Insurance Should Be Third Tier

I just finished a case that showcased how smart people are tricked by the insurance industry. As I reflected on it I thought of a simple exercise that can keep others from falling into the same trap. I’d like to share the story and solution with you.

This client is a surgeon– a pretty smart guy. Yet he did something so inappropriate I could cry. He bought a cash value policy from Northwestern costing $3000/year. What’s wrong with that?

Sometimes (rarely) cash value life insurance is OK, so don’t automatically cash in your old policies. It depends. But this client had much debt and was eligible for a Roth he couldn’t afford to fund each year. These are two key points. They shout of the inappropriateness of cash value insurance, and the simple paradigm I’m about to share puts it in clear focus.

Here’s the paradigm. Most financial planning decisions fall in one of three broad categories: repaying debt, saving/investing, or insuring. Yet financial planning decisions being made every day are more detailed: buy this stock or that mutual fund, accelerate the mortgage or fund a 529 plan, a Roth or more in the 401k, etc. It’s easy to lose sight of the forest for the trees.

So here’s the plan. It’s worth its weight in gold. Clip it and save it and use it for the rest of your life. It will help you avoid many costly mistakes.

When confronted with a decision of where to send your precious few discretionary financial planning dollars, first step back and view the decision from a higher altitude. First put the decision at hand in one of these three broad categories:
1. Repay debt
2. Save/Invest
3. Insure

Initially don’t sweat the small stuff, don’t swallow the camel while straining at the gnats, and don’t be pound foolish while trying to be penny wise. The abundance of similar maxims testifies of this strong human tendency that trips people up. For now, simply put the decision in its general category; one of three; simple.

The agent directed his focus to preparing for death with a $75,000 whole life policy. Knock out that issue with a policy that pays after your term ends. Sound good? But it’s out of context. For this client, buying the policy is obviously insurance, category 3. He could quickly realize that’s the lowest priority and until the top two are satisfied, he shouldn’t spend extra insuring. He still had unpaid consumer debt (1) and an unfunded Roth (2), so expensive cash-value insurance should’ve stayed relegated to the back seat until 1 and 2 were satisfied.

Why are these ranked in that order? It’s as simple as asking which advances your net worth in the most surefooted manner:
1) By saving interest, debt-repayment dollars are guaranteed to increase your net worth, from day one; 1) investment dollars may do the same, depending on transaction costs and how invested (it could go down);
2) insurance dollars (for most people), decrease your net worth because transactions costs are the highest of the three and for most the insured peril does not occur.

For this client, these dynamics were extreme. His most expensive debt was at 11% interest and the cash value policy he bought, after three years’ premiums totaling almost $10k, had a surrender value of only $2000. In defense of the insurance sale, the doctor did not have this high interest debt when he bought the policy. Incriminating the sale however is that the company sells other policies building cash values much quicker. This was clearly commission driven.

No sense in cursing the darkness (caveat emptor), so how could this client have avoided this mistake? By stopping to put the decision at hand in its broad category. Insurance should be third tier in the scheme of financial priorities.

An agent will try to make it first tier… so expect it. Your emotions will also lure you to give it a higher priority than appropriate. Seldom do emotions lead well in finances.

If you relegate insurance to the back seat, you’ll make better decisions. There will be some exceptions, and that they are …exceptions, not the rule. Postpone them or deal with them a cheaper way (term insurance), but hold fast that pecking order.

What might that look like? Higher deductibles, not insuring old cars for collision, skipping dental insurance for most people, term life insurance often at smaller amounts, tinier long-term care policies or none at all, recognizing that self-insurance is the cheapest form of insurance and not insuring that which you can pay for yourself.

It’s not just that insurance is so bad, but that other options are so priority. You can’t do it all. Tenaciously keep right priorities: honor God with the tithe, be at least somewhat generous to others as you’d want done to you, avoid debt like the plague (and aggressively work to get out of it), keep a reasonable emergency fund, fund your matched 401k and maybe a Roth.  This will likely moderate your use of insurance and help you come out ahead.

Value (Routinely) Added – Case Study #3

I finished a case this week that bears out an important point: many who come to me for insurance advice walk away with something they didn’t expect; frequently it’s more valuable than what they came for.

This client is a UPS pilot considering long-term care insurance and wanted me to look over his life insurance as well. Like a lot of pilots he had a military background and already connected with a good insurance company, USAA. He got a 20 year term policy at preferred rates 6 1/2 years old so he could not improve upon it. Then the question of long-term care insurance became the focus.

As we reviewed his overall financial picture, which is something I always do, his most glaring deficiency was using a home equity line of credit (HELOC) to buy his house. He did not currently have any equity. Furthermore, he had a $30K loan from USAA at 3.25% and the cash was just sitting there as an emergency fund. It made him feel comfortable, though he almost never used it. He had a very high monthly take-home paycheck, and like a lot of high income people he had gotten a little loose in his spending habits.

