What Kind of Life Insurance Should I Buy?

The following is a guest post by Kent E. Irwin of eFinPLAN. Want to know which is better for you -- term or cash value life insurance? Read on.

Virtually all fee financial planners and writers today recommend that people should only buy term life insurance instead of one of the other types of life insurance that have cash value. The insurance industry of course strongly argues the merits of cash value insurance. Over the years I’ve witnessed many emotional discussions between the insurance industry, financial experts and the financial media about the type of insurance people should buy.  I’ve been in both camps.

Prior to creating eFinPLAN financial planning software for consumers I was a fee only financial planner, holding the designation Chartered Financial Consultant or ChFC. During my 25 years experience in the financial services industry I have also sold life insurance, and worked in the home office of a life insurance company. In each of these roles I have tried to be an objective educator giving people good information so that they can make good decisions for themselves. The following discussion should provide some balance on the issue.

The conventional wisdom today regarding life insurance that only term insurance should be purchased may indeed be true for most people, however I think it is good to be informed about all the issues so that people can make well informed decisions.

Why do most experts recommend term insurance:

1. Term costs less than other forms of life insurance both initially and over 10 to 30 years.
2. Lower cost life insurance maximizes the amount of money someone can save and invest.
3. Cash value insurance earns a low rate-of-return on the cash build up.
4. Most people will not need life insurance when they are older if they have little debt and large investments.

Why life insurance agents recommend cash value insurance:

Cash Value insurance is also known as permanent because it lasts at least until age 100. Term insurance expires at the end of the term. Cash value insurance comes in many forms such as Whole, Universal and Variable life insurance. For a full grid comparing most insurance types, click here.  The following are the major reasons insurance agents recommend cash value insurance.

1. Cash value insurance costs less than term insurance, if you compare it over a long period of time.
2. Cash value insurance forces people to save money, which is helpful to people who lack the discipline to save.
3. Cash value insurance’s rate-of-return is comparable with the part of a client’s portfolio that might otherwise be invested in bonds or cash.
4. Many people need life insurance in their older ages: Wealthy people for estate planning, middle income people who were unable to save enough to self-insure.
5. Retirement income: Life insurance cash values grow tax-deferred and may be borrowed tax-free.

Costs & Need for Life Insurance Later in Life

Life Insurance provides protection. It is purchased to provide immediate cash so that loved ones are able to maintain a certain standard of living in case you die. Term life insurance is indeed the lowest cost life insurance initially and if you compare total out-of-pocket costs for premiums for the 20 or so years that most people need it most - when children are still at home and you have a mortgage.

However, there are situations in which people need insurance for longer periods of time. After divorce or death people start new families and have young children later in life. In addition to these “blended families” some don’t save enough and often carry too much debt. Therefore, if you compare term versus cash value insurance over very long time periods, cash value insurance may be lower.

Young people just starting out with new families, careers and mortgages are often at a point in time that their income is low, they have large needs and they can’t afford to compare long term costs. They need the lowest cost for their budget today, giving them maximum cash flow for savings and investing. Many people are underinsured for disability, if they have additional dollars, disability insurance should be a top priority.

Some agents suggest that if you have prosperous financial ventures, your net worth may some day be worth several million dollars. At that time you would need life insurance for estate planning. This may be true, however it is difficult to justify purchasing a lot of cash value life insurance when you are young on the chance of that future possibility. If you need it when you become wealthy, you will probably be able to afford it then.

Some may need life insurance in their older age to provide for their family. Bad decisions, setbacks, blended families and low savings may cause some in their 50’s to wish they had some life insurance other than term, because their term policy may soon expire or cost a lot to renew. They may also have health problems that may hinder their ability to obtain competitive life insurance.

Forced Savings, Rate of Return and Retirement Income

When I was a young insurance agent, one of the main motivations to encourage young people to buy cash value insurance was to force savings discipline. In actuality those that were undisciplined savers eventually let their policies lapse, and those that were disciplined sometimes cashed in their policies because they could see their other savings and investments growing faster. Instead of buying cash value life insurance to force savings they would probably be better off learning good budgeting habits and family financial management.

Is life insurance rate of return that bad when compared to other like investments?

Some argue: Since most people should have some of their investments in cash, money markets and bonds for safety, for reducing volatility and for emergencies – why not put some of that into cash value life insurance? Over the long term life insurance cash values from good policies and companies should perform in the middle single digits similar to a intermediate term bond. Some of the best policies may perform in the upper single digits – not bad for your “safe money.”  However these cash value policies may take 5 to 15 years to break even, and much longer to earn these comparable rates of return.  If you can afford to wait for these types of return, and are saving enough for emergencies and retirement, then you might want to consider cash value life insurance.

