Do You Need Permanent Life Insurance?
Life insurance is necessary. However, most individuals do not carry enough of it. The idea behind life insurance is that we all die. If your spouse dies prematurely, a life insurance policy will make sure that there is enough income to make your family whole for the financial loss you've suffered. Pretty much every adviser agrees having life insurance is a good thing.
However, financial professionals often disagree about how much and what type of insurance one should carry. The perception is that term insurance is always the easiest and most cost effective. To this end, many advisers and financial "gurus" like Suze Orman and Dave Ramsey often suggest that their audience forget about cash value insurance and instead focus on good-sounding investments. In short...they hate whole life insurance.
Life insurance agents of course love cash value insurance. The investment industry does a pretty good job of putting down the insurance industry. So...who's right?
It is sometimes surprising that the financial industry is charged with the responsibility of informing and educating the rest of society about saving and investing principles, and yet many of the advisors that represent the industry seem to be less concerned about truth and honesty, and more concerned about injecting their own personal agenda.
On both sides of the debate, neither is doing a very good job of defending their respective position. It amazes me to see so many financial professionals leave out important information about not only their products but about the nature of insurance contracts. I wonder sometimes if they even have any idea of how life insurance really works.
The motivation for lying can be as simple as "money". There is a lot of money floating around in the financial industry, and everyone is competing for it. So, while isn't anything wrong with demonstrating flaws in a financial product, it has to be done objectively. In regards to life insurance, it's not. The attacks are baseless and unsound, and most, if not all, of them are coming from very well known financial professionals. Here are a few of the misconceptions being passed around. Many of them have been repeated so many times, that most people think they are true (they aren't):
Lie number one:
Cash value life insurance is one of the worst financial products available, and it is definitely the worst type of insurance you can buy to insure your life. The BEST kind of insurance is term insurance because it's cheap and I'm not paying all those extra fees to the evil and greedy insurance company. Besides, don't insurance companies have a record of being reckless, cheating their policyholders, and systematically going out of business.
Fact: About 1% of all term policies pay a claim. So, your family has (roughly) a 1% chance that they will benefit from that term policy. Term insurance is cheap - IF you are only considering the cost per thousand dollars of insurance. It is guaranteed to get more expensive as time goes on (and you will see this if your policy gets repriced). Life insurance companies are not dumb. They know they can collect premiums from term life and make a killing because the turnover rate is high (people drop their policies before the term is up) or the policy owner simply doesn't die before the term is up. Life insurance companies are in the business to make money and provide a product. You have to understand how they position their products and how they make money.
Insurance uses something called the Law of Large Numbers. Basically this is how it works: the larger the group of people you are insuring, the more certain you can be about the number of losses you will sustain.
Let's suppose you were to start an insurance company and you only had one customer - let's call him "Jim". You would be taking on an incredible risk by insuring just Jim. If Jim kicks the bucket, then you're on the hook for a lot of money that you may not have. You would be business very quickly (imagine: Jim gives you $20 for a $500,000 death benefit and then they die the very next day...where do you come up with $500K for Jim's family?). However, if you have thousands of customers just like Jim, then you have the unique ability to better control the risk you take by insuring Jim's life. No one can predict when Jim will die, but if you study a large enough group of people just like Jim, then you can begin to make very, very accurate predictions about the number of people just like Jim that will die in any given year. Given the accuracy of insurance companies in predicting deaths every year, what do their statistics tell us?
They say that that term insurance doesn't pay, since most individuals live until age 65. This is why I say permanent is a better deal. In the long-run, it's cheaper. I know, I know...there are probably a few of you saying "no way, it is always cheaper to buy term insurance". Oh yeah? Watch this:
A male (let's use Jim again), age 25 and in good health with a wife and a child finds that he needs life insurance. Jim is looking for $250,000 in coverage. A typical 30-year term policy - a policy that has level premium payments for 30 years - should cost Jim around $370 per year until he reaches age fifty-five. At that point, the premiums jump up significantly (as all term insurance premiums do) to a tad over $4,700 per year.
