Debt-free Is Stronger than Well-Insured Case Study #2

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Clients typically have two or three primary goals, each of which is in tension with the others: they may want to be debt-free and save for retirement, or they may want to have adequate insurance while investing adequately too.

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 many 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.  From this tension, we get the title of this blog.

Being well-insured has a possible advantage:

  • if the precise event insured occurs, proceeds will be paid.

However, being well-insured also has risks:

  • most term policies expire before the insured does, so much premium is wasted.
  • This means that every $1 spent on insurance tends to yield less than $1. Most people pay more into insurance than they get out of it.

Being debt-free has a guaranteed advantage:

  • saving interest.
  • Regardless of which contingency arises (death, disability, or losing a job), it helps to not have debt payments.

Being debt-free does not have the risks of carrying insurance 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.

For example, many people buy insurance and then lose their jobs… to discover insurance doesn’t help at all.  Insurance is often like France’s Maginot Line, not only ineffective but also so expensive to maintain that it results in underfunding other priorities.  On the other hand, those who are debt free can better weather a variety of financial storms: disability, death, layoff, shrinking real estate values, etc.

How does this translate in the real world?  I’m working with a 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 have term life insurance of $450K on him and $400K on her.  Their goals are to pay off debt, save for retirement, and optimize their insurance.

How much LI 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 (often more security conscious) may want $350K on her husband.  We can always justify more, but that means less for debt repayment.  A major tape running in the back on my mind is that 95%+ of term policies end up in the trash can anyway.

You don’t get this emphasis from a sales agent and this couple’s decision will largely hinge on their emotional comfort with an amount reduction.  Some don’t feel comfortable reducing coverage and I respect that.  However at least they get the nudge toward what’s likely provide the best long-term return.  Being debt-free is some of the best insurance you can have.

 

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

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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.

The Paradox of Insurance

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Moderating or even skipping life insurance can strengthen the widowhood most wives will experience, if those premiums are invested well.  Doesn’t seem right?  It’s a paradox.

There are many economic paradoxes: using a home equity loan to get that new car or vacation “you deserve” ends up reducing long-term life style, raising tax rates decreases total government tax revenue; sponsoring welfare kills personal initiative and fosters generational poverty; lowering lending standards to encourage home ownership creates a housing crisis.

Wouldn’t it be nice if we could trust our instincts to do the right thing?  We can’t.  Since most people pay more into insurance than they receive from it, astute consumers use it sparingly not liberally; and as soon as they can responsibly afford to, they’ll not use it at all.  That’s why Larry Burkett said, “Don’t insure that you can afford to pay for yourself”.

Recently a well-intentioned 61-year old husband called about buying a $250k 15-year level premium term life policy for $1250/year.  The actuarial tables say the chance (after screening with an exam and blood work) he will die within 15 years (by age 76) is highly unlikely.

Normal life expectancy is young 80’s for men, comfortably (for the insurer) beyond the reach of the 15-year level period. Think about it: how many $250,000 claims can they pay collecting $18,750 (15yrs x $1250/yr)?  After 15 years, at age 76, the premiums explode as he approaches normal life expectancy, forcing most policyholders to discontinue.

Many people play this game, speculating on a premature death for a segment of time ending well before normal life expectancy, (age 61-76 in this example).  Somewhat like the lottery, it’s a loser’s game.

Our imagination is often our enemy.  In this case they just had a close family member die from an accident.  With this fresh in their mind, their most easily recallable fear lures them to a plan unlikely to deliver.  She is likely to become a widow, but not in the next 15 years.

Here are some things to get firmly in mind:

  • How well are you self-insured? Get a handle on Social Security widow’s benefit, 401k assets, support from children, etc. “The cheapest form of insurance is self-insurance.”
  • Know what normal life expectancy is, considering your health, etc.
  • Know what future term policy premiums are after the level period.
  • Know the opportunity cost. Figure what premiums would accrue to if invested for the same duration.  Consider a Roth IRA.  Investing that cash flow at 8% grows it to over $50k by his age 81 normal life expectancy.  This is what the policy will likely cost her, i.e. the opportunity cost.

Many people bought level term policies 10,15, and 20 years ago who have exhausted that period and now must decide to let it go or re-up.  Often what made them buy that duration has been accomplished: the kids are independent, the mortgage has been paid, the 401k has grown…but they feel they need a little more time.  What to do?

Re-upping appeals because it creates an illusion of addressing the problem…for a low monthly outlay.  But it’s more illusory than real and for most it’s just kicking the can down the road and at 76 (in this example) they’ll be facing the same decision, but at much higher premiums.

Rather than taking the easy way out, it may be time to do some serious soul searching:

  • Do you have any inheritance coming?
  • At your death where will your widow live? If she moves to be near kids, what will housing cost there?  Will downsizing release equity for income?
  • Seriously consider not taking Social Security until your age 70, which will make her lifetime pension larger.
  • Have a heart to heart talk with your kids. What kind of support might mom expect from them?  I know you “don’t want to be a burden”, and you won’t unnecessarily, but the family unit is the oldest form of insurance, so don’t ignore it.  (This answer impacts the Long-term Care insurance decision too.)
  • Take a pulse on your wife’s fear and contentment level. The more content she is, the less you may have to dissipate on insurance today, the more you can invest, and the better off she’ll like be. If anxiety compels you, try to think like an actuary, and see if you can achieve unity in this delicate decision.