Life insurance is also sold to provide retirement income. Sometimes it is referred to as an IRA or 401(k) alternative, or under the LEAP system. Life insurance cash values grow tax deferred, and if properly arranged can be taken out in the form of loans without paying income tax. The computerized models of these programs can look competitive with other investments. Most advisors recommend that people take full advantage of the available retirement and IRA plans before ever considering such an approach. If you desire to investigate this, make sure that the agent provides computer illustrations that show results of lower rates of return and higher mortality and other expenses. Then perform internal rate-of-return calculations on these modest projections. If this still interests you, closely examine the insurance company and obtain quotes from other high quality insurance companies.

Conclusion

Term insurance is often the best decision for most consumers, especially for those with modest incomes and large needs. The first phase of financial planning, forming a secure foundation, usually begins with establishing an emergency fund, having adequate term life and disability insurance, and maximizing IRAs and employer sponsored retirement plans. Those with more mature financial plans may want to consider having a percentage of their life insurance to be the cash value type, depending upon their individual family circumstances, personal preferences, and overall financial circumstances and plan.

Comments

[LC]

Am I alone in thinking that this isn't an important topic for most people? Both me and my husband work, and our lifestyle is easily covered by either of our salaries. In addition, both our companies offer 2.5 times our salary for life insurance, which is more than enough. I see no need for additional life insurance in our case. Is it really that uncommon for this type of coverage at work?

[FMF]

LC --

Assuming you have no dependents, then you're fine. But most people have others that rely on their incomes to survive (I have a wife and kids, for instance) and, as such, this is a very, very big issue.

And, unless people have a huge amount of savings set aside, 2.5 times annual income isn't even close to covering what will be needed if they pass away.

[Kent Irwin]

If people are dependent on each others income and there are children, people usually need about 6x income, plus debt, minus non-retirement savings/investments. This is a rough estimate, rely on planning software and needs calculators to help more closely determine needs.

[LC]

I do not have kids, but if I did and both my husband and I died, the combined life insurance would leave over $1000/mo to support them for the next 18 years. We are saving separately for their college, and we also have many other assets that would be passed on to them. Also, as they get older, you need less and less money to support them (total). I would think that life insurance would be beneficial for someone with a lower income or young children. On the other hand, disability insurance makes more sense to me and I think should be emphasized more than life insurance.

[FMF]

LC --

Do you think $12,000 a year is a lot to care for two kids? I don't.

FYI, I agree that disability insurance is needed as well, but that doesn't negate the need for life insurance.

[No Debt Plan]

I think the rate of return/cash value portion of whole life insurance has been beaten to death by Dave Ramsey. My understand is that after fees, you are looking at rate of return somewhere in the 1-2% range. For the extra cost, you'd be much better off finding a conservative bond fund to invest your additional funds if you're looking for stability in a portfolio.

Whole term companies like New York Life teach their new sales people to sign their family members up first. I interviewed with them a while back. Seems awfully shady to me.

Point taken, but first of all, kids can be raised on $12,000 pretty easily, but more importantly, I was saying that all of our retirement money and other savings would also be given to them as well. But every person has to look at their own situation and decide what's best. I just can't imagine it being needed in our situation above what we already have.

[JK]

My wife and I are 28 and 27 respectively. We have term and permanent life insurance in the amount of 20 times each of our annual salaries. We are both working full-time at nearly equal salaries with no children.

This amount was chosen to replace income and to compensate for other household chores done by each of use, (ie - housecleaning, laundry, lawn-mowing, snow removal, etc) for the life of the surviving spouse.

We chose whole life because we are already maxing out our other options, and we can move the money out of the policy tax-free, and move extra money back in tax-free by loaning it out to family, business, and others by charging interest.

@No Debt Plan-

I think that Dave Ramsey arguing against ANYTHING would automatically make me more likely to consider it. For example, he argues against using credit cards. FMF tells us how much he makes off of his credit cards, and we both know that many people use them very responsibly. And for the record, my "rate of return" is greater than 7% (subject to change every year) with Northwestern Mutual.
Yes there are fees... They are providing a service. Do you know anyone that provides a service without charging a fee? They are particularly high in the first 2 years... About 30% of your premium the first, and 15% in the second year, but after that, your cash value goes up by about 10% more than your premium.

