Why I Disagree with Dave Ramsey’s Insurance Advice (Part 2)

After writing Part 1 of “Why I Disagree…”, I got a call from the 32-year old dad with the infant daughter, addressed in Part 1. Here is why he would have been better off skipping life insurance when single.

This young couple have been renting for $900/month and want to buy a modest house for $130k.  Buying a house is part of raising a family.

Here’s the financing package:

House costs $130k.  He needs to only put down 3% as a first-time homebuyer.  $126k mortgage @ 4.25% for 30 yrs is $620/mo (principal and interest), $162/month property tax, $48/month PMI (private mortgage insurance), $100/month for property insurance, totals $930/month, what they’re paying in rent.

I suggested a 15-year mortgage for a lower interest rate, save on PMI, saves a ton of interest, and doubles as an education saving plan for their baby girl who will be going to college about then. This will be a huge help in their future.

Here’s what a 15-year mortgage looks like:

$126k mortgage @ 3.875% for 15 yrs is $924/mo (principal and interest), $162/month property tax, $36/month PMI, $100/month for property insurance, is $1222/month, about $292/month more than the 30-year mortgage costs.

The 15-year mortgage is the better path, but the payment is higher and being able to swing it often hinges on how you’ve prepared.

15-year mortgage vs 30-year:

principal interest payment PMI Total savings Total lifetime P&I payments
30 yr @ 4.25% 174 446 620 $48/mo $223,000
15 yr @ 3.875% 518 406 924 $36/mo $166,000
  $40/mo $12/mo $52/mo   $57,000

What difference does it make?

Notice they pay down mortgage principal by three times as much with the 15-year plan, because the payment is higher and interest rate lower.  Also, not only is PMI less, but it can be dropped sooner when equity is at least 20% of house’s value.  They’ll save $57,000 of interest, half the price of the house!

They’ll pay it off two years before their daughter goes to college, can sock away $10k/yr for those two years and have $924/mo freed up for college tuition and a wedding, while the 30-year mortgage holder plods on with none of these funds.

How does this relate to Dave’s life insurance advice to singles: “The younger you are, the more affordable term life insurance is, so there’s no reason to wait until you have a family to get insured”?

One’s ability to avail themselves of the superior 15-year plan hinges on whether they are still paying on school debt and/or the size of their down payment.  The $300/month difference may be the college loan they are still paying … or aren’t.

Not only did buying life insurance when younger not save premiums, but it’s those sorts of decisions that undermine one’s ability to take the 15-year path.  Those premiums should have gone to school debt or a house down payment, rather than life insurance when single and without dependents.

Making a 10% Rate of Return by Paying Premiums Annually

Many people pay monthly, quarterly, or semi-annually for things they could pay annually.  Consider an insurance policy costing $1000 annually or $87.50 monthly.  How much does it cost to pay it monthly?  In absolute dollars, it’s an easy calculation: twelve $87.50 payments total $1,050 or $50 of annual interest.  But if I have at least $1,000 in savings, the question becomes, “Should I tap savings to pay annually and save $50, or should I leave savings undisturbed to earn interest?”  What does the $50 savings translate into as an interest rate and how does that compare to the rate of return I’m earning on savings?

At first blush one might think paying monthly costs about 5%, since $50 divided by $1000 equals 5%.  However, the outstanding balance to the insurer reduces each month.  Initially it’s $1000, but by year end it’s only $0.  So, the average outstanding balance for the year is around $500, making $50 closer to 10%.  Paying annually effectively saves about 10% on the money you must withdraw from savings to pay annually.

A financial calculator reveals the exact annualized interest cost for this example to be 10.8 %.  But it gets better!  Because interest must be paid with after-tax dollars, saving it is like earning 10.8% tax-free; whereas a 2% money market return, after federal and state income taxes, nets less.  I can effectively multiply my yield five times!  The bottom line is if I have enough in savings to pay annually, I’ll gain a lot more saving finance charges than earning a low taxable interest rate.

If you don’t have a financial calculator and want to know how this relates to your situation, do like we did in the above example: Multiply the monthly payment by 12 to see how much extra you pay vs paying annually ($50); divide this by the annual payment ($1000); double the resulting 5% to 10%.  This will give you a percentage factor.

I wrote this article years ago when one could earn 5% on money market accounts, to show that saving 10% finance charges was a better use of savings.  Since then money market rates have declined, while finance factors with many insurers stayed the same, making the advantage even greater.

For insurance policies, typically you can change to an annual payment mode even if you’re not at the policy anniversary.  Simply ask the company how much is needed to pay to the anniversary.

If you pay annually and decide to drop a policy midyear, typically insurers will refund unearned premium.  You can confirm this when changing to annual mode.

Remember that we are addressing a fine-tuning process for after you’ve addressed more consequential issues such as these:

  • Do I even need this product or service?
  • Is this the best buy, the right type of coverage, the right duration, etc.

There is also a behavioral dimension that can trump saving finance charges.  The discipline of systematic monthly withdrawals from checking is huge.  If you take the annual payment from savings, it’s important to make monthly payments back into savings.  If you spend even one of these, you will more than unravel the interest advantage you have realized.  Automation beats procrastination!

Saving $50 of interest on an insurance policy may not seem significant, but over many years adds up.  Financially successful people often think in terms of percentages, not just absolute dollars.  Moving savings from earning a taxable 2% to saving an after-tax 10% is a dramatically better use of dollars.

 

Is Whole Life Viable for Anyone? New Policies- Rarely; Old Policies- Sometimes Case Study #14

I’m wrapping up a case that illustrates some guidelines applicable to many.  This client is smart, financially gifted, well managed, mature, but he made a decision five years ago regarding a whole life policy which he is reconsidering and sought my advice.

