Top 10 Life Insurance Myths
By Mark P. Cussen, CFP®, CMFC, AFC on August 21, 2012
Life insurance is not a simple product. Even term life policies have many elements that must be considered carefully in order to arrive at the proper type and amount of coverage. But the technical aspects of life insurance are far less difficult for most people to deal with than trying to get a handle on how much coverage they need and why. This article will briefly examine the top 10 misconceptions surrounding life insurance and the realities that they distort.
Myth #1: I'm Single and Don't Have Dependents, so I Don't Need Coverage
Even single persons need at least enough life insurance to cover the costs of personal debts, medical and funeral bills. If you are uninsured, you may leave a legacy of unpaid expenses for your family or executor to deal with. Plus, this can be a good way for low-income singles to leave a legacy to a favorite charity or other cause.
Myth #2: My Life Insurance Coverage Needs Only Be Twice My Annual Salary
The amount of life insurance each person needs depends on each person's specific situation. There are many factors to consider. In addition to medical and funeral bills, you may need to pay off debts such as your mortgage and provide for your family for several years. A cash flow analysis is usually necessary in order to determine the true amount of insurance that must be purchased - the days of computing life coverage based only on one's income-earning ability are long gone.
Myth #3: My Term Life Insurance Coverage at Work Is Sufficient
Maybe, maybe not. For a single person of modest means, employer-paid or provided term coverage may actually be enough. But if you have a spouse or other dependents, or know that you will need coverage upon your death to pay estate taxes, then additional coverage may be necessary if the term policy does not meet the needs of the policyholder.
Myth #4: The Cost of My Premiums Will Be Deductible
Afraid not, at least in most cases. The cost of personal life insurance is never deductible unless the policyholder is self-employed and the coverage is used as asset protection for the business owner. Then the premiums are deductible on the Schedule C of the Form 1040.
Myth #5: I Absolutely MUST Have Life Insurance at Any Cost
In many cases, this is probably true. However, people with sizable assets and no debt or dependents may be better off self-insuring. If you have medical and funeral costs covered, then life insurance coverage may be optional.
Myth #6: I Should ALWAYS Buy Term and Invest the Difference
Not necessarily. There are distinct differences between term and permanent life insurance, and the cost of term life coverage can become prohibitively high in later years. Therefore, those who know for certain that they must be covered at death should consider permanent coverage. The total premium outlay for a more expensive permanent policy may be less than the ongoing premiums that could last for years longer with a less expensive term policy.
There is also the risk of non-insurability to consider, which could be disastrous for those who may have estate tax issues and need life insurance to pay them. But this risk can be avoided with permanent coverage, which becomes paid up after a certain amount of premium has been paid and then remains in force until death.
Myth #7: Variable Universal Life Policies Are Always Superior to Straight Universal Life Policies Over the Long Run
Many universal policies pay competitive interest rates, and variable universal life (VUL) policies contain several layers of fees relating to both the insurance and securities elements present in the policy. Therefore, if the variable subaccounts within the policy do not perform well, then the variable policyholder may well see a lower cash value than someone with a straight universal life policy. Poor market performance can even generate substantial cash calls inside variable policies that require additional premiums to be paid in order to keep the policy in force.
Myth #8: Only Breadwinners Need Life Insurance Coverage
Nonsense. The cost of replacing the services formerly provided by a deceased homemaker can be higher than you think, and insuring against the loss of a homemakermay make more sense than one might think, especially when it comes to cleaning and daycare costs.
Myth #9: I Should Always Purchase the Return-of-Premium (ROP) Rider on Any Term Policy
There are usually different levels of ROP riders available for policies that offer this feature. Many financial planners will tell you that this rider is not cost-effective and should be avoided. Whether you include this rider will depend on your risk tolerance and other possible investment objectives. A cash flow analysis will reveal whether you could come out ahead by investing the additional amount of the rider elsewhere versus including it in the policy.
Myth #10: I'm Better off Investing My Money Than Buying Life Insurance of Any Kind
Hogwash. Until you reach the breakeven point of asset accumulation, you need life coverage of some sort (barring the exception discussed in Myth No.5.) Once you amass $1 million of liquid assets, you can consider whether to discontinue (or at least reduce) your million-dollar policy. But you take a big chance when you depend solely on your investments in the early years of your life, especially if you have dependents. If you die without coverage for them, there may be no other means of provision after the depletion of your current assets.