Example: Premium $1000/yr

Year Premium Cash Value
1 $1000 $700
2 $1000 $1600
3 $1000 $2812
4 $1000 $4108
5 $1000 $5495
6 $1000 $6980
7 $1000 $8570
8 $1000 $10270

You will notice there is a "negative" return for the first 4 years, but you are also paying for life insurance, so if you subtract the term premiums the "rate of return" will be significantly better. However, we don't really think of this as an investment per se, but as a place to put liquid money that is safe, from lawsuits, etc.

I'm not saying it is for everyone, but I know way too many people who blindly follow "experts" like Dave Ramsey to their own detriment.

Let's look at the record:

Bankruptcies

Dave Ramsey ME
1 0

So by that measure, I'm a little better at money management than Dave already, as I bet most of us on here are. Use your own brain, please!

[FS]

I'll second JK with the "20 times" rule-of-thumb - as 20 times your current salary (or annual expenses) would allow total proceeds to be invested and conservatively yield (~5% annually) an amount equal to replace your salary for beneficiaries. Suggest you also consider future growth in salary and annual expenses.

Finally, note that whole life makes sense for JK as he's maxed out all other savings options. The same would be true for you. Most of us are much better off with term life insurance.

[sow]

JK,
I like the way you think. We have all whole life insurance. I'm not sure how many times our life insurance policy's death benefit is vs our income but I know that it's the MOST we can get. Our plan is to supercharge our policies by overfunding them. We stopped contributing to our Qualified Retirement Plans and actually cashed them out. Better in our hands to utilize than someone else like the government. Not only does it act as a savings account, liquid, earn a rate of return, protect our human life value...it's under our control. It's our personal bank. Whole Life Insurance is like our swiss army knife...one tool that can do many things.

[MJM]

@JK,FS

When you say you've "maxed out all other savings options", what are you referring to? Roth IRA, traditional IRA, 401K? Any other options? 529's?
...

Also does anyone here have any experience with the LEAP system that the author is referring to in this post? I was given the LEAP sales pitch last year, and I left the meeting with a bad gut feeling - the salesmen was playing fast and loose with interest and future tax rate projections and downplaying the value of 401k's and traditional IRA's. I got the impression that LEAP was a sales tactic designed to sell cash value life policies with large premiums.

I'm making enough now that I'm maxing out my Roth IRA and 401k and have extra money left to invest. Right now I've been putting the excess into index funds. I don't see myself having dependents for a few years, so life insurance isn't necessary in the traditional sense. However, I'm interested in how other people are using cash value policies for retirement income. FMF - I enjoy your blog immensely, perhaps a specific post on this topic?

[FMF]

MJM --

I'll add it to my list? ;-)

[Evan]

I have access to the LEAP system through my chosen career (at least during the day!) but I am not that familiar with it yet - currently I take a macroeconomic look at each client (caveat I am a Director of Financial Planning at a Fee Based Firm with clients that range from 25 year olds just starting out to $100milliion+ (suprisingly she didn't know she was worth that much until we did all the work for her!!!)).

I understand that for 98% of people the following comment will mean nothing to most people, but you have to remember placing Life Insurance in an ILIT vs. Paying IRD (Income in Respect to a Decedent) upon death. Google those terms or post a comment and I'll start explaining!

[JK]

@MJM-

When I say I've maxed out my options, I mean whatever retirement vehicles are available to me. SIMPLE or 401k and Traditional IRA (not eligible for Roth IRA), I have not and would not fund a 529. This is because I feel that my children should have to pay for their own education, as I have. A 529 can count against what a child can borrow, which I have no interest in doing. If anything, I would help pay off student loans AFTER graduation, but I have quite a few years to think about that!

Retirement plan funds and cash value life insurance are not counted as parental or student assets on the FAFSA (Free Application for Federal Student Aid), as the 529 is. Withdrawal from the cash value of your life policy is also not a taxable event, nor does it count as income, as it is a loan.

I have seen the LEAP system and I share some of your feelings about it. I do however believe that taxes will go up with the next administration. Dem or Rep. The book "Becoming Your Own Banker" By Nelson Nash is the Bible to those who advocate using cash-value policies as a "Bank". I'm slightly more risk-averse than "sow" as I choose to diversify my funds outside of a well-funded whole-life policy as well.

I am planning on converting all traditional IRA funds into a Roth in 2010, as I am fairly young. I am also urging my employer to start a Roth 401k, as I did at my previous employer.

I'm going to start enjoying my day off! You can find my agent's website here: http://www.alphaomega-fs.com/resources.php

Good day!

JK

[sow]

We don't see ourselves as "risky" by not diversifying our money in Qualified Retirement Plans. After reading books like LEAP, Becoming your Own Banker, Missed Fortune 101, Rich Dad Poor Dad, etc., we were better off not contributing into QRPs. Now, we do other things but our whole life insurance policies are the backbone of our financial plan and model. We actually find QRPs too risky for us.

