Tuesday, December 31, 1996
A Foolish Look at
Insurance
by
MF Sheard
Now that I have a son, a mortgage, and a tenuous grasp on this "adult" thing, life insurance is an issue I've had to address. Kind of like making out a will, deciding on life insurance isn't nearly as fun as watching a basketball game, but it's necessary for those of us who aren't already on Easy Street.
There are lots of ways to go with insurance these days, but two major types of insurance dominate the market. Term insurance is simple insurance, no investment component attached. You pay the premium each year for a fixed amount of insurance. If you die, your beneficiary receives that amount. As you get older, and the odds of your dying increase, so does the premium you must pay. But in general, the premium is fairly low.
Whole life insurance is part insurance, part investment. You pay a fixed premium and you build up equity in your policy. Over time, that cash value increases and the dividends you earn in the policy help you buy more insurance without increasing your out-of-pocket costs each year. It's more expensive than term for the same face-value on the policy, but the investment aspect is supposed to make up for it.
Which policy makes more sense? I recently received a packet from an insurance agent, trying to convince me that term insurance was a mistake. The agent included all the premiums over time, the cash values, etc. He also included a scenario comparing the whole life policy to investing in a mutual fund and buying term instead. As it turns out, his numbers only tell half the story. Let's look.
For a 30-year-old male who doesn't smoke, a $500,000 whole life policy costs $4,507 a year. You pay the same amount each year and the dividends buy more coverage. At the end of 25 years, you have a cash value (your equity) of $243,236 and a death benefit of $641,181.
But taking that same $4,507 each year, buying a $500,000 term-life policy and then investing the rest in the Dow Approach provides an interesting comparison. Even after taking out 33% in taxes each year (the figure used in the agent's comparison, I assume to include state taxes, too?), this plan is vastly superior.
After 25 years of paying the increasing premium for the term policy, investing the difference in the Dow Approach (at 23% a year) and paying 33% in taxes, you would still have the $500,000 life insurance policy should you die, plus just over $1 million in your portfolio. The greatest advantage to the buy-term-and-invest-the-difference plan is you don't have to die to enjoy the returns. That portfolio is yours to do with it as you will.
The agent also tried to show that most people give up on their term insurance after a period and are losing the "opportunity cost" for that money. But I believe that's exactly what you should do. Insurance isn't an investment; it's simply protection against a premature death of a breadwinner. And you're paying a relatively low price for that security with term until you no longer need the protection. If by age 55, you've got more than a million socked away, your kids are out of the house and presumably you're debt free, why do you need life insurance anyway?
So in our example, let's say you stop paying the term-life premiums after 25 years and keep investing the $4,507 a year in the Dow Approach. Thirty years later, it's true you have no life insurance, but you've got an after-tax portfolio of nearly -- get this -- $77 million!
If you had continued putting that $4,507 in to the whole life policy each year, your cash value after the entire 55 years is worth $1.8 million and your death benefit is only $2.1 million. That's less than a 6.5% compound annual growth rate over 55 years. Some bargain!
Insurance is insurance; it's not an investment. It's almost a guarantee that the more complicated financial products like insurance and annuities get, the people benefiting from them are those selling them, not those buying them. Buy term as long as you genuinely need it and invest the difference. You'll stop needing the insurance sooner than you've been conditioned to think. And you'll have a whole lot more cash to show for it than if you turn over your investments to an insurance company.
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