Ok, let’s go.
Savings And Insurance: These Are Your Two Basic Options
Most people believe that there are a million different ways to save money and plan for your future.
That’s not true. You really only have 2 choices (that matter):
- You can go it alone or;
- You can insure your future.
“Going it alone” means you don’t buy life insurance to insure your future savings.
You try to “outdo” the insurance industry, in essence, by saving money on your own without any help or safety net.
If you die before you’ve saved up enough money for retirement, your family gets what they get – whatever savings you’ve managed to scrounge together.
Single people tend not to worry too much about insurance (even though they should if they’re planning on getting married and having a family someday).
Most people insure their future savings by buying life insurance. What this means is that a life insurance company pays a death benefit if you aren’t able to save up enough money before you die.
This death benefit is normally enough to make up any difference between what you’ve managed to save and what your family still needs to be financially secure.
That’s peace of mind.
But, even if you decide to insure your savings (which is a very good idea), there are several ways to go about doing it.
You can buy permanent life insurance (which combines elements of insurance and savings into one contract), you can buy term insurance (which is pure death benefit protection) and use some other financial product to help you accumulate savings (e.g. mutual funds inside a 401(k)), or you can buy permanent insurance and also buy other financial products, like stocks, mutual funds, real estate or anything else you think would make you money.
Let’s start with the basics: permanent life insurance. Specifically, whole life insurance:
With whole life insurance, you pay a premium, which is sort of like a monthly bill or payment.
In return, you get a death benefit and a cash value (which functions as a savings you can tap into while you’re alive, and for any reason).
As long as you keep paying premiums, you keep getting the death benefit and the cash value keeps growing.
As the cash value increases, the amount of pure insurance you purchase decreases.
…and think of pure insurance as insurance that’s not directly covered by savings. It’s a liability that the insurer has to manage (i.e. the business of insurance). If you die, the insurer loses money.
…but if you live, that cash value starts replacing the pure insurance part of the contract.
This is a good deal for the insurer, because they’re on the hook for the death benefit they sell you.
Here’s another way to think about all of this:
The difference between that cash value savings and the total death benefit amount is the pure insurance amount, which is also called the “net amount at risk” or “at-risk amount” and refers to the amount of risk, quantified in dollars and cents, that the insurer is taking for insuring (underwriting) your life.
Over time, that pure insurance gets pretty expensive on a per $1,000 of coverage basis…
…that’s why you never see people picking up a one-year term policy at age 80…
…and it’s why the net amount at risk decreases over time (though sometimes not in a strictly linear fashion).
It’s just too damn expensive to insure a human being when they’re at the end of their natural lifespan.
Some types of whole life pay dividends, which can be used to buy more whole life insurance (called “paid up additional insurance” or “paid up additions”).
We call this “participating whole life.” This is the type of policy I own.
Under this type of contract, I still have the cash value and pure insurance component, but with dividends added, the picture looks more like this:
When dividends are used to buy additional paid-up life insurance, it generates more cash value and more dividends for the policy.
Dividends aren’t guaranteed, but most of the old mutuals like Mass Mutual, The Guardian, Northwestern Mutual, Penn Mutual, New York Life, and Ohio National have paid dividends every year for the better part of 100 years, and in some cases, much longer.
Not so fast.
While I do like my own whole life policy, I have to admit that it’s not an “off the shelf” product.
No, in order to get the amazing performance I wanted, I had to take the plain-vanilla product, tear it apart, and rebuild it.
I wanted the ability to pay more than the contractually guaranteed premium so that I could boost up my cash value.
I also wanted the flexibility to add on more term life insurance which I could convert to whole life at any time. It makes the contract more flexible and helps drive down costs – costs that absolutely crush performance.
If I didn’t know what I was doing, had no one to trust, and I wanted a whole life policy, I’d probably have purchased a 10-pay or 20-pay whole life product from either Mass Mutual, The Guardian, MetLife, or one of the other strong contenders in the industry.
But, I do know what I’m doing, so here’s what I did:
- I bought a small amount of whole life.
- I blended the basic policy with quite a lot of low-cost term insurance.
- I purchased a hell of a lot of low-cost paid-up additional insurance, in addition to the term insurance, through a special rider offered by the insurance company, which helps grow cash values quickly.
For my policy, I chose Mass Mutual, partially because it’s a huge company, it’s well-run, and it has excellent financials:
- Its net total return on invested assets is between 6 and 7 percent, and that number seems to be fairly consistent from year to year.
- It generates an amazing amount of income from non-insurance businesses that are rock solid, even during a recession.