By the time he is 65, he will have spent $58,780 on premiums. Keep in mind that the insurance company collected this money but never has to give it back. There's no cash value in term insurance, so the contract only pays when he dies.
What would have happened if he had, say, purchased the same amount of death benefit but used a universal life insurance policy with slightly higher but level annual premiums of $1739 every year to age 100? By his 65th birthday, 'ole Jimbo would have had a total premium outlay of $69,560 ($1739 x 40). But, he would have built up $157,000 of cash value inside the policy.
This money is part of the policy's living benefits, and can be used on a tax-free basis to supplement his retirement or left alone to continue growing. Some life insurance companies also offer an option to spend down up to 100% of the death benefit if you become chronically or terminally ill. If you haven't been able to accumulate a lot of money, this can be very helpful.
Lie number two:
Cash value life insurance is overpriced for what you get. You never know how much money you are spending on the death benefit, how much money is actually going into the cash value of the policy, and how much interest you are really earning. Term insurance is so much simpler.
Fact: Whole life insurance carries a stigma in that it is often difficult to determine how much the death benefit is costing you. However, universal life insurance is, in actuality, a term policy with a separate savings account - often called 'the pot of money'. The costs are broken down and the policy is very transparent. Cash value insurance can seem expensive in comparison to term insurance because of the front loaded nature of the contract and the fact that you are forced to save money in a cash account. Sadly, the fees charged by the insurance company are being stressed (I guess they don't know that all financial products carry similar fees).
Be thankful that you pay some of the fees that you do. It makes saving and investing money a lot easier than having to fire a lawyer to negotiate every individual contract you sign. A life insurance contract can be set up to maximize the death benefit (maximizing the cost of the contract), or it can be set up to focus on cash accumulation (minimizing expense charges to .5% - 1% of the interest earned over the life of the policy). The expenses associated with a permanent life insurance contract can be made just as efficient and in some cases more so than what the antagonists suggest as an alternative - which is usually some type of mutual fund - without sacrificing the practicality of owning the contract. But again, why are the antagonists trying to compare the cost of insurance to an investment?
Over the long-term, you should get all of your money back that you put into a cash value policy with interest (note: the exception to this is variable life insurance which doesn't guarantee cash values). If the policy is structured properly, you can also be left with a sizable amount that can be drawn on in retirement.
Lie number three:
If you are smart with the money you have today and you get rid of your mortgage, car loans and credit card debt and put money into retirement plans you don't need insurance 30 years from now to protect your family when you die.
Fact: You might need insurance to protect your children from a big tax burden. Even if you are "smart" with your money, you can't predict the future with absolute certainty. Some people alive today are experiencing a 40% loss in their retirement accounts 5 years before retirement. This is money that was supposed to be there for them and it isn't. If your investments take a hit right before YOU are ready to retire, it doesn't matter how "smart" you were with your money.
Is life insurance is necessary as you get older? You will be shocked at the costs of even a modest funeral these days. What does the average funeral cost in your home town? Ask a funeral director. What is the inflation effect in the funeral industry. If it costs $12,000 today, what will it cost in 10 years? 20 years? 30 years? Ask any beneficiary who has been left any amount of money what they paid in taxes and if it was financially disruptive to them personally.
Your financial guru told you cash value insurance was evil, but it could have really helped out of a jam when the tax man cometh. You could also bypassing probate, providing an income tax free death benefit and, inside of a life insurance trust, completely avoid the estate tax.
Although many so-called experts try to compare life insurance to an investment, don't be fooled. Yes, life insurance, if properly structured, can build very strong cash values that rival investment products (my guess as to why the investment folks are upset). They try to tell you what a lousy investment cash value life insurance is. But comparing this type of insurance to investing is nonsensical. It's like asking "how many walkmans does it take to equal an Ipod?"...cash value insurance serves a different purpose from an investment. Each has their own different objectives.
Before you make a final decision on whether to buy term or cash value life insurance, consider what you are really looking for. If you are looking for an investment, then be prepared to look for stocks, bonds, no load mutual funds, options, and other various financial derivatives (and learn how to research them). If you're looking for a long-term savings tool, then cash value life insurance can fit that need very well.
