The reasons for protecting your income are detailed in my post titled “Why Life Insurance”. This post will be geared to what type of income protection (life insurance) you should have. There are two basic types of life insurance. On one side of the ledger, you have what’s called “Whole Life”, “Universal Life” and/or “Variable Life”. Thess types of insurance policies combine the income protection along within a savings/investment account that is tied to the life insurance company. This savings/investment account is typically referred to as the “cash value”. On the other side of the ledger, we have term insurance. This type of policy covers the client for a set amount of time, example 10 yrs, 20 yrs or up to as many as 35 yrs. Term insurance has no internal savings attached.
There are some significant differences between the two, so let’s jump in!
First, the “cash values” type policies. This is the type of policy that the insurance industry has typically offered the client. The major point agents of this type of insurance policy harp on is the “permanent coverage” aspect of these policies. There is no limit on the time the coverage is in place. As long as you are willing to pay the premium, the policy will remain in place. At first glance, this seems like a great deal. You get income protection and a savings account. Unfortunately, these type of policies are not all what they seem.
Disadvantages of the “cash value” policies. Take this example. A 29 yr old, in average health young man, can get 100,000 worth of coverage for roughly $83/month. Not bad right?
One, the $83/m rate is typically three to five times more expensive than term insurance for the same coverage amount. Two, in addition to being more expensive, to access the “cash value” portion of the policy it’s considered a loan. The insurance company charges a 4-6% rate of interest on any withdraws of the “cash value”. Remember, the “cash value” is your money that the insurance company is basically overcharging you. In order for you to access that overcharge money, they charge you interest on the money. Three, another “benefit” as they call it is that your “cash value” will increase in value over time as a result of dividend income. The typical illustration usually uses a 4-5% rate of return. So, in theory, if I have $10,000 in my “cash value” at the end of the year, that should produce $500 in “dividends” which in turn I can reinvest to grow my “cash value”. Problem is the dividend is rarely 4-5%. The forth and final nail. What happens should you pass along the way? Again, for argument sake, let’s say you pass at age 50. The policy has been in place for 21 yrs paying $83/m. So you have paid $20,916 into the policy, You might have accumulated $15,800 in your cash value (A $100,000 policy should be about $20/month. Using that figure, that leave $63 each month into the savings side of the policy). What do you think the beneficiary will receive? The answer is: $100,000. What?…Why? Should it be at the very least $115,800? In these types of policies, the beneficiary never gets both the face amount coverage, in this example $100,000 and the “cash value”. The beneficiary get the $100,000 face amount. The “cash value” of $15,800 stays with the insurance company. In reality, the policy would actually be $84,200 (100,000 minus your cash value $15,800 would leave $84,200). You will hear proponents of “cash value” policies say you can get both if the policy is structured that way at the beginning which is rarely the case. Additionally, it will be even more expensive for that “benefit”.
Now, term life policies. This type of product is sold by every insurance company, however, more often than not, it’s not what first comes to the forefront when presenting clients with options. Term policies, as mentioned above, have an expiration date. The policies can be renewed but that rarely takes place for several factors. Cost versus need is the main reason that term policies are not renewed. I’ll explain more in detail below. But first, let’s look at the same example above. With a term policy, the same 29 yr old average health male can get $250,000 for roughly $28/month. One, that’s two and half times more coverage that a “cash value” policy for a third of the price. And this policy will be in force for 35 yrs. Advantage: Term. Two, in addition to the policy we are going to simultaneously open an investment account in a mutual fund (topic to be discussed in a future post). With the “cash value” policy the young man was paying $83/month. Now he’s paying $28/month. A savings of $55/month which in turn is invested. Advantage: Term. Three, in order to access the money growing in the investment account, as long as it’s not a retirement account, he can access his money whenever he desires. It’s not a loan as with the “cash value” policy. Advantage: Term. Rate of return on his investment can be whatever his risk tolerance will dictate. If he’s an aggressive investor, Rates of return of 8-12% can be achieved, not 4-5% as within the “cash value” policy. Advantage: Term. Finally, what happens if the young man passes at age 50? What will the beneficiary receive? In this case, the beneficiary would receive the $250,000 face coverage amount PLUS whatever was in the investment account. Using the same 21 yrs, $58/month invested @10% rate of return would leave the beneficiary with an additional $50,265. Total beneficiary would receive is $300,265. Advantage: Term.
As you can see, I strongly feel that term insurance in combination with an investment account is by far the most beneficial plan. I do not stand alone in this regard. Many financial experts such as Dave Ramsey and Suzie Orman are strong proponents of buy term over “cash value” policies. Additionally, we can show you how your actual need for life insurance decreases as your assets and net worth grow overtime. Life/Income Protection is in place to protect against you passing to soon. With buying term and investing the difference, you work to become self-insured and your investments grow to protect you against living to long.
The choice is ultimately yours. My only hope is that now you are better informed. If you would like an individualize, commitment free consultation please email me at louis@louisromero.com.