Having life insurance to cover yourself and your dependents is an important part of financial planning. Life insurance ensures that you, or your dependents, will receive some money to cope with the unfortunate loss of a loved one. This includes the income that the deceased earned for the family.
Life Insurance Is Important
For most of us, having some form of life insurance coverage would be a responsible thing to do. It is more important should we have family members like our children, parents or spouse who rely on our income.
There are two main forms of life insurance. Whole Life Insurance and Term Insurance.
Term insurance is a cheaper form of life insurance compared to whole life insurance. It is also easier to understand. You tell the insurance company how much coverage you want, and for how long. They quote you a price for the coverage, depending on your age and medical history.
You receive a payout only if something bad happens during the duration of the coverage, while the insurance is in effect.
Read Also: Why You Should Buy Term And Invest The Rest
Whole Life Insurance – Pay A Limited Period, But Enjoy Coverage For Life
One of the key value propositions for whole life insurance is the premium payment for a specific time period, with lifetime coverage.
Policy Assumptions: 29 year old female, non-smoker
The policyholder pays a premium of $1,876 each year in return for guaranteed life insurance coverage of $60,000. This seems expensive, but there are some points worth noting.
#1 You Pay For 20 Years
We see from the death benefit illustration above that total premiums paid to-date stop increasing from year 20 onwards. This is because the policy only requires payment for the first 20 years.
#2 Multiplier Effect 3X Before Age 70
Even though the sum guaranteed is $60,000, the policy actually provides a guaranteed 3X death benefit payout before the age of 70. So death benefit coverage is actually $180,000, before the age of 70.
Whole Life Insurance – Cash Surrender Value
The other value proposition that makes a whole life insurance attractive is the cash value component that such policies contain. If policyholder decides at any point in time to surrender the policy, they would receive the cash surrender value component of the policy.
The surrender value is determined by two components. The insurance company guarantees the “Guaranteed” portion. There is also a “Non-Guaranteed” portion determined through the investment returns that the insurance company earns.
For example, if at age 70, the policyholder decides to surrender the policy, the insurance company would provide a guaranteed payout of $31,200.
Assuming the investment return is at 3.25% per year, there would be a non-guaranteed payout of $14,750. In total, the policyholder would receive $45,950.
There are 2 things you need to remember about cash surrender value:
#1 The Projected Investment Return Is NOT Your Return
If you are not good with numbers, you might be forgiven for assuming that a 3.25% return is what you can get from this plan. You may think that being able to buy a policy that provides insurance and a 3.25% annual return sounds like a good deal. But there are fundamental flaws with the argument.
Firstly, the return is NOT guaranteed. The insurance company only needs to guarantee you the “guaranteed” portion, which is $31,200.
Secondly, the 3.25% is NOT your return. The illustration is saying how much you will get IF the projected return reaches 3.25% per annum.
When we did the math, getting $45,950 after a 40-year period based on the structure of how the premium is paid, it gives us a return closer to 0.7% per annum. Ouch.
To be fair, part of the reason why the returns are low is because we are excluding the insurance cost, which is included as part of the premium.
#2 Death Benefit Does Not Equal Surrender Value
If you compare the two tables above, surrender value is always lower than death benefit, even after the age of 70, when the multiplier effect for death benefit is no longer in place.
|Age||Death Benefit||Surrender Benefit|
* Assumption that investment returns are projected at 3.25% per annum
** Before the age of 70, death benefit is $180,000, due to 3X multiplier effect
Due to the limited pay period, policyholders should expect to pay more for a whole life insurance plan compared to a term plan. This is for the perks of getting a whole life coverage (till age 99), and the cash surrender component. As consumers, we get what we pay for.
In our opinion, the main priority is to ensure that your life insurance policy gives you exactly what you need it for, and that is, sufficient coverage for you and your family in the event that something happens.
Secondly, affordability plays a part as well. We need to balance our insurance needs with other financial goals such as savings and investing. It is pointless to be paying so much for a life insurance plan, only to realize that you do not have enough left for your investment and saving goals.
Last but not least, we think it is best to avoid treating your whole life insurance as a saving or investment plan. It is neither. As a saving plan, the policy provides very little liquidity, since any surrender of the plan before the age of 70 is likely to result in a “loss” from the premium paid.
From an investment perspective, the returns are hardly sufficient to justify it as an efficient allocation of funds. Moreover, you get no control over the type of investments you wish to make.
This does not mean that a whole life insurance plan does not have a place in our financial planning portfolio. As a life insurance policy, it offers coverage for life. The multiplier effect gives you added coverage when you are young. The cash surrender value gives us option in the future to cash in during our old age.
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