- Its surplus (excess cash) has grown by monstrous proportions in just the last 5 years: 45 percent in 2010, 56 percent in 2011, 61 percent in 2012, 72 percent in 2013, and 67 percent in 2014. The industry average is just 34 percent.
- They have a stellar management team that is committed to growing the GIA (general investment account) and long-term profits for policyholders.
I also really like Mass Mutual’s commitment to mutuality.
A mutual insurer is a company that’s owned by its policyholders. It is not beholden to outside investors. That means the management’s interests are more closely aligned with the policyholders, and that’s a very good thing.
Its current financial situation is explained by its long history and accomplishments, like the fact that it has paid dividends on whole life for more than 140 consecutive years and has always made good on its promises.
That’s good for policyholders and, being a policyholder, that’s what I want to hear.
Had I forgone the whole life insurance option, I would have purchased a term life insurance contract and then invested the difference.
These contracts almost never last longer than 30 years (though there are some that do last until age 70, 80, or 100) and, with term life, I get no cash value savings so I have to do that part myself.
This is where the “invest the difference” parts comes from in the “buy term and invest the difference” strategy (BTID; but this is sometimes referred to as “buy term and save the difference”, or “BTSD”. I use these terms interchangeably because they mean the same thing).
Term insurance products are “pure insurance” products, meaning 100 percent of the death benefit represents the “net amount at risk.”
The way the insurer makes money off this deal is it hopes that you outlive the contract term so that it doesn’t have to pay the death benefit (most of the time, people do outlive the contract term).
The way you benefit from this deal is that your premium is much lower than with whole life, so you invest the difference between your term insurance premium and the hypothetical whole life premium you would have paid.
That savings usually goes into a 401(k) plan, an IRA, or some other type of qualified retirement plan or real estate (which seems to be making a huge comeback).
Unlike whole life, there are lots of restrictions, penalties, and fees for accessing the money in these retirement plans before you turn 59 1/2.
But, hopefully, you can see that, in both scenarios, you’re doing almost the exact same thing (conceptually): you’re buying insurance, and building a savings.
You’re just going about it (practically) in different ways.
Now that we understand the basics, the next step is to delve deeper and figure out how much all of this is going to cost.
You also want to know what you’re getting in return for your money.
Where Most People Fall Down — Even Professionals
It’s time to break out those costs and investment returns embedded in the whole life policy.
This is where most people fall down.
But, don’t worry. I’m going to walk you through the entire process, step-by-step.
When you buy a whole life policy, you receive a policy illustration, which explains how your policy works.
Unfortunately, whole life is considered a “bundled product,” meaning the cash value and insurance components are bundled together, making it more difficult to compare it to other contracts.
Fortunately, there’s an app for that. It’s called “reverse-engineering.”
So, that’s what I decided to do.
It’s important to keep in mind that, without doing this, it’s virtually impossible to make an “apples to apples” comparison between a 30-year term policy and whole life.
This is huge.
Almost no one in the financial services industry does this.
Most of the analyses I see out there assume the premium for whole life represents its cost.
This is a huge, huge, huge mistake.
If you were going to assume that the premium represented the cost, you’d have to have some way to account for the fact that a substantial part of that premium for whole life goes into the cash value and earns interest but…
…no one does this.
That’s why I calculated the costs the way I did to take this into account.
Here’s what I discovered:
Here it is in graphical format:
Wow, that’s a lot of numbers.
As you can see, my policy’s costs (in yellow), relative to cash value (in green) and premium payments (in blue), aren’t excessive.
A lot of people will tell you that whole life is expensive, but those costs clearly don’t eat up the policy values…
…which is good, because I’ll need them later.
For this policy, I purchased $353,848 of death benefit, some of it being supplemental term insurance which converts to whole life every year automatically, along with a small amount of base whole life.
At no point during the contract is the policy scheduled to become a modified endowment contract (MEC).
If you don’t know what that means, hit me up in the comments section. I don’t have the space to go off on a tangent here.
Collectively, this is still called a whole life policy, so that’s how I’m going to refer to it.
The cost per $1,000 starts at just over $8. Then, it drops before it rises substantially in the older ages.
The 30 year average cost per $1,000 of whole life insurance is $7.19.
Think of the cost per $1,000 as the “unit cost” or “unit price” of insurance/savings.
Since whole life combines both insurance and savings, we’re measuring those combined costs.
You know when you go into a supermarket and you look at the price of something, and somewhere on the shelf is the “unit price?”
Usually, a product’s unit price is listed as so many dollars or cents per gallon, or per ounce, or per pound.
