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 Life Insurance 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 (although I could have probably gotten free quotes at a website like MyLifeInsuranceQuotes101.com):
• Option A) Variable: $250 per month
• Option B) Term: $58 per month
As I often highly encourage on My Money Design, crunch the numbers and prove to yourself which one is really 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 / Permanent 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 Permanent life insurance 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.
1) What Should Be in Your Safety Net?
3) 10 Tips for Saving More Money
Photo Credit: Microsoft Clip Art
I do love the write-up and I believe term is the winner for people that are responsible with their finances.
However, in the scenario you listed above, if somebody was in massive debt and didn’t have a lot of wealth 30 years from now (after the term insurance expired) then they’d NEED to go buy more term life insurance. By this time the cost of insurance would be astronomical and the Variable Life would have been a better deal.
I’d encourage you to check out Cash Value Universal Life Insurance (for no other purpose than knowledge). It grows money the best and keeps the cost of insurance lower compared to the variable life. I’m not recommending it (because TERM IS BETTER!) but this product works well for HIGH income earners and is definitely better than the variable for a few reasons: (1) the investments are tied to an index but you don’t have ANY negative years and (2) you get your cash value PLUS the death benefit.
The other cool thing about cash value in life insurance is that you CAN withdrawal the cash value TAX-FREE like a Roth IRA. Oh snap…pretty cool. The downside is that it’s extremely complicated and technically you’re taking loans again your cash value (you’re not actually withdrawing it). I realize that “a loan” sounds bad but it isn’t as bad as it sounds. It’s too complicated to explain via this comment though.
Jason – Thanks for the great addition. This is great information! I’ll have to look into Universal just for my own curiosity. By the way – I contacted two companies for quotes about annuities.
Quick question – Is that tax-free after age 59 ½ or tax-free whenever I need it?
Kim @Moneyandrisk says
Insurance is too complicated to go into in a comment but I’d like to add the following for you to consider:
1) Insurance products are design for specific purposes. When a sales rep doesn’t understand the purpose or sell you something that doesn’t match the product, it goes very wrong.
2) Your analysis forgot to take into account taxes each year on your annual returns of the earnings and also used a return that is way too high. A better return number is 5% pretax. The earnings inside the policy isn’t income taxable. The insurance companies are only making around 2% a year right now even with all their mixes of investments.
3) Your personal needs doesn’t match the Variable life product. It’s too sophisticate for what you need. Typically, you manage it so that the built up cash value covers the cost and you stop paying premiums while being covered. It’s also used for several other purposes that’s too involved to explain.
Jason pointed out a very key point. You may need insurance much later in life after the 30 yrs and you can’t afford it then or cannot qualify to get it. I can’t stress enough how important this is.
Your rep should have laid out term along with another option and give you pros & cons.
Hi Kim: Thanks for visiting and for adding your thoughts. All good points!
I must agree that some people who do not adequately plan for later in life will need to rely on these policies. Unfortunately when I purchased the Variable plan, I was younger and not as quick to analyze investments. You are right that a better product line-up could have been offered.
On your second point: My bad – I did not specifically mention this, but I was assuming that our alternative investment account growing at 8% would be in some type of tax-advantaged account (for example – a Roth IRA that consists of an S&P 500 index fund or similar). Since both monthly insurance payments and Roth IRA principal contributions are initially funded using after-tax dollars, this would make the two choices equal in terms of tax-advantage.
I love this post. Very few people know that you lose cash value in case if you die. You’ve hit the nail on the head, “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.” This is why I believe in buying term insurance and invest rest on my own. Life insurance is not meant to be an investment instrument; it’s purpose is to cover death benefit. Term insurance does that job superbly!
Amen Shilpan! Exactly the conclusion I came to. I feel much better about controlling the extra money and investing it how I see fit. All the while I’m covered by the Term until my needs outgrow it.
Karunesh @ chase-a-dream.com says
I have plans for both to get Term insurance.I already have Permanent insurance. Term insurance is a nice way to cover the risks when there are lot of liabilities on me. For example – If I am the primary earner and I have a mortgage. so I would chose a term insurance till I do not pay that mortgage.
Karunesh: You’ve got the idea! You really only need insurance for as long as you’ve got a mortgage, a job, kids to support, etc. If you plan to be retired in 25-30 years, have your house paid off, and everything else taken care of, then there is no longer any need to keep it around. I’m in the same boat and Term fit my needs much better!
Karunesh @ chase-a-dream.com says
I have included this blog post at my website weekly roundup
Thanks Karunesh! I appreciate the mention!
So do you recommend letting go of a permanent insurance plan even though I already paid into it for quite some time? Should I just lose all that money already put into the plan?
It depends upon your situation. How long have you been paying in? Do you have a significant cash value to your policy? How many more years do you need coverage? How much money would you save if you switched to Term right now? Would you even qualify for Term if you applied? In my case, I qualified for a very low Term rate at 30 years which was exactly what I needed. Plus my cash value didn’t even meet the minimum payout requirement, so I literally had nothing to lose by switching.
Lorillia | Your Money Mentor says
I’m from Yakezie and its my first time at the site, what will you do once the term expire in 30 years. Depending on you health and of course you will be older you will pay a higher premium.
I would just not consider getting the VL if its just for your life insurance needs. It’s pricer and it may not meet your needs. I have wrote contract on vl for clients who looking to preserve their estate, insurance is used to fund an estate plan, and VL or VUL or very common.
Maybe you should consider a term policy with a conversion part. That allows you to pay lower premiums in the early years and it converts to permanent policy usually after 5 years. There is new underwriting and converts to a permnanent policy. Talk to your rep or advisor.
Hi Lorillia! Welcome to the site. I am not from Yakezie or apart of the challenge, but I certainly do interact with a lot of their members.
In short, I won’t need the insurance in 30 years! Remember that insurance is intended to replace my income in case I die. Once you stop working and your retirement account income takes over, that’s it. You don’t really need the policy anymore. And I fully expect to be retired well before 30 years.
On the investment side of things, I have yet to receive any VL quotes that show I would make a better return than if I just invested myself in an IRA – especially after you account for the high fees that erode the returns.
Great article. I guess the correct answer would be…depending on what you are using the insurance for.
The book “Be Your Own Banker” or “Retire Tax Free” makes a good argument for Whole Life.
Like all financial decisions, yes, it really does depend on your situation. Obviously from my own experience, I’m leaning towards Term. But I’m curious – what are those books’ arguments for Whole Life?
[email protected] full coverage auto insurance quotes says
from my experience i feel that buying permanent insurance is cheaper than term insurance….but it is not possible for everyone to pay for permanent insurance…..:)