I Posted this 6 months ago in response to Buy Term & Invest the Difference. I'm pleased to see well educated responses to this post on the value of properly owned permanent whole life insurance.

1) I believe in purchasing your Human Economic Life Value in Life Insurance. I disagree with the trends of purchasing only what your "think" your family "needs" - How do you know what your family will need or what your life will look like in five years - let alone 20 or 30. For those of you that haven't heard of human economic life value - do some research on Solomon Huebner - the Father of Insurance education.

2)I own term insurance and permanent whole life insurance - thats right - the insurance that magazines, financial institutions and radio talk shows [Dave Ramsey] say is evil. In fact, permanent life insurance is the centerpiece of my investment strategy. Permanent LI is not for everyone, you must have the cashflow to correctly fund and implement this strategy.

Reasons why I own PL insurance.

a) Death Benefit that is guaranteed and increases with a quality product- I won't need to worry about renewing my term or losing an asset in my families' life when my term insurance comes up - it is permanent - it will go to my family, church or charity when I leave this earth.
b) Disability protection - every dollar that goes to my permanent policy is protected in the event of a disability. Even if you own disability insurance -how many of you can say that if they became disabled their 401K, RothIRA, and 529s will continue to be funded- Waiver of premium protects every dollar I put into my policy in the event of disability.
c) Guarantees - Unlike the stock market, bonds, etc.. I have contractual guarantees in my policy - I don't need to lose sleep about the market swings and losing principal - in fact - since I own a policy from a mutual LI company I recieve dividends every year that are projected over the course of the policy to give me a net return of 5-6% - with no 1099 tax - in my tax bracket that equals a 9+% taxable rate of return with no risk.
d) Creditor Protection - in my state, the cash value is 100% lawsuit protected - ***not all states have this protection
e)Liquidity - access to Cash Value - no penalties or taxes if cash is accessed correctly - you can't say that about government controlled retirment plans - in fact I can use my policy value to get in and out of the stock market at my control.
f) Asset Maximization - I have an asset (Death Benefit) that never goes away - it gives me infinite number of options to spend down my other assets instead of merely living off the interest in retirement. You are correct to say that you may not "need" life insurance in retirement if your house is paid off, kids are gone, etc.. but for this reason alone you may "want" life insurance.
g) Flexibility - I can put more money in, stop putting money in, have the policy pay for itself - take tax free dividends, etc...
h) It works in all circumstances and is the supercharger that makes every other asset more efficient from a macroeconomic view.

Please - first buy as much term as the insurance company will give you HEL (usually 15-20 times your income) and protect your family, but remember term insurance is a cost - it is not a wealth building strategy! (studies have shown that only about 1% of term policies pay out - others are canceled, converted, expired). Please contact a qualified insurance "professional" to see what guaranteed products work in your circumstance (I'm personally not a fan of UL & VUL products - they don't work in all circumstances and don't hold the same effiency and benefits of a whole life product from one of the remaining mutual insurance companies)

Note - I am a professional in the financial service industry, I have studyed economics, I hold an MBA and multiple other licenses in the insurance and securities industry. I Love this FMF website as it encourages people to save more money - we have a savings epidemic and we all should utilize many of the strategies FMF puts forth. I am simply answering FMF question with what I am doing and some of the strategies I teach my clients

Posted by: Aaron | October 02, 2007 at 10:04 PM

[Kent Irwin]

It has been many years since I examined the LEAP system, it may have changed since then. The LEAP system, when you boiled out all of the marketing hype, involves using life insurance to provide tax free income. Life insurance cash values grow tax deferred, and can be borrowed without paying income tax, as long as the policy is not and does not become a MEC or modified endowment contract. A MEC is a policy that is not just max funded but over funded, and it looses the tax free loan piece. Some LEAP'ers argue against max funding 401(k) plans, because your income from them will be taxable.

[FS]

@MJM - I understood that JK meant he was maxing out the retirement vehicles available.

Not to sound like a broken record, but I also agree with JK on 529s and the importance of children paying the majority (if not all) of their higher education expense via scholarships and work (with few if any loans.)

[JK]

@sow

The risks that I think applies in Infinite Banking is that they will change the tax circumstances around cash value whole life, like they did in the 80's when they instituted the 7-pay regulations. They could just as easily make every transaction in or out of a whole life policy taxable. I feel that by diversifying my funds, I will have the most options in the future and at retirement. Having said that, I realize that if nothing changes with the tax treatment of whole-life, I will have missed some opportunities by putting money in Qualified Plans instead of whole life.