This is the cost that lets you make an “apples to apples” comparison between two similar or dissimilar products.
That’s exactly what I’ve done here…
…except I’ve done it for life insurance.
Since insurance is priced per “per $1,000” of insurance/savings, that’s what I used as the unit price here.
This is what I’ll compare to buying a 30-year term policy and investing the difference because a 30-year term policy is very common.
But, I also wanted to know what the cost would be if I held the contract to the maximum age: 121.
The average cost per $1,000 over 86 years is $60.27 on a non-guaranteed basis.
This means that the insurance company assumes this is what the costs will be, but those costs could vary a bit over the years.
God I hope I live that long.
Next, let’s look at the costs and savings or cash value build-up if I were to buy term life insurance and some other savings product, like an investment of some kind or a hypothetical non-investment financial product:
And again in graphical format.
This illustration assumes the same 7.1 percent compounding rate as the whole life policy.
I chose this rate because I wanted to approximate a true “buy term and invest the difference” scenario…meaning if I broke apart my whole life policy, and bought the term and investment part separately, how would I do?
By pure coincidence, this interest rate approximates the historical returns of a classic 60/40 split (60 percent of savings invested in the stock market, 40 percent of savings invested in bonds).
The long-term average of the S&P500 stock market index is about 10-11 percent. Going forward, professional investors like Warren Buffett assume a 6-7 percent return, adjusted for inflation.
This comes out to about 8 to 9 percent, excluding inflation.
But, bond yields have been compressed. That means I’d be lucky to get 3 percent from fixed-interest investments…
…which sucks because bonds are a necessary safety net for the volatility of the stock market – they help preserve my savings and give me income from the interest they generate.
With a long-term rate of return on stocks of 8-9 percent, and a long-term return from bonds of 3 percent, my weighted average return from a 60/40 split would be about 7 percent.
I also assumed an average 1.44 percent total fee for investing with mutual funds inside a qualified investment account (based on the 401(k) Averages Book, 14th edition, this fee seems reasonable for a small business but keep in mind that fees could be higher or lower depending on the size of the business).
Finally, I assumed a term policy premium of $359 on $350,000 of death benefit for the next 30 years.
Let Me Address The Elephant In The Room Right Now
After giving this some thought…this kind of analysis is not something I’m completely satisfied or happy showing you…because whole life insurance comes bundled with an insurance component for more than 100 years.
Which means…this kind of analysis is unfairly biased toward the “buy term and invest the difference” side because…
…the 30-year term policy assumes there’s an insurance component for only 30 years.
If I extended the term for as long as possible, I’d end up paying $370 or so dollars per month (over $4,000 per year just for the insurance — see how expensive term insurance is to carry for your whole life?). If I switched to a universal life policy designed strictly for death benefit protection out to age 100, I’d still pay something like $190 per month (over $2,200 per year).
As you’ll see later, that would have made it “no contest.” Seriously.
Under those conditions… the whole life policy would be a much better choice…and by a wide and very obvious margin.
But, most skeptics will say most people would drop the term coverage after 30 years and rely on their savings from that point forward.
And, maybe it’s true. But…
…it’s not a great “apples-to-apples” comparison and is more than a bit lopsided. Still, it’s the way most people do it so… I want to address it that way (in this post anyway).
But, there is another reason I’m willing to do this “lopsided” analysis. And, that reason is…
I want to see how much of a handicap this particular whole life policy can handle!
And, as it turns out, this little policy can handle a lot.
OK, Back To The Analysis
I bumped up the annual contribution amount on the “buy term and save the difference” side to just over $15,000 to account for the tax benefit I would get from setting aside money on a pretax basis (e.g. a 401(k)).
My average (after tax) annual premium payment for life insurance was only $12,037.
The 30-year average cost per $1,000 for this BTID strategy: $7.86.
Not bad, but my custom whole life policy is a little bit cheaper.
Where I might save money is after 86 years (at age 121), where the average cost per $1,000 of insurance and savings is just $12.26.
One thing to note with the BTID strategy is that the death benefit stays level for those 30 years.
If I needed more insurance over time, I would have had to purchase more which would have affected the cost per $1,000. I didn’t calculate a rising term insurance amount because…well…partially because I’m lazy but also because this analysis is already complicated enough. Anyway…what I want you to understand is…
…the cost of insurance doesn’t tell you everything about the “goodness” or “badness” of your insurance policy. People get so focused on the cost…they miss the bigger picture.
What The Cost Of Insurance Doesn’t Tell You
If you just look at the costs, you’re not going to get a very clear picture of how good the product is…
…because you’re only looking at how bad something is.
