NOTE: This post is part of an ongoing education series. This information is for educational purposes only. This information does not constitute investment advice. No rational person would make investment decisions based on a blog post. Please consult with your financial advisor before taking any action.
Today we are going to talk about life insurance. There are many different types and it can get very confusing. One of my basic investing philosophies is KISS (Keep It Simple Silly). If you don’t understand what you are buying – YOU SHOULD NOT BUY IT!
Today I will talk about the difference between Whole and Term life insurance. Term insurance lasts as long as you pay for it. It is like car insurance, if you stop paying the bill, the insurance stops! Term insurance is VERY cheap because your odds of dying are very small, at least while you are young and in good health. However, Term insurance will adjust (and go up) each and every year. When you get over 50-60 it gets quite expensive. You can also get term that keeps the rate same for 10, 20 or even 30 years. You start by paying more – but the payment will stay level.
Whole insurance is a type of permanent insurance. It will last until you die, if you pay the bill! It starts at a much higher rate but, never goes up. Generally, these policies will have an age at which they end, often 100. It is very hard to buy straight whole life. Usually, it is sold as insurance and investment combined. They will give you projected returns which almost never come true. This type of policy also costs much much more per year.
There are many other types of life insurance. I will cover some of them in later posts. With some rare exceptions, I generally think the more complicated an insurance policy it – the worse it is for you. Remember KISS! I also think that insurance is a poor investment. I am a strong proponent of, “buy term and invest the rest.”
I will now go over a specific example of Term vs. Whole life.
Our sample person is a 30 year old male and has his first kid on the way. He is in good health and does not smoke or engage in risky activity. He wants to have life insurance long enough for this child and any others that may show up to make it thru college. He thinks that $1,000,000 should do the trick so he starts to compare the two choices.
The 30 year level pay term insurance will cost as little as $700 per year or less than $60 per month. He will have $1,000,000 of insurance from the age of 30 to 60. After that time more insurance will be quite expensive. The same coverage could be about $5,000 – $6,000 per year.
Whole life will cost this same person about $9,600 per year. You not only have the insurance but you can build cash value. If needed, you can loan yourself money. However, it often takes several years for the cash value to start to build and the extra funds from the first few years pay all of the expenses and you may have a cash value of $0 for several years. After that the money may grow at 2-4% per year. A sales person may show you a projection with 6 or 7% return as an estimate. Your return is determined by the insurance company.
Now some fancy math….
If you buy the Whole life you will have $1,000,000 in life insurance for the rest of your life. If you make it to 100 years old – They give you the $1,000,000. If you want any money out your insurance before then you have to take a loan against your insurance and those you care about may get less than you expected.
If you buy 30 year level pay term and invest the extra $8,900 in the stock market and make an annual return of 10% per year your investment will have a value over $1,000,000 in just 26 years. You won’t need to borrow money – you have money. After 30 years you let the term policy expire. The kids are grown, out of college and you now have $1,600,000 – who needs insurance?
After the 30 years are over you can retire and spend your money or if you don’t need it, let it keep growing. Let’s say you die at the age of 80. What would you prefer to leave to your wife and kids….$1,000,000 or around $10,000,000?
NOTE: This post is part of an ongoing education series. This information is for educational purposes only. This information does not constitute investment advice. Please consult with your financial advisor (or Polaris Financial Planning) before taking any action.
Below is a description of an investment product. This is based on real and available products but does not represent any specific product. Numbers below are estimates and are only intended to show how this product works.
There is a new product it is a combination of the best of bonds and the stock market. It is a guaranteed mutual fund. Part of the money is invested in an index fund and some is invested in Zero-coupon bonds issued by the US Government – AAA Grade. You get the benefit of the stocks and bonds. The best part of all is that in the next 10 years, you are guaranteed a 40% return. That’s like getting 4% each and every year. That’s right you will make at least 40% return on your investment and you have the unlimited potential to make more if the stock market goes up. Just sign here and give me $100!
Now for all of the details that the sales person did not tell you about. The odd thing is that they did not need to tell you verbally because all of the details are in the prospectus – 72 pages of 6 point font written in the best legalese. You signed a form that said you read it. Now they can do almost anything to you. You thought if you invested $100 you would have $140 in 10 years. Now we will get the details.
10 years – You will want to keep this investment for 10 years because if you sell it early you have to pay a 10% penalty. Whoops… did we forget to tell you that.
4% per year – Actually it is closer to 3.3% per year compounded but hey it’s only money.
The Load – oh… did we forget to tell you there is an 8% load. A load is a sales fee that is collected from you and paid to the sales person. 8% is on the high side for mutual funds but, this is a really good investment so it is a small fee to pay. The $140 after 10 years was based on an investment of $100 you only invested $92 ($8 covers the load).
$140 – 8 = $132
You do not make $40 but $37 (remember you only invested $92). So when it’s all done you have $129 – still really good.
$140 – 8 – 3 = $129
Annual expense ratio – We told you the 40% return is guaranteed – and it is. So is the annual expense ratio. This is to cover the cost to the company that manages you money – and they deserve it for getting you such a great product. The fee is just 1.8% per year. Just above the industry average but your worth it. Total cost is just $18 over ten years. Your total return is still $111 that’s great. Right?
$140 – 8 – 3 – 18 = $111
Insurance – Your money is guaranteed, it’s a kind of insurance. You pay for auto and home insurance – of course you have to pay a little something for this insurance. The cost is just 1.5% per year. Total over 10 years is about $15. Your total return is $95 – isn’t this, a wonderful investment.
$140 – 8 – 3 – 18 – 15 = $96
Taxes – The IRS does not want to wait and tax you on all the money you are going to make with the Zero Coupon Bonds. So they created a thing called imputed interest. They collect tax on the money you are going to get. Don’t think that you lost money. You did not! You made money but agreed to a lot of high expenses. That’s your problem not the IRS’s. So…. ya gotta pay the tax. I will call it $8. So now your awesome investment of $100 after ten years is now worth around $88.
$140 – 8 – 3 – 18 – 15 – 8 = $88
Who wants to buy now?
Invester alert from FINRA (formerly NASD)