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A hurricance of reactions to my Life Insurance Post! February 20, 2008

Posted by shaferfinancial in Uncategorized.
Tags: , , , , ,

Holy Smokes, lots of phone calls on my post about Cash Value Life Insurance!

Most were insistent that I prove my point on the investment value for life insurance.  But I have already run the numbers based on realistic assumptions and so have others and the outcome favors the life insurance contract.  So I have challenged myself to find a set of assumptions that leads to a different conclusion.  So here it is, enjoy!

Let’s look at two cases:

Assumptions:  The  S&P 500 Index returns one third what it has historically returned or 4% going forward.  Now lets compare putting $100,000 into a indexed universal life insurance contract as opposed to $100,000 into a low expense, indexed mutual fund.  Assume a 45 year old man in good health.  Further lets assume the mutual fund was in a 401K wrapper for tax deferral.  And finally lets assume a 15% marginal tax rate, the lowest possible which means they live in one of the five states that doesn’t have a state income tax. 

First the life insurance contract. In order for it to abide by IRS rules and avoid being a modified endowment contract it must be funded over 5 annual payments.  So we start with $100,000 make our first $20,000 payment and then put the balance of $80,000 in a money market getting 3%.

That buys us $400,000 worth of insurance which we index to the S&P 500 Index.

So if we die after 10 years we get $400,000. Our rate of return is 14.4%

If we die after 20 years we get $400,000.  Our rate of return is 7.2%

We live to our life expectancy of 80 and we get $400,000.  Our rate of return is 4.1%.

But wait you say, you can’t get to that money in a life insurance contract.

Wrong, you can access the surrender value anytime you want taking out policy loans.  At age 67 there would be $170,000 to access.

But there is more to this strategy.  You could use the interest earned in that money market fund you created to fund the life insurance to buy more insurance or you could just let it be.  After your five payments are made there would be $6400 in the account.  Let’s assume you took the interest and purchased an additional 20 year term policy with it.  You could purchase a $150,000 policy.  Remember, you will accumulate no cash value with this so it is just added protection which will add to your wealth before retirement if you don’t make it.

Now you have $550,000 if you die after 10 years.  Rate of  return is 18.6%

At the 20 year mark you die and you have $550,000.  Rate of return is 8.9%.

At 80 it would be the same (4.1%) since the term policy is no longer in force.

Now let’s compare that to the mutual fund.  Once again it is an index mutual fund tied to the S&P 500 Index with a very low overall expense ratio of .5% (average is 2.5%). The rate of return for the fund is 3.5% (4% Index rate minus .5% expense ratio).

If you die after 10 years you would receive $141,060.  But there are income taxes due (your heir has to pay it). We assumed the lowest marginal tax rate of 15% so you pay $21,159 in taxes and end up with $119,901 for an after tax return of 1.8%.  Not good!

OK, you live to retirement age of 65.  You have $198,979, but you gotta pay taxes on that so it reduces the amount to $169,132.  Your return is 2.7%.

You live to 80.  Congratulations!  If you have not used the account.  You have $333,359 in the account.  After taxes it is worth $283,355 for a return of 3.1%.

Let’s review:

                                      LI                                              MF

10 year R/R                 18.6%                                        1.8%

20 year R/R                  8.9%                                         2.7%

35 year R/R                  4.1%                                         3.1%

Available cash at 65   $148,000                              $169,132  

Bottom line is that you have significant better rate of returns from the life insurance at a cost of $21,000 in cash flow at age 65.  A toss up in my book.   

Let’s do this if the S&P 500 Index returns in the future what it has in the past because it dramatically changes the calculations.  Your marginal tax rate goes up to 25% because you have to withdraw an amount that puts you in a higher tax rate. You also have a estate tax problem that cost you if you leave it in the mutual fund until age 80.  All other assumptions stay the same, but the historical return of the index is 12%.

                                       LI                                         MF

10 year R/R                   18.6%                                  9.7%

20 year R/R                    9.6%                                   9.8%

35 year R/R                    8.5%                                   9.8%

Available cash at 65   $429,377                              $661,155  

So what I have done is to put the real numbers from insurance software against the best case of a mutual fund.  So, if you have a mutual fund with an expense ratio of .5% which is 2% below average and you never access it.  If you live to your age expectancy.  If the market returns the same as it has historically done. If you are in the lowest tax rate possible and live in a state with no state income tax.  And finally, if when you need the money the market is not in a down period then you come out ahead putting your money in a mutual fund.  If any of these things are different then you don’t.

So there it is, I believe I have made a case for the mutual fund over cash value life insurance!  Had to work hard to do it!

I think this demonstration answers the question, is cash value life insurance an investment easily.  It doesn’t answer the question which is best for you.  Only you can look at your situation and answer that.  For me, I have a large equity indexed insurance contract and still own mutual funds from previous employers retirement plans.  Although, I am starting to sell the mutual funds in favor of a single stock.  But that is a story for a future post!

PS I let my securities license lapse, so anything I have said should not be considered in any way or form investment advice.


1. Life insurance in Canada - February 21, 2008

Good job David, I see you are a true expert! It is a pitty that still many people are very trustful when dealing with life insurance and many agents are misusing their position just to get best rates for them. Anyway we in disability insurance Canada are trying to implement similar processes when dealing with life insurance, trying to make the best performance for customers, however there are often many misunderstandings with clients being too consevative. Communication is sometimes more inevitable than numbers…

2. traderpig - February 21, 2008

Dr. Shafer, thank you for your recent series of articles concerning how to build wealth. Some of the ideas are quite insightful and unconventional.

