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.

Collecting Multiple Life Insurance Policies Leads to Redundancy and Waste

Do you own several life insurance policies? People tend to buy policies piecemeal in response to life events like the birth of a child or an agent’s sales pitch. Collecting life insurance policies is often uncoordinated and inefficient. Just having multiple policies, each with an annual policy fee, and missing volume discounts of larger policies is costly. How do I know if I have too much life insurance and am wasting resources?

Most consumers think this way:
• My agent recommended it; it seems reasonable.
• We are expecting our first child! It seems time to buy.

A proactive consumer thinks this way:
• I’ll get objective opinion from someone who does not sell policies.
• I’ll engage someone familiar with the entire insurance market, rather than primarily representing one company.
• I won’t allow my worst recallable memory to become my baseline (e.g. an uncle who died young), but I’ll think in terms of probabilities.
• I’ll consider the opportunity cost of premiums if invested elsewhere.

Case Studies: The Pastor and the Doctor

I just finished two cases, one for a 65-year-old doctor with no dependent children and the other for a 32-year-old pastor expecting their first child. Despite having good companies (USAA, State Farm, and Northwestern Mutual), they both improved a lot. Insurance consumers can profit from a gatekeeper. Instead, most rock along leaking significant resources month after month, year after year, unaware of how much they could save.

The young pastor had a $100,000 20-year level premium State Farm policy that was 8 years old (12 years left of level premiums) costing $24/month (not a good buy), a 100k term life policy provided by his church, and had just been sold a $750k Northwestern term policy.

I directed him to socialsecurity.gov/myaccount to see what survivorship benefits his child and wife would get at his death: about $2400/month. He was ignorant of this, which is a shame that something so relevant to an insurance purchaser is rarely addressed by an agent. Social security survivorship benefits for him are essentially equivalent to a $500,000 term policy.

He replaced the State Farm’s 100k and NML’s 750k term, with a 500k personal policy. 500k with the 100k through work buys a nice house near family, a 100k education fund, and a 100k emergency fund. With no mortgage and liberal savings to replace a car, etc., Social Security will pay the bills. She’s a teacher who could work once their child is school age.

We talked about the low probability of death within 20 years, which makes for better choices than a fear-inducing (What if…?) sale’s pitch. This improbability translates into a high probability of “wasting” those premiums. We considered the opportunity cost compared to putting more of it into a Roth or accelerating the mortgage. The insurance amount respects the wife’s emotional temperament.

The Northwestern term cost $407 first year, growing to $1200/yr by the 20th year. The new policy costs $316/yr guaranteed level for 20 years. He dropped the State Farm and Northwestern, the doctor dropped the USAA, big name companies that are strong in property and casualty and cash value policies, but not term insurance.

The Potential Savings

This 32-year old initially saves $32/month, which may not seem like much. However, in a Roth using a Sector strategy, it could grow to $25,000 by their baby’s first college year, or over $1 million in 50 years, his normal life expectancy. Rather than buying excessive insurance paying only in the unlikely event of death within 20 years, savings are redirected towards life events that normally occur.

The doctor had collected a hodge-podge of life policies over his career. We started with an income goal for his wife and saw he was over insured. I evaluated each policy (NML and USAA cash value and AMA term), and he began dropping the poorest and keeping the best. This will save $400/month from the first three, plus more from the one Northwestern he kept but modified. His health is good.

I guarantee clients save my fee back within 18 months, a 60+% return. This doctor saves it back in less than three months. Please see Testimonials. I’ll give an initial interview free. Call me at 706-722-5665, or email to talk about your situation.

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.

 

 

 

Life Insurance You May Not Know About Defined-benefit Pension Plan In-Service Death Benefits

If you participate in a defined benefit pension plan it can dramatically reduce the amount of life insurance you need.

Few employers sponsor this type of pension plans these days, however they are still typical for government employees, military, school systems, utilities, and some large employers like IBM, UPS, Lockheed Martin, et al.  DB plans remove classic retirement challenges like stock market volatility or living too long. but they require decisions of their own, such as which survivorship option to elect or should I buy back years if eligible?

I once helped a school administrator, under the Teachers Retirement System of Georgia, make some decisions at his retirement: which survivorship election to make and what to do with his voluntary term life insurance.  He had worked for the school system over 30 years, and the formula for his pension was number of years of service, times 2%, times highest salary in the last two years which is typically the final salary. Most DB pensions have a similar formula.  He didn’t elect a survivorship benefit, because he was in good health, had significant assets, and most importantly his wife was a schoolteacher with over 30 years of service and entitled to her own pension.  This gave him the highest lifetime income.

He had carried voluntary term life insurance by payroll deduction most of his career, which ended at retirement. and wanted to know what to do about it.  Premiums were no small amount, about $200/month.  It started out cheap and convenient: just check the box and its payroll deducted.  The danger of payroll deduction is out of sight out of mind. He’d elected five times salary, and as his salary and age crept us, his premiums followed.

As we probed into the details of his pension, it became clear that had he died since the time he had been vested (after 10 years of service or for the last 20 years!) his named beneficiary would have received a lifetime income.  This is an “in-service death benefit”– the benefit paid to the employee’s beneficiary if the employee dies during their working career, after they are vested but before they retire.

This man had a high salary and great number of years of service, so his survivorship benefit was equivalent to a substantial amount of essentially hidden life insurance, well over $1 million. In other words, it would take $1 million invested at 5% to generate the lifetime monthly income his beneficiary had been entitled to.

Let’s consider a teacher making $40,000/year working for 15 years.  If they died, 30% of their salary (2 X number of years of service) or $1,000/month would go to their beneficiary for life.  How much life insurance does it take to generate this much income?  $250,000 of life insurance, invested at 5%, yields about $1000/month. In other words, this in-service death benefit is like owning a $250,000 life insurance policy.

It stands to reason that such a benefit would exist, for the employer pre-funds the DB pension over many years which creates a value which doesn’t disappear in event of the participant’s early death. The more popular 401(k) pension plan balance simply goes to the named beneficiary in a lump sum, while the in-service death benefit goes to the DB beneficiary.

Most participants in defined-benefit pension plans are unaware of this. Adding insult to injury, many sign up for voluntary term insurance which ends at retirement, and it only duplicates the in-service death benefit under the pension.  That premium could be accelerating the mortgage or funding a Roth for a definite future benefit, instead of renting term insurance expiring at retirement.

The point is simply that if you participate in such a plan, call human resources and see what income your beneficiary is entitled to should you die before retirement. Translate this into the amount of life insurance it takes to generate this income and it should reduce the amount of life insurance you carry.

When you call HR also find out the rate schedule for your voluntary term policy’s future years so you can compare it to a level premium term policy.  Employer sponsored voluntary term is usually not a good buy for a healthy person.  It’s often offered on a guaranteed issue basis with no or minimum underwriting required.  An individually underwritten policy requires a physical, blood work, etc., while the group term does not (guarantee issue; “just check the box”), so its rates are higher.

Lastly, rates for term through work usually increase every five years, versus 10, 15, or 20 for a personal policy.

Don’t bog down in comparing rates until you first fine tune the amount of coverage considering the hidden life insurance from in-service death benefits and other assets.  “There’s nothing more wasteful than doing efficiently that which shouldn’t be done at all”, says Peter Drucker.