Let’s go back to the supermarket example for a minute. The unit price of a single bag of Ramen noodles, for example, is important because it tells us the relative cost for what we’re buying.
But, it doesn’t tell us anything about the benefit of the noodles (the nutritional value we get for that cost).
And, the benefit of something is at least as important as its cost.
Think of it this way:
Ramen noodles have a lower unit cost than a bushel of apples – but apples are far healthier…
They’re much more nutritious…
…which brings us to the next step in the process:
Something Else You Need To Think About
If the only thing that mattered was the cost of insurance, we would give up investing and just buy a 30 year (or longer) term policy.
That’s not going to work because you need savings, I need savings…everyone needs savings.
And, there’s really only one reason why you need savings:
You want…no..you need to spend it.
So, what you really care about is what you’re getting for your money – how much money you have to spend now and later.
With most retirement plans, you put away a lot of money in savings and that’s it – you can’t really spend much, if any, of it until you retire. When you do, you’re on your own to figure out how much money you can safely withdraw for retirement income.
The maximum amount of money you’ll ever get from your savings is called “terminal income value.”
To figure out that maximum income amount, we use an annuity. An annuity is an insurance product that converts your savings into a guaranteed monthly income.
Here’s what it looks like if we convert the cash value from the whole life insurance policy to income, starting at various ages — starting at either 65, 70, or age 75:
@ Age 65: $5,032/month
@ Age 70: $8,033/month
@Age 75: $13,085/month
All of this income is tax-free, so long as you keep the whole life policy in-force (there are several ways to do this, which is way beyond the scope of this post).
Now for the BTID (BTSD) strategy, starting income at:
@ Age 65: $5,155/month
@ Age 70: $7,861/month
@Age 75: $10,179/month
There are a few things to note here with these numbers.
First, the maximum income from the whole life policy and BTID/BTSD strategy is about the same at age 65, but the whole life plan absolutely crushes the amount I could have withdrawn from a qualified retirement plan, like a 401(k) or IRA at age 70 and beyond.
Part of the reason for this is taxes.
Delaying taxes inside of a 401(k) for all those years only racked up a bigger tax bill later. This is something I understood conceptually for many years. But, it’s nice to see it “in print.”
Secondly, because the IRS forces everyone to take income from IRAs and 401(k)s at age 70 1/2, I’d be eating into my savings before age 75 whether I want to or not. This results in a lower net income (and I adjusted the “@ age 75” income to account for the withdrawals made between 70 and 75).
So, from an income standpoint, it doesn’t help to wait until later in a retirement account. At the same time, taking income at age 70 means that I have a smaller account balance to work with.
Finally, I did not figure in Social Security Income. I honestly don’t know what’s happening with that program. You might want to ask your Congressman.
Many people don’t believe Social Security will be around by the time they’re ready to retire. Some do.
If you’re relying on it in your old age, the BTID/BTSD numbers will be lower, because between 50 percent and 85 percent of your benefits will be taxed, depending on your income, increasing your tax liability.
Whole life insurance does not cause your Social Security benefits to become taxable. So, the benefit would simply increase your income.
How Income Volatility Complicates Things…And Why You Need To Know About It
Income volatility is the effect of the natural “ups and downs” of the stock market while you’re trying to draw an income.
Up until this point, I’ve assumed that my savings would grow at 7.1 percent, compounded annually. It’s called the “compound annual growth rate” or CAGR.
The benefit of calculating investment returns this way is that it smooths out that volatility in any given year and tells you what you would have to earn to get the dollar amount calculated in that year.
The problem with using the CAGR is that it hides the natural volatility of the stock market…
…which is OK if you’re just buying and holding investments. You don’t really worry about losing money in any given year.
All you care about is the value of the savings in year 30 (or whatever year you happen to be retiring).
The problem starts when you want to draw an income. Now we have to account for that volatility because drawing an income and losing money in the stock market could really screw us up.
What happens if I draw an income and lose 38% in the market (this actually happened to some people in 2008)?
How long would my savings last if that happened once or twice during my lifetime?
Probably not as long.
Yes, there are ways to try to guess what a “safe withdrawal rate” would be, but they all suffer from the same problem: no one can really predict the future.
So, unless you have a crystal ball, predicting your future savings is a lot of guesswork.
When you buy whole life insurance, you completely insulate yourself from the risks of the stock market.
The insurance company manages that risk for you, guarantees your cash value each year, offers you the possibility of dividends to increase that cash value savings beyond the basic guarantee, and then offers you a guaranteed income when you retire.