The issue of “whole vs. term and invest the difference” is something I cut my teeth on 40 years ago when entering this business as a full-time life insurance agent with Northwestern Mutual, and I became adept at promoting whole life’s virtues.

The debate is done best when refined: the best cash value insurance vs the most competitive term with the difference invested most effectively.  This client had a whole life policy that is superlative for two reasons:

  • Northwestern provides probably the best whole life value in the marketplace. (That’s why I spent 15 years selling them.)
  • The heavy front-end load has been paid on this one, so it’s elite.

Jim is a 56-year-old electrical engineer, with a homemaker wife, grown kids, 1.25 million in 401k/IRA’s, healthy emergency fund, and no debt.  He’s healthy and thinks he’ll live to late 80’s (though stats say mid 80’s), but either way is 30 years.

Keeping an old policy, where the onerous initiation fee (commissions) have already been paid, is very different than the question of buying a new one.

As I typically do, I got an in-force ledger, and NML shows the rate of return on the premiums with respect to the death benefit with insured dying at various ages.

Ruminate on these a bit.  Early death yields the greater return (but the odds are low), death at normal life expectancy is mediocre, and at older ages is even lower.  Whether the normal life expectancy’s 5% is “good” or “bad” all depends on alternatives.  After all it’s likely a 30-year investment for Jim.

This puts before us, on a silver platter, the essence of the decision.  “Insurance” is a misnomer for the inevitable, since as my favorite line from Brave Heart goes, “All men die.”  For Jim 95% of the premium goes into investment and 5% for insurance.  The investment portion goes mainly into bonds and mortgages with inherently lower returns.  The mortality aspect costs more than a term policy.  Expenses are exorbitant.

What if Jim redirected the NML cash value and premiums into other investments?  What would they grow to by normal life expectancy of age 85?

Such a 30-year (long-term) investment lends itself to equities with higher returns, albeit higher volatility too, for three reasons:

  • Life insurance is a longer-term investment than even retirement funding.
  • The dollar-cost-averaging nature of how premiums are paid in over decades.
  • The high expense load of a whole life policy hits your net worth far worse than dollar-cost-averaging into the worst possible equity investing scenario, e.g. starting off at top of market bubbles like Dec. 1999 or fall 2007.

Let’s see what’s at stake.  The Northwestern policy would have a death benefit at age 85 of $500k based on the current dividend scale with dividends buying paid up additional insurance.

If its current cash surrender value, along with scheduled premiums were redirected to alternative investments over the same time, it would accrue to these:

Qualifications:  I assumed with “Same cash flow” scenarios that Jim bought a comparable amount of term insurance to replicate the NML death benefit in event of an early death, reducing the cash flow into the alternative investment.  Jim is self-insured through other assets so won’t buy a term policy, making his investing alternative numbers a tad better than what’s shown here.

In a sense, this is a definitive comparison, bending over backwards to help whole life win, because I’ve cherry picked an elite commission-already-been-paid policy.  You can’t go out and buy something this good.

The engine that drives this comparison is equity investing at 8-12%.  I have monitored returns from various investment strategies and these are realistic, even the 12% that may seem like a stretch, if greater volatility is acceptable, as it should be when dollar-cost-averaging into an investment over many years.

The difference is invested in Roth IRA’s because it mimics the tax-free nature of life insurance death proceeds.  (Roth’s are tax superior overall.)  In my early years there was no comparable tax rival and even today NML’s ledger shows total insurance rate of returns assuming a 28% tax bracket, inflating the actual rate of return.  This is irrelevant when using the Roth, a nail in the coffin of whole life.  The other nails are higher equity returns, lower expenses via no-load mutual funds and ETF’s, and cheaper mortality cost through level term policies, which can be tailored to degree needed, rather than yoked to the investment, as in whole life.

In Jim’s case, since he already maxes his and his wife’s Roth’s each year, he will begin to fund Roth’s for his adult kids.  This is vulnerable to being unraveled, so must be done carefully.  But it also offers the opportunity to educate your kids about beneficial investing principles, rather than passively paying money to an insurance company for decades, probably worth the risk for the future generation.

Why do consumers miss out on the better opportunity?

  • Consumers are responders rather than initiators. The industry has an army of agents promoting cash value insurance, whereas alternative better uses of money has few advocates and depends on consumer initiative.
  • It’s easy to miss the dramatic advantage of 8-12% vs 5%. Consumers don’t know how to carefully evaluate; they may not comprehend opportunity cost.

In summary, when I look at least doubling the result for heirs compared to a five-year-old whole life policy with a premier company like NML, I can categorically say whole life policyowners ought to do like Jim and rethink.

So, what’s Jim going to do?  Cash out his NML policy and fund Roths?  Not so fast.  There’s often some salvage value in an old policy.  Many advisors make sweeping disparagements leading clients to throw the baby out with the bathwater.

Whole life is a poor long-term investment, but an old NML policy cash value earns an attractive dividend interest rate.  It’s cash value of about 50k is about the same as Jim’s emergency fund currently earning 1.2%.  If he takes a paid-up policy, then without future premiums, the cash value grows by 3.5% each year (aside from a little extra death benefit).  Earnings are tax-free until he recovers the loss he has in the policy.  This liberates his current emergency fund for equity funds for those higher long-term returns.

Buying a new whole life policy is rarely a good idea.  What to do with an old one is best decided with experienced counsel.  Your current need for coverage, your health, knowing the real dividend interest rate on your current policy, taxable gain at surrender, possibly consolidating it with another life policy or annuity to not waste a loss, Roth eligibility, investing strategies… all influence this “rarely” and “sometimes” decision.

 

 

 

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.