My first recommendation was to pay off this unnecessary loan which was costing him over $80 per month interest. Recommendation number two was to carefully track all expenses for his two months to reveal where his money was going and what could be cut out to build up his emergency fund. His debt service for the USAA loan was $450/month which we committed to build the emergency fund with the goal of quickly growing it to one-month’s disposable income. After this he will pay off 20% of the HELOC loan so he can get permanent financing on his house and not have to pay private mortgage insurance.

We put the long-term care insurance on hold (see Debt-Free is Stronger than Well- Insured post) until we get on a sound budget and debt repayment plan. Interestingly USAA discouraged him from repaying the loan even though he rarely used it. (They have an agenda too.) If he has an emergency that exceeds his currently-too-small emergency fund, he can put it on a credit card. No sense paying interest to have a fund for an emergency that may never occur.

So the agent promotes long-term care insurance (a low priority); USAA promotes an (unnecessary) loan, and that’s the nature of commerce: everyone is trying to get him to buy something, when the real secret to his financial advancement is to cease buying anything (insurance included) while he pays for that which he has already bought (his house).

This client got a benefit he didn’t expect and will receive a 160% annual after-tax return on the fee he paid me just for the debt repayment idea, aside from another handful of ideas.

Debt-free is stronger than well-insured: Case Study #2

Clients typically have two or three primary objectives, each of which is in tension with the others: they may want to get out of debt and save for retirement, or they may want to be sure their insurance is adequate and build up their emergency fund.

The nature of economics is the distribution of limited resources, and every dollar spent on insurance means one less dollar available for debt repayment. Each of these goals may strengthen you financially and both can be done simultaneously, but the resources that go to one cannot go to the other. The real question is often which should be emphasized and which should be deemphasized. It is from this tension that we get the title of this blog.

Being well-insured has a possible advantage:

  • if the precise event insured against occurs, an amount of money will be paid.

Being well-insured has risks:

  • the insured event frequently never happens and much premium is wasted.
  • This means that every $1 spent on insurance tends to yield less than $1 return (for term life insurance, it’s $.05)

Being debt-free has a guaranteed advantage:

  • saving interest.
  • If you die, are disabled, or have a salary reduction, it helps to have no payments.

Being debt-free does not have the risks cited above:

  • you always save money, regardless of what contingencies materialize in the future.
  • every dollar spent on debt tends to save a $1.20, after accounting for interest saved.

Many people have liberally bought insurance and then lost their jobs, to discover their insurance didn’t help at all. (Can you spell “Maginot”?) On the other hand many who were debt free have been able to weather a variety of financial storms: disability, death, a layoff, or shrinking real estate values.

How does this translate into the real world? I’m working with a California couple both about 50 years old with two independent children. Husband and wife each earn about $70,000 and their chief concern is a $200,000 mortgage.

Currently they each have a $250K variable life policy. Additionally, they each have 10 year term policies: $200K on him and $150K on her, for a total of $450K on him and $400K on her. Their goals are to pay off debt, save for retirement, and optimize their insurance.

How much should they carry? What about $250K each, just enough to pay off the mortgage and bolster the emergency fund? The survivor is debt-free, gets a $50,000 emergency fund, and has a reasonable ongoing salary. The wife (typically more security-oriented) may want $350K on her husband. We can always justify more, but that translates into less for debt repayment, and I’m keenly aware that 95%+ of term policies end up in the trash can.

This is the emphasis you don’t typically get from a sales agent and this couple’s decision will largely hinge on their emotional comfort with an amount reduction. Many don’t want to reduce coverage (see Sharon Baergen on our Testimonials page) and that’s fine too. However at least they get the nudge toward what’s likely to strengthen them most, since being debt-free is some of the best insurance one can have.

What does an Insurance Checkup look like? Case Study #1

For those interested in how life insurance checkups work, I thought I’d provide some case studies. The first one is on Brenda, a physical therapist in New Jersey. She came to me after her recent divorce with doubt about whether her current life and disability policies were optimal and would do what her agent said they would (be paid up after ten years). I spoke twice with the agent who had some strong ideas, and she wanted an objective opinion. She had nine policies with four companies, more than most clients.

The first thing we did was assess her overall financial picture and need for insurance. It was simple and straightforward: one daughter almost through college, a small mortgage, healthy 401k and income. She had been sold policies at major life events, mostly with Metropolitan: birth of her daughter, purchase of a home; bought an ING term policy to replace the voluntary payroll deduction term at work; individual disability policies with Unum, Paul Revere, Provident.

Base on her stated goals and in light of an almost independent daughter, low debt, and healthy 401K, she needed about one third the amount of life insurance she had. Interestingly she didn’t realize how much she had until I totaled it up. She described herself as a “worry wart” and had collected along life’s way more policies than needed. The agent had done a good (or poor, depending on which side of the fence you’re on) job regularly promoting the cause. A heart murmur that developed since the purchase of most precluded her from getting better policies (Met is not the best, but not the worst either), so from there it was a matter of discerning which to keep or jettison.

