 years, we are all retired and living off of our investments as opposed to still working. Therefore, there is no longer any need for the life insurance and a Term plan for 30 years should be more than enough.
By the way, when I did switch over to the Term policy, my insurance rep did try to persuade me with some complicated, exotic combination of Term and Whole life plans. Again, I passed. No matter what anyone offers you, run the numbers and see if it makes sense. Most of the time, it probably won’t.
In summary, remember that when you buy life insurance, you should buy just that: insurance – protection for your family in case the worst should happen. Don’t buy it as investment or as a ticket to get rich quick. Keep it simple and buy what it is you’re truly after: peace of mind for those you love.
Photo Credit: Microsoft Clip Art