The Bottom Line
These are just some of the more prevalent misunderstandings concerning life insurance that the public faces today. Therefore, there are many life insurance questions you should ask yourself. The key concept to understand is that you shouldn't leave life insurance out of your budget unless you have enough assets to cover expenses after you're gone. For more information, consult your life insurance agent or financial advisor.
by Mark P. Cussen, CFP®, CMFC, AFC, has 20 years of experience in the financial industry, which includes working with investments, insurance, mortgages, taxes and financial planning. He has several years of experience as a financial author and has written numerous educational articles for various financial websites. He has also worked in retail, discount and bank brokerage systems and is currently working as a financial planner for the U.S. military. Mark has a Bachelor of Science in English from the University of Kansas and completed his CFP coursework at the Bloch School of Business at the University of Missouri-Kansas City in August of 2001.
THE EXAMINER • | MAY 25, 2011 AT 7:05 PM
For anyone weary of writing checks to pay for life insurance, retirement used to spell relief. With the mortgage paid, the kids on their own, and Medicare and Social Security on the way, common sense suggested you could safely let your insurance expire. But if you're like many fifty- and sixtysomethings today, you don't have the flexibility to shorten the life of your life insurance.
You could buy another term policy if you're healthy, but that coverage could still end before your needs disappear. If you want your insurance to last for the rest of your life -- no matter how long you live -- then signing up for a "permanent," cash-value insurance policy may make sense. In return, you get tax advantages and savings guarantees -- plus a death benefit that never expires.
Permanent life insurance has a couple of strong suits. The first is safety: With the exception of AIG, life insurers survived the credit crisis and the recession in excellent financial condition. The second is falling costs: Competition and longer life expectancies are driving the cost of all life insurance policies down, including for people age 50 and older.
Permanent life insurance also appeals to risk-averse people who don't have time to recover investment losses in the event of another financial crash. A limited-payment policy -- you pay higher premiums for fewer years -- is an option that is becoming popular among pre-retirees who want to time the end of their premium obligations with a retirement date. A 10-year payment plan between age 50 and 60 costs perhaps twice as much per year as regular premiums you would pay over your lifetime. But by putting more into the pot early, your cash value also compounds quicker.
Cash-value life insurance can also be a good portfolio diversifier. That's because a whole life policy is unconnected to the securities markets. You can think of it as the cash or bond allocation in your overall investment mix that allows you to be more aggressive with stocks, commodities or real estate in your IRA, 401(k), or taxable brokerage accounts.
Cash-value insurance is also an alternative to a home-equity line of credit or other sources of borrowed money. A policy loan is instant credit. You can borrow up to your total premiums paid, with no questions asked, by sending a fax or calling the insurance company and requesting a check or wire transfer. Nobody runs a credit check or ties the interest rate to your credit score. And you don't have to repay the money on any schedule.
By Michael Markey - http://www.producersweb.com/r/pwebmc/d/printFocus/?pcID=71e4d0f0e4268217168737eff1c91c89
It’s absolutely, unequivocally, undeniably, inexplicably clear Dave Ramsey does NOT believe in permanent insurance. He believes there’s no need for life insurance when you have no mortgage, no debts, and have saved hundreds of thousands of dollars earning 12 percent “average” annual returns. (another Dave Ramsey myth, debunked many times)
Dave tells his followers to be intentional with their money. Is it possible Dave is intentional with his wordings? Is it possible Dave himself would’ve been better off owning permanent insurance rather than term? Is it possible Dave is wrong about 12 percent annual returns (which is another primary reason he advises term)? Is it possible there’s a perpetual need for permanent insurance for some people, and that permanent insurance provides increased liquidity and spending capability in retirement?
The math proves yes.
A while back I stumbled upon an episode of Dave’s TV show in which he read an email from a listener named Tyler that posed the following question: How can you advise term insurance when it expires just when people need it the most? In response, Dave tried to insult Tyler, saying he sounded like a true life insurance salesman. Dave goes on to explain that he recommends term because when it expires his followers will have no debt, no house payment and hundreds of thousands in savings.
As the rant continues, Dave accidentally reveals one reason why permanent insurance can be better. It’s not about the level premiums or the internal rates of return or estate taxes or income replacement as my compadres (as one reader referred to us last month) have vehemently argued in the past. It’s about security. Insurance equals security, and the security of death benefit proceeds doesn’t completely or necessarily evaporate with the elimination of debt and/or creation of wealth.
Dave has said, and I quote: “I’m 47 years old and still carry a few million in term insurance because SWI.” He gets this southern boy grin and explains, “SWI is because Sharon wants it.” (Sharon is Dave’s wife.) He goes on to say that it’s more important to have the coverage than it is to put something new on her finger.