After studying my Life Insurance Needs one page summary/overview, she wanted to keep $100K-150K ongoing, and an extra $100K until her daughter was totally independent, about three more years max. That was more than needed from my assessment (because of other assets- she is really well-managed), but that decision is more emotional than most folks recognize and she’s a mom, not a businessman. I state my case, but then respect the emotional aspect of the decision and help the client figure out how to best achieve their wishes.

I obtained in-force ledgers from Met to see how the premiums, dividends, and cash values of each of her three permanent Met policies grew: one universal life, one variable universal life, and one whole life policy. The whole life was best and the mortality costs within the UL were lower than within the variable UL. It was also lower than within the ING term policy which is rare, but the heart murmur made the ING (the most recent purchase) rate her, skewing those costs.

We dropped the ING term and Met variable UL; kept the whole life (indefinitely) and the Met UL (for three years). The UL was underfunded and on schedule to expire well before her normal life expectancy, a common problem among those type policies (which many don’t recognize, but need to). We reduced its death benefit from 150K to 100K and the death benefit option (from increasing to level) in order to reduce internal mortality costs. After these changes it will serve well as a three year term policy.

Her disability policies were both good, but she has group disability through work, so we dropped the poorest value of the two (and the smallest) today, and the other as soon her primary mortgage is paid in 13 months. They were only 1100/mo and 300/mo benefits anyway.

She now knows her whole life will not be paid up as soon as she had thought. This was due to dividend rate declines which have occurred industry wide. I encouraged her to accelerate paying off her 7% mortgage (only 13 months left; too little to justify refinancing) and we came up with several sources to do so. As a financial planner and investment advisor, it’s rare I don’t come up with additional recommendations beyond the scope of insurance.

She should recover the fee she paid me in 9.5 months and then save it again each year for the next 15 years, over a 125% annual after-tax return on her fee. She was under no pressure to buy anything. She now has peace of mind things are optimized and simplified. For a worry wart this is important.

How to Best Care for your Future Widow

Buy more life insurance, build the emergency fund, accelerate the mortgage, or fund a Roth? Which is likely to help her more? The answer will surprise you.

We are more emotional than we would like to think, especially when it comes to fear-driven issues like life insurance. It leads to overbuying: a $1,000,000 policy when $500,000 would do, $500,000 instead of $250,000, or $250,000 instead of $100,000. It may be motivated by the noble intentions of a husband, the anxiety of a wife, or a respected authority’s rule of thumb to buy 8-10 times salary in life insurance.

It’s often accompanied by unawareness of other survivorship benefits like a death benefit under a pension plan, or a reluctance to rely on benefits like Social Security Survivorship benefits. Agents whose compensation is a percentage of premium collected are more tempted to fan those embers of fear than explain to their clients how they are insured already, how unlikely they are to get a return on their premium dollar, or alternative uses of those dollars.

The paradox of overbuying is that, while creating an illusion of security, those expansive decisions rarely help the family. Well over 95% of 10-, 15-, and 20-year term policies expire before the insured does. They are paid for over their term and then thrown in the trash can. It’s somewhat like playing the lottery: a bad bet.

On the other hand, a man’s wife is likely to become his widow. Men on average die five years before women and their wives are sometimes younger than they are. How do they address this need?

Ironically it’s not through buying more term life insurance. First look at some simple probabilities. These are tapes that are always running in the back of my head when advising clients on life insurance.

For each $100 paid in, what are you likely to get out after 20 years?

Paid In Received Out
Term life insurance $100 $2
Emergency fund $100 $100
Mortgage prepayment $100 $150
Roth- Sector Rotation $100 $300

What’s the source of these numbers? A $500k 20-year level premium term policy costs $375/year for 20 years totaling $7500. After commissions, state premiums taxes, company overhead and stockholder profits, and compounded at 4%, it cannot on average pay more than this. The emergency fund doesn’t earn much at today’s rates, so you essentially get out what you pay in. A typical mortgage rate, after the tax deduction, costs about 4% compounded for 20 years.

The Roth IRA numbers assume a 10% return. This would be low compared to historic Sector Rotation returns. Many Sound Mind Investing readers haven’t used this more volatile strategy and doing so with a dollar cost averaging approach over 20 years may be a good way to begin. Or one could use SMIFX. It may take a while to get up to the minimum fund requirements.

Here is what I’m getting at: Paying $50/month rather than $100/month on term and putting the difference in one of these alternatives, it is likely to benefit your family 50 to 150 times more!

Example – Suppose a 50-year-old husband after a careful assessment of his “should-I-die-today” scenario, could save $50/month in premiums, either by reducing or getting a less expensive policy. Compounding $50/month savings for 20 years, and then compounding that total another 10 years without further premium contribution (this puts him closer to normal life expectancy), equals $103k in a Roth for his wife’s (or his) ultimate use, versus a term policy in the trash can. Which do you think would mean most to his future widow?

(This first appeared as a guest blog on Sound Mind Investing Editor’s blog, February 4, 2011.)