Most advice is given by commissioned agents who are happy to sell a policy.  They will not point out these weaknesses, nor advantages of alternative uses of premiums.  The commission is $900 if you buy, and nothing if you don’t.

Don’t insist on a perfect contingency plan for an unlikely segment of time.  It’s a contingency plan, not a probable plan.  Insisting it be perfect (“comfortable”) today, robs resources and usually leads to less financial margin in later years when health care and other unknowable’s may need it most.

How to Best Care for Your Future Widow

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Let’s say you’re in your mid 50’s, the kids are leaving the nest, the mortgage is nearly paid, and the 401k has grown well.  Your financial position isn’t where you want it, but it is within striking distance.

But you’ve also lost a parent or two, and the brevity of life is coming into clearer focus.  You consider the final quarter and envision your wife as a widow, as statistics say most women become.  You can buy a 20-year level premium $250,000 term policy for only $100/month to bridge the gap while getting closer to Social Security age and completing financial goals. Is that a good idea?

Or is there a better use of that money, say to accelerate the mortgage or fund a Roth?  Which is likely to help her more?  Let’s see how it usually plays out.

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.  It may be motivated by noble intentions of a husband, anxiety of a wife, or an agent.

It’s often accompanied by unawareness of other survivorship benefits like a death benefit under a pension plan, or how the 401k could bridge the gap to 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 insurance premium dollars, or alternative uses of those dollars.

The paradox of overbuying is that, while creating an immediate 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 trashcan.  Like playing the lottery: a bad bet.

On the other hand, your wife is likely to become your widow.  Men on average die five years before women and their wives are sometimes younger too.  How should you address this need?

Ironically, it’s not necessarily by buying more life insurance.  Look at some simple probabilities.  These are tapes that are always running in the back of my head when advising clients on life insurance.

What will $100/month, directed three different ways, likely become by the time our 55-year-old dies?

After 20 years: In another 10 years, near normal life expectancy
Term life ins. 90%+ get nothing
Prepay 4% Mortgage $36,000 greater house equity $53,000
Roth IRA @ 8% $59,000 $130,000

This example considers a male in his mid-50’s, buying a $250k 20-year level term policy for $100/month, or using the same amount to prepay the mortgage, or fund a Roth.

Compounding $100/month savings for 20 years, and then compounding that total another 10 years without further premium contribution (puts him closer to normal life expectancy), equals $130k in a Roth for his wife’s (or his) ultimate use, versus a term policy in the trash can.  Which better cares for their likely future?

 

(This is a revision of a guest blog on Sound Mind Investing Editor’s blog, February 4, 2011.)

America, the Colossal Example

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We’ve talked about how we are creatures of fear, how fear can move us to idols, and how idols levy a heavy toll. Insurance can become an idol. Because this is rooted in the human heart, you see it played out at different levels. Let’s look at a macro and micro-level example.

You hear a lot about the debt, but one of America’s greatest economic challenges is insurance: Social Security, Medicare, and now national health care. Each has enormous overhead. Consider our move to national health care. Already private health insurance has been the greatest facilitator of inflated health care costs, encouraging provider greed and consumer abuse. Now we want to take it to a new level, with incomprehensible overhead to boot. (Can you define “insanity”?)

What would address the real problem at its roots is moving oppositely: rather than bolstering insurance, unraveling insurance.

Simultaneous with this harmful expansion, we are borrowing trillions we cannot repay. So we have two mega forces working against us. Massive insurance plans whittling down every dollar that goes through them by the overhead inherent in any type of insurance; along with interest that makes every dollar cost two.

Now consider the same dynamic on a micro level. For about ten years I worked with a school system on its group benefits. Frequently I would see teachers paying $30-40/month for Short Term Disability insurance, with another significant amount going to credit card interest. This was two slow bleeds each month: premiums and interest.

Because they spent on premiums money that should go to emergency fund, when an unexpected event occurred (new tires or washing machine) it had to go on the card (meaning even more interest). Then because they had this credit payment they were afraid to drop the insurance. (Fearing if sick they couldn’t make payments). One fueled the other.

Why this dual damaging dynamic? Many bought the insurance because of how it was promoted: “What would you do without a paycheck?” However once reminded of Sick Days, the ability to borrow from a retirement account, and the likely poor return on the insurance, they had a different attitude. Many dropped the insurance and redirected premiums to credit cards. Carefully thinking about how they were insured already allowed them to jettison extraneous insurance, pay down debts, and build emergency funds, which allowed them to stay debt free.

Uncle Sam should do the same.

There is a corollary lesson here. The source of advice on how to best use insurance made a big difference for these teachers. The purpose of Impartial Insurance Advisor is to offer an alternative source of high quality, experienced advice from someone not under the influence (of commissions).