However, financial professionals often disagree about how much and what type of insurance one should carry. The perception is that term insurance is always the easiest and most cost effective. To this end, many advisers and financial "gurus" like Suze Orman and Dave Ramsey often suggest that their audience forget about cash value insurance and instead focus on good-sounding investments. In short...they hate whole life insurance.
Life insurance agents of course love cash value insurance. The investment industry does a pretty good job of putting down the insurance industry. So...who's right?
It is sometimes surprising that the financial industry is charged with the responsibility of informing and educating the rest of society about saving and investing principles, and yet many of the advisors that represent the industry seem to be less concerned about truth and honesty, and more concerned about injecting their own personal agenda.
On both sides of the debate, neither is doing a very good job of defending their respective position. It amazes me to see so many financial professionals leave out important information about not only their products but about the nature of insurance contracts. I wonder sometimes if they even have any idea of how life insurance really works.
The motivation for lying can be as simple as "money". There is a lot of money floating around in the financial industry, and everyone is competing for it. So, while isn't anything wrong with demonstrating flaws in a financial product, it has to be done objectively. In regards to life insurance, it's not. The attacks are baseless and unsound, and most, if not all, of them are coming from very well known financial professionals. Here are a few of the misconceptions being passed around. Many of them have been repeated so many times, that most people think they are true (they aren't):
Lie number one:
Cash value life insurance is one of the worst financial products available, and it is definitely the worst type of insurance you can buy to insure your life. The BEST kind of insurance is term insurance because it's cheap and I'm not paying all those extra fees to the evil and greedy insurance company. Besides, don't insurance companies have a record of being reckless, cheating their policyholders, and systematically going out of business.
Fact: About 1% of all term policies pay a claim. So, your family has (roughly) a 1% chance that they will benefit from that term policy. Term insurance is cheap - IF you are only considering the cost per thousand dollars of insurance. It is guaranteed to get more expensive as time goes on (and you will see this if your policy gets repriced). Life insurance companies are not dumb. They know they can collect premiums from term life and make a killing because the turnover rate is high (people drop their policies before the term is up) or the policy owner simply doesn't die before the term is up. Life insurance companies are in the business to make money and provide a product. You have to understand how they position their products and how they make money.
Insurance uses something called the Law of Large Numbers. Basically this is how it works: the larger the group of people you are insuring, the more certain you can be about the number of losses you will sustain.
Let's suppose you were to start an insurance company and you only had one customer - let's call him "Jim". You would be taking on an incredible risk by insuring just Jim. If Jim kicks the bucket, then you're on the hook for a lot of money that you may not have. You would be business very quickly (imagine: Jim gives you $20 for a $500,000 death benefit and then they die the very next day...where do you come up with $500K for Jim's family?). However, if you have thousands of customers just like Jim, then you have the unique ability to better control the risk you take by insuring Jim's life. No one can predict when Jim will die, but if you study a large enough group of people just like Jim, then you can begin to make very, very accurate predictions about the number of people just like Jim that will die in any given year. Given the accuracy of insurance companies in predicting deaths every year, what do their statistics tell us?
They say that that term insurance doesn't pay, since most individuals live until age 65. This is why I say permanent is a better deal. In the long-run, it's cheaper. I know, I know...there are probably a few of you saying "no way, it is always cheaper to buy term insurance". Oh yeah? Watch this:
A male (let's use Jim again), age 25 and in good health with a wife and a child finds that he needs life insurance. Jim is looking for $250,000 in coverage. A typical 30-year term policy - a policy that has level premium payments for 30 years - should cost Jim around $370 per year until he reaches age fifty-five. At that point, the premiums jump up significantly (as all term insurance premiums do) to a tad over $4,700 per year.
By the time he is 65, he will have spent $58,780 on premiums. Keep in mind that the insurance company collected this money but never has to give it back. There's no cash value in term insurance, so the contract only pays when he dies.