[MJM]

@JK - Thanks for the feedback.

Any other books you would recommend on this strategy?

[sow]

@JK,
Point taken. Taxes will be different in the future. But I like taking advantage of the tax advantages now with my whole life policies. To me, I would be defeating the purpose of utilizing this tax strategy by putting money in a tax deferred account at the same time. I'd be saving tax in one pocket and paying tax in another. But best of all, the policies allow me to access this money on my terms, as Aaron has posted above.

Do you find it ironic that if I take a loan against a 401k, it's due in 5 years (sometimes 10-15). But if I lose my job, the means in which I was using to make the payments, that loan could be due in 60 days.

[JK]

@sow,

Taking a loan from a 401k is SUCH a bad idea, I haven't considered the ramifications of taking loans from it. I would sooner go to "Uncle Guido" than my 401k. Average (this includes 98% of ALL FPs, in my estimation!) financial planning will prepare an individual adequately so they don't have to take loans from qualified plans.

If I were to rely on my whole life policy solely, and the rules changed to treat all whole life policies used in this manner as MECs (taxing every step!) then I would not have many good options at retirement. However, I am diversifying my assets in 401K, Roth 401k, Traditional and Roth IRA (when I am/was eligible), as well as whole-life policies.

@MJM,

"The Pirates of Manhattan" by Barry Dyke is a good one also. You will find a lot of good information with anything by Lew Rockwell and Murray Rothbard too. They focus on some "libertarian" ideas embraced most publicly by presidential candidate Ron Paul, including bringing back the gold standard, free market economics, etc.

As you read through this stuff, you will begin to realize that the Federal Reserve and our banking system is really a house of cards that was built on the sand!

The changes that will make our economy much more stable will be VERY uncomfortable when/if they are made, but I think that beats dealing with similar pain every 5, 10, or 20 years.

[aks]

JK,
Quick comment on change of tax rules on whole life policies. Wouldn't/shouldn't govt allow grandfathering tax rules for policies already in existence in case they decide to change tax rules for whole life ins policies in future?

[CS]

I've been an advisor for about ten years and I have yet to meet someone who was happy when their term life insurance expired or was about to expire. In fact, they're usually flat out angry, to put it mildly. Buy term and invest the difference doesn't work because no one ever invests the difference, or least what they would need. I always ask clients if they were at a casino, would you play the game with only a 1-2% chance of winning? I never hear yes, but that's the odds of a term policy paying out. That being said, I use plenty of term insurance for my clients to help cover the need for coverage, and still make it affordable. But it is a band aid solution, and we need some permanent life ins (I prefer limited payment whole life, usually paid at 65). If they can't afford it now, we convert it in later years.

As to not needing it at retirement, that's the best time to have whole life insurance:
(1) If you have a defined benefit pension, it allows you to take a higher defined benefit pension payout and still cover your spouse (and kids, grandkids, charity, which a survivor option on a pension won't do)
(2) Allows you more spendability of your savings while simultaneously reducing longevity and market risk through the use of immediate annuities - the most under utilized but one of the best retirement income planning tools around. Life insurance replaces annuity income at death with tax free, guaranteed dollars. And why are people reluctant to use immediate annuities - because the money stops at death and they have no life insurance, because they thought they would only need it during the working years!
(3) Tax free distributions from cash value.
(4) You don't need insurance to be inforce during retirement, you need it to be in force at death. It has been my experince death usually occurs AFTER retirement. That's why you need permanent.

Remember, retirement planning during the working years is about asset accumulation, but when you're actually there, it is ALL ABOUT INCOME!!! If you have the money but are afraid to spend it because no advisor or any individual can control either market volatility AND life expectancy, what good is it? Permanent, cash rich, whole life insurance helps solves this problem. If TV personalities like Suze Orman and Dave Ramsey could for one minute focus on something other than the "cheaper is better" mentality, they would realize that their Wal-Mart method of planning is doing more harm than good.

[Denise]

If you are left to make a choice between term life and insurance and whole life insurance, it comes down to how much you are willing and able to pay for your premiums and how much coverage you are looking for. If you can afford to pay a higher premium for your entire life, a whole life policy is the one for you as it also brings with it a cash value along with the death benefits. If you have a young growing family and want to protect it from hardship after your death, a term life policy comes highly recommended. The death benefits can be used to pay for funeral expenses, mortgage bills, education loans and help maintain your family’s standard of living even in your absence. But whatever you choose at the end of the day depending on your individual requirements, ensure that buying a policy – any type – is non-negotiable.