Did Your Life Insurance Policy Kill Your Financial Plan?
Is permanent life insurance (also known as whole life insurance) the protection you need? Many of us have heard the sales pitch, “You’re young, if you buy life insurance now it is cheap. If you wait, it is expensive. You can take withdrawals tax-free and the policy pays you dividends.” Sound familiar? Oh, and don’t get me started on the financial advisors that try to sell you life insurance on your children. Please do not give these insurance agents or financial advisors (it pains me to call them advisors) another minute of your time.
There may be a case for permanent life insurance in some situations. For the majority of those seeking life insurance, term insurance may be a more suitable solution.
*This article does not go into the need for life insurance for business owners, estate planning purposes, and other unique planning needs.
Why do you need life insurance?
For most families, it is to protect them in the event that one of the family members passes away. Do you need life insurance? You do not need to be a financial expert to answer that question. Just ask yourself, “If I passed away, would my family be OK?” What about your spouse? Easy - would your family be provided for if they passed away? If the answer to those questions were “Yes - we would be fine,” then you probably do not need life insurance. If the answer was “No,” then we have to determine the amount of insurance needed to make that answer a “Yes.”
Every person has two forms of capital. Their human capital and their financial capital. Your human capital is your potential earnings over the rest of your life. Your financial capital is the assets you have accumulated by saving and investing. When your human capital (or potential future earnings) is more than your financial capital (what you already have saved), there is a good chance that you need life insurance. As your human capital diminishes, the need for life insurance also goes away. When your human capital is gone, would your family face financial problems if you were to pass away? The loss would be difficult for them emotionally. But financially, they would probably be alright.
When you are young and accumulating assets, you have a large amount of human capital. Here, your family would most likely face hardship if a primary income source was taken away. Once you have accumulated a significant amount of financial assets, your family should be provided for in the event of a premature death.
Put simply - the need for life insurance is high when you are in the early stages of your career and the need usually goes away as you move closer to retirement. For this reason, we use life insurance as a “Band-Aid” to protect our clients during these years of their life. Since the protection is only needed during the years where there is a low risk of death, the protection is quite affordable, and our clients can invest the additional savings for their retirement.
Let’s look at an example:
Kathy and Mike Smith are both 22 years old. They just started their career, so they do not have any financial assets. They each have a salary of $50,000. They both have a 401(k) where they contribute 6% of their salary. Their employer matches the first 3% dollar-for-dollar and 50 cents on the dollar for the next 3% (a total of 4.5%). They both plan on retiring at the age of 65 and they have living expenses of $6,000 per month.
Kathy and Mike have a large amount of human capital as they begin their career. One risk to the financial plan is that they have no financial assets. If they have children that depend on them for financial support, they should purchase life insurance. A rule of thumb is to have about ten times your salary in life insurance. In this example, $500,000 for Kathy and another $500,000 for Mike is a good place to start. Should they buy whole life (or permanent) policies or should they buy term life (or temporary) policies. The cost for $500,000 of life insurance in this example is $4,500 per year for a whole life policy and $200 per year for a 20-year term life policy (after the 20 years, the coverage would go away).
First, it is important that this coverage is enough to protect the Smiths in the event Kathy or Mike pass away prematurely. Below, is a chart showing the Smith’s financial capital over time if they were to buy a 20-year term life policy. Their financial capital continues to grow as Kathy and Mike save for their retirement. Knowing that Kathy and Mike each have $500,000 of coverage, this amount would be added to their financial capital if either one of them were to pass away (or $1,000,000 if both passed away). For example, at the age of 30, they have $169,314 of financial capital. If Kathy or Mike passed away, they would have a total of $669,314 ($169,314 plus the $500,000 of life insurance) or $1,169,314 if both passed to support their family. The life insurance protection would go away after 20 years (age 42) but Kathy and Mike have accumulated $921,140 in savings. If they passed away, their children would have $942,140 to live on. If this is enough to support them, they do not need any life insurance.
Kathy and Mike Smith’s Financial Capital (Term Life)
Below, you will see additional graphs of Kathy and Mike’s financial capital if they were to pass away this year. Again, the level of assets (financial capital) are sufficient throughout the plan to take care of their family.
But what if I want permanent life insurance?
Below, is the same example, only this time Kathy and Mike decide to purchase a whole life policy. As you can see, the additional cost of the whole life policy hinders their ability to accumulate assets for retirement. At the age of 40, they have only accumulated $519,608 instead of $726,390 with the term policy. Furthermore, at the end of the financial plan, they have $7,718,482 instead of $8,831,734 with the term policy. A difference of $1,113,252! An expensive mistake if you listened to the insurance salesperson that told you whole life was the suitable choice for you.
Kathy and Mike Smith’s Financial Capital (Whole Life)
Below, you will see additional graphs of Kathy and Mike’s financial capital if they were to pass away this year. With whole life insurance, the protection is the same for the first twenty years, but the additional cost of the protection causes the financial plan to run out of money at the age of 85.
Insurance salespeople may also state that you can withdraw your cash value or take a loan tax-free. Yes, that sounds nice until you take a step back and remember that you are only taking out your after-tax contributions to the policy - of course it is tax-free! What about the dividends the contracts pay you? Again, sounds good but it loses its appeal once you dig under the surface. Many dividends from whole life policies occur because the policy holder (i.e. you) is overpaying for the coverage they receive and the insurance company is refunding the excess payment to you in the form of a dividend. To the IRS, this is considered a tax-free return of premium. If you paid $105 for something worth $100 and then subsequently received five dollars tax-free from the seller for your over payment, did you get a good deal?
But if term life policies make more sense, why don’t more advisors and insurance agents recommend using term policies?
Unfortunately, the commissions earned on whole life policies are significantly more. In fact, the commissions on term life policies are sometimes not worth the time for many agents. At Noble Wealth Partners, we are a fee-only practice which means we don’t earn commissions on any products we recommend. For this reason, it is easy for us to say, term life policies are most likely in your best interest.
There are many other reasons why we do not like whole life insurance, but I would like to keep this article at a reasonable length. Please call us at (720)588-4103 if you have additional questions about life insurance policies or annuities that have been recommended to you. We are happy to help you and provide our thoughts.
To a long life and a successful retirement,
Grant Glenn, CFA, CFP®