Now, this is where we get to have some fun. Let’s look at the math between permanent and term for a hypothetical 40-year-old. We need a name for our mystery man. Let’s call him Dave, shall we? We’ll compare Dave buying a 20-year term policy at ages 40 and 60 versus buying a guaranteed universal life policy (GUL) at age 40. With the term scenario, we’ll assume he invests the saved premium into the market. We’ll break down the comparison with the following gross rates of return rate: 6, 8, 10, and 12. We’ll factor 1 percent for annual expenses and front end sales charges of 5.75 percent. Lastly, we’ll review if being half wrong on the rate of return equals out to half the value. (Your guess is as good as mine, unless of course you’re guessing yes … then your guess is half as good as mine.)
I ran the rates through a life insurance quote engine and took the median price for each age bracket, assuming the best underwriting health class. Keep in mind that I’m giving a huge advantage to term here, since it’s more likely for a 40-year-old to qualify for best class underwriting and less likely for a 60-year-old, which is the attained age for the second term scenario.
Using today’s rates, our 40-year-old Dave can get a $2M-death-benefit, 20-year term policy for around $1,345 per year. The 60-year-old Dave could purchase the same policy for $9,830. In comparison, our 40-year-old Dave could purchase a GUL for $10,170.
This means the 40-year-old term-buyer can invest $8,317 after sales charges into four different Class A “good growth” mutual funds. (Remember I’m only referring to our hypothetical Dave, not the real Dave. Use the math as illustrative and inspiration to do the math. Side note: One thing the real Dave and I agree on: Being intentional with our wordings is impactful.)
The 60-year-old Dave only has about $320 of saved premiums to invest per year.
I’ve also assumed that once every 10 years we’ll want to completely rebalance the gains in the portfolio. This would create capital gains and additional sales charges. In other words, we have a portfolio turnover rate of once every 20–30 years, since we’re only rebalancing or reallocating the gains.
Here’s how the chart looks for each at 10, 20, 30 and 40 years.
Dave yells at financial people like myself for hurting people with our “theories” and lack of real world experience helping people. He jokes about how we grab for our HP calculators. Well, my HP calculator proves his math wrong. Even at a gross 10 percent compounded annual growth rate (CAGR) you have nearly $600k less than the death benefit of the life insurance in 40 years.
Who wants 10 percent when they can get 12 percent? The 12 percent Dave uses is an average rate, not a CAGR (see Stoffel vs Ramsey). Ten percent CAGR for the S&P 500 is more mathematically valid than 12 percent. Remember that stock price reflects growth, which is partly a byproduct of inflation. The currently higher CAGR includes higher inflationary periods, which, during lower inflationary periods like we’re in now, equates to lower CAGR. Hence, the long term 12 percent math is flawed. Warren Buffett expects CAGR to be closer to 7 percent due to the lower inflationary period we’re currently in.
First, the majority of the savings between term and GUL is during the first 20 years, not the second. Thus, a lower CAGR during this period would greatly reduce the outcome.
Second, the death benefit of the life insurance is guaranteed. It’s not hypothetical. It’s a risk-free $2M benefit (oh, and tax-free,too … the numbers above don’t account for any estate taxes). Now, what would the risk adjusted return of the S&P 500 be? I’ve seen that number to be less than 5 percent. In fact, one of our readers who is an actuarial statistician wrote to me personally and showed how he got 4.91 percent. (Thank you, Anthony!)
Side note: Ever wonder why at 12 percent returns anyone would pay off a mortgage? One reader last month sent in an audio clip where a millionaire asked why he should pay off his 4 percent fixed interest rate mortgage. In summation, Dave said the 12 percent has risk and being debt free changes your mindset. (Thanks for the clip, William!) Shouldn’t this be the same argument with permanent life insurance? The death benefit is guaranteed, whereas the discipline to save the additional premiums, the rate of growth and the number of years to grow are not guaranteed. Hence, the additional risk outweighs the possible additional benefit.
Those who practice personal finance and make plans for an individual’s specific situation are held accountable to the mathematical results. We use calculators to examine the results. In the Total Money Makeover, on TV, and on the radio, Dave often proclaims that even if he’s half wrong, he has still helped his followers. Just like term insurance isn’t better 100 percent of the time, this conclusion isn’t 100 percent correct. It’s nowhere close, in fact. If the math is half wrong, if 12 percent gross is actually 6 percent gross — which is 5 percent net after the 1 percent fee — then the person who followed this advice would’ve bought term, invested the difference, and been left with $1.4M LESS than the $2M death benefit in 40 YEARS.
Let that sink in for a minute.