That’s a lot of guarantees.
And, if you noticed, I actually did better than my hypothetical, diversified, stock market portfolio.
Now, I want to make something very clear about comparing whole life to the stock market:
Normally, you shouldn’t do it.
Whole life insurance doesn’t always outperform an investment strategy, but it did this time. But..it’s still not really a fair comparison.
Had I done some stock analysis, I could have probably found a company with outsized returns that beat the guarantees and non-guaranteed dividends of whole life. In this example, I used a hypothetical return for BTID/BTSD that mirrored the whole life dividend interest rate so that you had a reference point.
I don’t see buying whole life insurance and investing in the stock market as mutually exclusive. But, I do want to point out, and make perfectly clear, if you do not understand investing…do not want to invest…or do not trust your own ability to invest…then whole life is a very appropriate way to save money for your future.
And, you can use that cash value savings throughout your life for any reason, and with no restrictions or penalties.
No roller coaster ride.
No sleepless nights.
No wondering whether you should take out a loan to fix up the house, buy a car, go on vacation, buy a new Mac, pay your kid’s college tuition, or pay your health insurance deductible.
If you need the money, it’s there. If you don’t, it keeps working for you.
If you want to invest in stocks, you can. If you don’t want to, you don’t have to.
Choice. Control. Peace of mind.
That’s what I have that I don’t have with other strategies. And, if you decide to do this, that’s what you’ll have, too.
So…Should You Buy Whole Life Or Buy Term And Invest The Difference?
Honestly, I don’t know.
After all that analysis, the answer should be obvious, right?
Not so fast.
One thing you give up when you buy a whole life insurance policy and call it a day is the thrill of investing.
If you love the rollercoaster ride (some people do), this is not the product for you. Whole life is boring, safe, and predictable.
But, there’s another reason why this might not work for you.
I’ve seen it before, and I can’t fully explain it. There is a certain personality type that, when something is working well, that person decides it’s working “too well” and they have to break it so they have something to do.
If that describes you, this is a terrible strategy.
How else can I say this? If you love to tinker with investments, day trade, or you genuinely love doing research and analysis on investments (e.g. it’s your profession), this might not be a very satisfying product for you to buy.
Another potential thing that I see a lot of people complain about is the low rate of return in whole life. I hope by now you can see that those people simply don’t know what they’re talking about.
…there are a lot of those kinds of people out there.
But, there is a ring of truth in those criticisms. Buying whole life for its cash value potential only works when you buy a high cash value policy.
Specifically, it works the best when you buy a blended whole life policy.
And, those are highly customized products. You cannot buy them “off the shelf” from just anyone. You have to buy them from a life insurance specialist.
With those caveats aside, it can be a great strategy if your primary focus is protecting and preserving your savings, with a keen eye for steady growth over the long-term.
As of this writing, I’m 35 (update: I’m 36). Whole life insurance worked out great for me.
Oh…Just One More Thing
There’s just one more thing you need to know.
This one thing is really important. It’s so important that it will probably make this strategy a not-so-good strategy for you. You see, when I publish something like this, there’s always one person in the crowd that dives off the deep end without looking.
They make a beeline to the nearest life insurance salesman and ask them to design something like this.
And, why not?
It guarantees your future savings. It takes a lot of the guesswork out of retirement planning. It consolidates a lot of problems into one solution. It’s almost foolproof.
You see, there is a lot of criticism out there on the Interwebs about whole life. And, most of it is undeserved. It’s a great product. I’d sell it to my mother (I did, in fact).
But, there is a weak hinge in this strategy. And, it has absolutely nothing to do with the product.
It has to do with…
What I haven’t said up until now, but which you’ve probably started to surmise, is that whole life is a premium-hungry monster.
To say it another way…
I have a very high savings potential.
In other words, I’ve figured out how to really goose my savings to superhuman levels.
If you want to use whole life insurance as a savings product, you need to have a high savings potential.
…you’re probably not there just yet.
…if my case study made you stop and say “hmmm”…
…if you like the way I roll…
…if you think maybe, just maybe, you’d like to learn a little more about this strategy, and other similar financial tricks I have learned over the past 10 years in this business, here’s what you need to do:
Sign Up To My Email List
If you want to know how to save a ridiculous amount of money every month, without making any personal sacrifices, then sign up to my email list and I’ll teach you how I personally do it.
You’ll receive DAILY (yes daily, even on Sundays) financial tips, and promotional emails, from me that will make a dramatic and immediate difference in your business and personal life (within 1 week of joining).
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