Some of my comments and questions:
1. Strategy #1: Cash value life insurance.
After reading your articles, it seems to me this is a good strategy for the already wealthy to build more wealth for their descendants? The problem with many curren situations is that many people are pushed by the insurance agents to buy these kind of products even before they could save enough for their retirement.

2. Strategy #2: Home equity harvesting
The bottom line is actually about “Investing With Leverage”. I believe the whole strategy should be implimented with the help of responsible professionals who understand mortgate, tax and especially investing. Stock investing is really risky sometimes, and it’s possible to lose your houses if you are not prudent with home equity harvesting.

3. Strategy #3: To employ but not to be employed.
Totally agree though it’s not suitable for everyone as you said.

4. What do the wealthy invest in?
“Think about starting a business that fills a niche. Think about investing in real estate. If you can find success in these two areas, then you are likely to join the wealthy or even the super wealthy! ”
I’m a starting-a-business and stock-investing guy and actully made some money in these 2 areas. I don’t know much about real estate invesing though I have some REITs in my long-term investment portfolio. I feel that building wealth by real estate investing is probably overated. It just looks “simple” to amateur real estate investors. Last but not the least, there’s a difference between what the wealth invest in and what they do to become wealthy ……

3. shaferfinancial - February 21, 2008

Thanks for your input. You have made some great comments.
I will try to answer your questions as best as I can.
1. Cash value life insurance is an excellent asset protection tool as you have noted. However, as I have demonstrated it is also a good tool for building wealth and managing risk. Although it won’t return what the market will, very few people get anywhere near market returns. So I think that there is alot to the strategy of reducing your overall market risk (risk= variance), managing the risk of death, and still getting decent returns. You also can access the funds and still have market gains, something you can’t do inside a 401K/IRA wrapper. Back when I didn’t pay cash for automobiles, I borrowed from my policy and paid myself back. Saved thousands of dollars in interest that would have been paid to a bank using that strategy.
Hope this helps clarify my thinking on cash value life insurance. Oh and the average life insurance salesperson has no idea how to use this product effectively or how to structure it correctly to maximize the investment side.
2. You hit the issue on the head with this one. My folks who take out home equity to invest never put it in the market. There are many safer places to invest, which guarantee principle. The numbers work without taking the risk of a down trending market, so don’t get greedy.
4. You hit another home run. Real estate investing is not easy, you need a mentor or a experienced professional to guide you. Fortunately, there are some out there. Between the tax laws and the leverage you can use, RE investing is far superior to any other I know. That is not to say that an individual can’t invest in other ways and build wealth, it is just harder in my opinion.
If you are interested here is the web site of a RE professional that can help folks with their RE investing:

Tell him Dave Shafer from “Uncommon Financial Wisdom” sent you and then tell me what you think!

4. traderpig - February 22, 2008

Dr. Shafer, thank you for the great comments. Your thoughts about RE investing certainly encouraged me to study it further.

5. jenista - March 9, 2008

Thanks a lot for best information on this site, it’s so useful for everyone who ‘s want to kown about it !!

6. david - October 29, 2008

Maybe this is just semantics, but I’m still not ready to insurance an investment. It seems more accurate to describe it as a “leveraged savings tool” or simply “leveraged savings”. In this example, you don’t have that $400,000, but you do have the $100,000. So, the insurance contract effectively leverages your savings. You didn’t have the risk of loss, which is why I would personally not use the term “investment”.

I had put together a few other objections to cash value insurance on my blog (http://www.twintierfinancial.com/the_uncommon_cents/2008/03/the-truth-about.html) that seem appropriate for the topic you have here. I don’t know if you’ve ever run into them or not. I hear them ALL THE TIME (which is why I finally sat down to write out a response to all of the critics). If it is not appropriate for me to reference this article, please remove it and accept my apologies.

I always enjoy reading your blog 🙂

7. david - October 29, 2008

My apologies, the link was cut off, it is here

8. shaferfinancial - October 29, 2008

Great link David. I thought it did a great job explaining permanent life insurance and taking on the critics. You are fully correct in staying away from calling life insurance an investment as insurance companies hate that because the SEC is really trying to take insurance products away from insurance sales people and limit them to SEC licensed individuals (indexed annuities). But I don’t think in terms of investment products, instead in terms of wealth building strategies. I believe EIULs belong in the arsenal of anyone having a serious wealth building plan. Unfornunately, many people get caught up in these straw man arguments pitting EIULs against mutual funds as you can see from the multiple comments on my blog. That is why I compare the two, not because I think they function the same way!

9. Titus Kleppinger National Agents Alliance - October 30, 2008

Great article – from one life guy to another – THANK YOU

10. Sean Carr - May 6, 2011

While I wouldn’t necessarily compare the two products, haven’t you left out the reinvested distribution of the index fund in your calculation? I believe the dividend yield is around 1.8% historically. It seems like there’s a good offering of very low load index funds such FIDELITY SPARTAN TOTAL MKT IDX ADVTG (FSTVX) with a load of 0.07%. No transaction fees as well.

shaferfinancial - May 11, 2011

Since I wrote that post my analysis has become more complex. While an insurance product will never be able to compete with a .07% expense ratio, the vast majority of people invest in 401Ks which have expense ratio’s averaging over 2%. The strategy employed by the insurance companies to derive the interest rate credit is significantly different than owning a indexed mutual fund [including dividends]. Historically the advantage goes to the insurance policy and is 1-2%, which can overcome even a 0% expense ratio. Thanks, as always your posts are thought provoking!

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