The real Dave Ramsey owned term insurance at age 47, and showed no regrets about owning it, nor any indication his term insurance ownership years were coming to an end. If the real Dave had bought permanent insurance at age 40 right now, he would be better off at age 54. He would be better off through his early 80s, even at a 10 percent gross rate of return. He would be better off not because of the internal rates of return, but because of his family’s desire for security. See, we make the mistake of believing that at $1M of liquid savings we’ll be secure. When $1M is your new normal, then $1M is where you feel secure. Then it’s $2M, then it’s $4M, and so on. Once you have what you’ve got, you don’t feel comfortable going backwards. Losing your spouse financially means the reduction of income, whether by the elimination of wages, pensions, or Social Security. Life insurance provides security against this.
Now some of you may argue the GUL premiums don’t cease at age 80, whereas if we see a 10 percent gross CAGR then the saved insurance premiums plus interest have matched the desired security blanket somewhere past age 80. You’re right; you pay the GUL premiums until you pass. This may be prior to reaching 80, or it may be later. But I think this was a fair comparison. If you want to squibble about it, then let’s squibble over the rate of return, as well. Anyway, to prevent future squibbling I ran a 10 pay GUL policy starting at age 40 and paid up at 50. (And don’t yell at me about “squibble” not being a word. It’s not. I made it up. I took a page out of Mr. Ramsey’s book: see investing advisor.)
We accounted for the cost of term insurance during the different age bands based on the rates assumed earlier. The first table below shows term insurance ending at age 60; the second shows it ending at age 80.
Term ending at age 60
Term ending at age 80
Again, the glaring point here is that being half wrong on the rate of return doesn’t equate to the outcome being half as much! This is why we use calculators and not blank statements or simplistic math that isn’t valid. (Thanks, HP calculator.) Furthermore, if you argue the first chart is more accurate since if you save the money you’ll no longer “need” the insurance, remember the mathematical need is not the same as the behavioral reality to maintain the additional security. Lastly, the ending amounts do not account for estate taxes, which certainly do change from time to time and would make the tax-free benefit of life insurance more attractive.
I noted earlier that life insurance can be used to create an estate. It doesn’t sound like a radical assertion, I know, but it goes against what Dave says.
On July 14th, 2014 a reader asked Dave if his 71-year-old mother should continue a universal life insurance policy she purchased to leave an estate, or if there was a better investment alternative. Dave answered this: “…You don’t use life insurance to leave an estate. It’s a bad idea. You leave an estate by saving and investing. The only people who will tell you to use a life insurance policy to leave an estate are life insurance salesmen.”
Wrong! Just plain wrong. Many individuals benefit from using life insurance in an estate. Let’s call our 71-year-old woman Betty. Like many of her generation, Betty has plenty of income from Social Security and pensions, but has relatively lower invested assets. At this point she’d like to make sure she leaves an estate. How would this be a bad thing? Earlier I mentioned the show where a caller asked why he should pay off his mortgage, since earning 12 percent growth is much better than 4 percent paid in interest. Dave replied that if your house was paid off and you were told to take out a mortgage and invest the proceeds, you’d think that was nuts. What he meant was that the security of having one’s house paid is greater than the potential additional interest made through leveraging. As our examples illustrated, the security of a known amount is better than the potential interest made through leveraging one’s need or desire for death benefit proceeds with volatile 100 percent stock investments made over the course of many years.
Here’s a shortened version of Dave’s response to Betty’s investment dilemma: “It would probably take about 13 years for the money to turn into $250,000. Assuming she’s healthy, I’d rather do that and bet on her living. That way, she can leave an estate and avoid the expense and rip-off part of the universal life policy.”
Interestingly enough, my HP calculator found that Dave’s right: It would only take 13.75 years to accumulate $250,000 if I input a 12 percent CAGR. But Dave has stated he understands the difference between compounded and average. He has also stated that he uses the 12 percent “average” rate to inspire and illustrate the power of compounding interest (once again see Stofell vs Ramsey). Yet when we do the math here, he’s using his standard go-to number of 12 percent, but in CAGR function not averaging. (There are plenty of examples online which will show how the math differs. Just use Google.)
Here’s the problem. First, when you use different growth methods at different times and don’t differentiate, it becomes very hard for people to know what you mean. Second, the average life expectancy for a 71-year-old female is 15 years (15.6 years, to be precise). So, what if Dave is half wrong? What if she earns only 6 percent before fees? Then it takes a bit over 20 years. If we account for the same tax and rebalancing as earlier, then it’s nearly 24 years. Furthermore, this assumption puts a portfolio which exceeds the average risk tolerance for most 71-year-old individuals. Therefore, even if the math is correct, it’s improbable that our Betty will maintain this course during adverse periods.