What would have happened if he had, say, purchased the same amount of death benefit but used a universal life insurance policy with slightly higher but level annual premiums of $1739 every year to age 100? By his 65th birthday, 'ole Jimbo would have had a total premium outlay of $69,560 ($1739 x 40). But, he would have built up $157,000 of cash value inside the policy.
This money is part of the policy's living benefits, and can be used on a tax-free basis to supplement his retirement or left alone to continue growing. Some life insurance companies also offer an option to spend down up to 100% of the death benefit if you become chronically or terminally ill. If you haven't been able to accumulate a lot of money, this can be very helpful.
Lie number two:
Cash value life insurance is overpriced for what you get. You never know how much money you are spending on the death benefit, how much money is actually going into the cash value of the policy, and how much interest you are really earning. Term insurance is so much simpler.
Fact: Whole life insurance carries a stigma in that it is often difficult to determine how much the death benefit is costing you. However, universal life insurance is, in actuality, a term policy with a separate savings account - often called 'the pot of money'. The costs are broken down and the policy is very transparent. Cash value insurance can seem expensive in comparison to term insurance because of the front loaded nature of the contract and the fact that you are forced to save money in a cash account. Sadly, the fees charged by the insurance company are being stressed (I guess they don't know that all financial products carry similar fees).
Be thankful that you pay some of the fees that you do. It makes saving and investing money a lot easier than having to fire a lawyer to negotiate every individual contract you sign. A life insurance contract can be set up to maximize the death benefit (maximizing the cost of the contract), or it can be set up to focus on cash accumulation (minimizing expense charges to .5% - 1% of the interest earned over the life of the policy). The expenses associated with a permanent life insurance contract can be made just as efficient and in some cases more so than what the antagonists suggest as an alternative - which is usually some type of mutual fund - without sacrificing the practicality of owning the contract. But again, why are the antagonists trying to compare the cost of insurance to an investment?
Over the long-term, you should get all of your money back that you put into a cash value policy with interest (note: the exception to this is variable life insurance which doesn't guarantee cash values). If the policy is structured properly, you can also be left with a sizable amount that can be drawn on in retirement.
Lie number three:
If you are smart with the money you have today and you get rid of your mortgage, car loans and credit card debt and put money into retirement plans you don't need insurance 30 years from now to protect your family when you die.
Fact: You might need insurance to protect your children from a big tax burden. Even if you are "smart" with your money, you can't predict the future with absolute certainty. Some people alive today are experiencing a 40% loss in their retirement accounts 5 years before retirement. This is money that was supposed to be there for them and it isn't. If your investments take a hit right before YOU are ready to retire, it doesn't matter how "smart" you were with your money.
Is life insurance is necessary as you get older? You will be shocked at the costs of even a modest funeral these days. What does the average funeral cost in your home town? Ask a funeral director. What is the inflation effect in the funeral industry. If it costs $12,000 today, what will it cost in 10 years? 20 years? 30 years? Ask any beneficiary who has been left any amount of money what they paid in taxes and if it was financially disruptive to them personally.
Your financial guru told you cash value insurance was evil, but it could have really helped out of a jam when the tax man cometh. You could also bypassing probate, providing an income tax free death benefit and, inside of a life insurance trust, completely avoid the estate tax.
Although many so-called experts try to compare life insurance to an investment, don't be fooled. Yes, life insurance, if properly structured, can build very strong cash values that rival investment products (my guess as to why the investment folks are upset). They try to tell you what a lousy investment cash value life insurance is. But comparing this type of insurance to investing is nonsensical. It's like asking "how many walkmans does it take to equal an Ipod?"...cash value insurance serves a different purpose from an investment. Each has their own different objectives.
Before you make a final decision on whether to buy term or cash value life insurance, consider what you are really looking for. If you are looking for an investment, then be prepared to look for stocks, bonds, no load mutual funds, options, and other various financial derivatives (and learn how to research them). If you're looking for a long-term savings tool, then cash value life insurance can fit that need very well.
About the Author:
Only so much information can be covered in one article. If you want more information about any aspect of personal financial planning, please visit David's website.
posted by Credit Counseling at
9:14 AM
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