Think of it this way: When Betty first starts putting money away, she can be riskier with these funds. As the balance accumulates and her life expectancy decreases, it’s reasonable to conclude she’d want to scale back on risk. It is one thing to experience a downturn after year three or four, when there’s only twenty to thirty thousand dollars at stake, but when the number is bigger — say a hundred thousand or so — then a sizable downturn has a greater impact, especially when you consider her life expectancy has decreased. Will she live long enough for the benefit to come back? Will she continue to save and invest during this period?
Lastly, let’s look at income replacement. Let’s talk Social Security for a moment. A few years ago we started to notice a trend. I noticed that married spouses rarely pass away in the same year. Mind-blowing information there, I know! When the first spouse passes, the surviving spouse (assuming they don’t remarry) is taxed as a single individual the following calendar year. The surviving spouse also loses the smaller of the two Social Security benefits and possibly some pension income, but let’s ignore that.
Here’s an example: Let’s say that Bob and Mary get $3,000 per month from Social Security combined. Bob gets $1,800 and Mary gets $1,200.They take out $1500 per month from their IRAs to supplement their income. They have no debts. They just like to live life, travel some, and help out the kids or grandkids where they can. In short, they’re a normal couple. Approximately $500 of their Social Security benefits are taxed. No big deal. Their adjusted gross income is $18,500 and standard deductions should wipe out all of their federal income tax liability.
Bob dies. And here’s the trend we’ve noticed. Spending doesn’t drastically change. Mary still wants to do the things she did while they were together. She still wants to give or help out the kids, do a little traveling, and live life. There are a few bills that are eliminated from Bob’s death, say a Medicare Part B premium, a car insurance, a supplemental insurance, and a cell phone bill. But overall, two do not spend much more than one. After Bob’s death, bottom line expenses change by less than $500 per month. Mary’s new Social Security benefit is only $1,800, and her monthly income need has gone from $4,500 down to $4,000.
What to do? We’ve noticed many who were taking $2,200 from the IRAs continue to do what they were doing before. The $2,200 per month distribution was $700 per month more than before, or $9,400 more annually. At the end of the year, Mary would owe a little more than $4,500 of tax she didn’t owe before. This wasn’t to increase her lifestyle; it was just to maintain it. If we deducted this as a monthly amount, she’d be short about $400 per month. If she wanted to make that up, she’d have to increase her withdrawals by another $5,500 per year. So, while as a married couple Mary and Bob were fine, as a surviving spouse, Mary must increase her distributions by about $14,000 per year. Not to mention, without any life insurance, their estate saw a negative cash flow of about $30k for burial and income for the 12 months +/- depending on funeral costs and depending on the month Bob passed. In this example, $20k-50k of permanent insurance would be beneficial to some and unnecessary for others depending on the other details regarding their personal situation.
I noted earlier that permanent life insurance can increase the spending capacity for retirees. I’ll give you a simple scenario. I met a woman whose husband had passed. He left her with $400,000. Together they had a goal of leaving $50,000 to each of their five children. To accomplish this goal without life insurance, she would need to purchase standalone LTCI insurance to protect against future healthcare costs, and could only base spending on the $150,000 of net assets. She would need to continue to work to make sure this would happen. The solution offered by life insurance is much more attractive: All she needed to do was purchase permanent life insurance. Make it a single pay and then make an irrevocable life insurance trust the owner. This eliminates the need for LTCI insurance, frees up more cash flow and leaves her with over $300,000 to spend as she sees fit, while still accomplishing their goal of leaving $50,000 to each child. The freed-up premiums would have increased her cash flow and therefore freed income to spend by nearly $400 per month, and now she had two times the amount of assets to draw an income from. Permanent insurance can increase one’s spending capacity if used in the correct form for the correct situation.
Dave Ramsey is an intelligent person. He understands the difference between compounded annualized growth rates and annual averages, but chooses to ignore the mathematical impact since the wonder of compounding interest will “inspire” people to invest. He asserts that we math nerds fight over a few percentage points which are irrelevant as long as he gets people to invest. He says there’s no need for permanent insurance, that it’s garbage and a rip-off. He uses the example of a 32-year-old buying a 20-year term policy who follows the Ramsey system to illustrate why permanent life insurance is not needed. Yet poor unknowing Dave proves his very own point wrong by sharing with us that, at 47 years old, with no personal or corporate debt, no mortgage, ample savings, and ample income, he still maintains coverage past the point where his plan says it’s needed.
I’m not making this up. I’m just stating the facts. The fact is term insurance exists for a reason. It’s good and appropriate for people given particular objectives, needs and desires. The fact is permanent insurance exists for a reason. It’s good and appropriate for people given particular objectives, needs and desires.
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