Transcript: Segment 2
Paul Winkler: And welcome to the Investor Coaching Show, Paul Winkler talking about the world of money and investing. That’s what we talk about, that money topic. And there’s always a lot to go around there. We’ve got a lot of stuff.
It’s going to be fun show. We got a lot of stuff today. You know, I found something, something really interesting that I wanted to cover. It was about, well, this is a life insurance thing. I’m going to start off with a life insurance thing. So, you know, people talk about life insurance and you have to have life insurance. It’s basically the idea is if something happens to you, you’re like a machine in the back room of your house, you’re producing income. And if let’s say that all of a sudden that machine stops working cause of death, then that you’ve got to replace it.
Life Insurance
So the issue is that with life insurance people, typically when they’re got the kids, they’ve got dependents, they got people that are concerned about, you know, making sure that they take care of if something happens to them, you have to have typically, you know, you hear any rules of thumb eight to ten times income insurance companies will typically go to about fifteen times income. So when you’re younger, you know that you’re going to be able to get the coverage, to take care of the family that you need now, a big debate in the industry.
So when you’re looking at the amount of insurance, it’s typically very, very costly. If you were to do this in what’s called a permanent form. And what permanent means is this: when we’re talking about whole life insurance or universal life insurance, that is a permanent type of insurance; it’s a type of insurance that continues. You can pay the premiums, continue to pay the premium, and it continues on until death. Until you part literally, I mean, permanent insurance, it’s all the way until you pass away, but it’s very, very expensive. And one of the debates has been forever in the industry about life insurance is whether you buy term insurance or whether you buy whole life insurance.
Now there’s a big thing out there right now, trying to sell permanent insurance as an investment and forever people didn’t take that seriously. That’s because what they did for a while, and then all of a sudden there were people out there, consumer advocates that came out and said, no, this is a really bad idea. You shouldn’t do this term. Insurance is a better way to go. Don’t do permanent insurance. It’s way too costly, and you’d do way better just buying term insurance and investing the difference someplace else. So the life insurance industry wasn’t too happy about that.
They were not pleased that somebody came in and just kind of rained on their parade. So they came out with something called universal life insurance, which is basically term insurance and investing. The different problem is that you’re investing in the difference in the same kind of garbage that the whole life did, which is fixed income investments or bonds and the long term returns. Well, they were great when the product first came out because interest rates were way, way high. We were able to illustrate, you know, 8, 10, 12% interest rates on these products.
And it was, it was unbelievable. Those things, they would show a growth rate that was unreal. And the income you could take projecting that into retirement was phenomenal. There was only one problem. Interest rates crashed. They came tumbling down and all of a sudden it was no longer a good deal. Well, they came out with something called a universal life variable—universal life, which was backed by mutual fund type of investment stocks and bonds. You could actually set up portfolios just like you wouldn’t in your 401k.
And now it grew at a rate of return, which was much higher because of the fact or potentially much higher because of the fact that was backed by equity markets. Well, there’s only one problem with that product. The expenses were so stinking high inside the product that it made it really hard to get any kind of level of accumulation. And then you also had issues when you try to take an income from it in retirement, it could be an absolute tax time bomb. So that was the problem. You had a tax time bomb on your hands.
You had a situation where literally, if you were pulling this money out tax-free, you pull out what you put in that’s tax rate, and then you go and you start taking loans. And that way you could actually skirt some of the tax law in terms of getting money tax free. Well, there was only one problem. If the policy lapsed, now you owe back taxes on all the gains. So this is kind of interesting that the Wall StreetJournal has this section called The Experts.
A case for term insurance
It’s a case for a kind of term insurance. And I thought, Oh, I better read this.What are they talking about? A case for a kind of term insurance, a term or whole life insurance. “There’s the middle ground options,” says Wall StreetJournal, wealth management expert. I wonder what makes him an expert? I didn’t see any degrees, but you know, I don’t know, might be an expert who knows works for the Wall Street Journal, I guess that makes you an expert. But anyway, says “buy term, invest the difference.” You’ve probably heard it before. The message is so deeply ingrained in the philosophies of various financial pundits and segments of the industry that it has almost reached the point of conventional wisdom.
It is best to keep the insurance and investing separate they’ll say, and this is because on the other end, it says on the other end of the spectrum, you can find people so aggressively pushing forms of permanent life insurance that you’d be forgiven to do think that perhaps permanent life insurance should be your only investment. And they are, they’re really good at selling this stuff really good at selling this stuff, you know, because when you listen to, Hey, look, you can put this money in. You don’t have to pay taxes on the gains.
And then when you hold the money out in retirement, you don’t have any taxes on the back end and you know, you’ll listen to it, go, Whoa, this sounds phenomenal. I remember going through a program cause I worked for an insurance company and what did they want me to sell? Well, they wanted me to sell insurance. Obviously that was the main idea, sell whatever I could to people. And the reality of it was I was so analytical. I would go through and go, I don’t know if I can do this, but they had this sales system that they brought us through.
And most of the guys I worked with, they just ate it up, believing this is really, really good. So I believe a lot of these people out there selling this stuff really believe in it, but you know, they don’t tend to be that numbers driven and they didn’t see through some of the misleading tactics being used in the sales process, which, you know, how the tax system works. I mean just a little minor, things like that, where they kind of skirted the whole deal and, and blew that. But anyway, so they have in here says on the other end of the spectrum, you find a field there that you think could be the only thing you ought to invest in.
They encourage you to be your own bank. You’ve may have heard this before bank on yourself, right? Be your own bank. That type of thing. There’s an interesting middle ground that deserves some further attention. He says, “return of premium term insurance.” Now this I’m going to tell you is incredibly enticing. It’s kind of like return of premium long term care insurance. Now people go, Oh man, what if I never go into a long term care facility? I’ve paid these premiums forever. And I’m not going to get my money back if I don’t go into a facility, as if you’d want to go into a facility.
But anyway, the idea being that you get your money back on all the premiums. If you don’t actually use the insurance, it’s very, very, it’s very appealing in reality. He says, “If you have life insurance coverage for some term twenty to thirty years, and if you survive that entire term, rather than having nothing to show for it as would be the case with traditional term insurance, you get all your premiums back.
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Insurance companies need to make money
Of course, insurance companies need to make money. So to get this benefit, you’re going to have to pay higher premiums than you otherwise would for comparable term insurance policy. So in essence, the idea being is it’s starting to look a little bit like a permanent insurance policy cause you’re paying higher premiums. Does this sound like that to you? “Well, psychologically, this can take the sting out of paying premiums for thirty years,” he writes, “and never using it, but it can be a good investment as well.”
is this something that would be a good idea? Well, he says, “there are a lot of misconceptions about these policies floating around one is that you’re just getting back money that you already put in.” I mean, that’s a “misconception” if you want to call it that, that I’ve made, you’re just paying extra money. So he says, “that’s a misconception.” I’m hooked. I want to see why, what I have taught for years there’s some misconception, which is the money that has lost out on years of compound interest.
However, this is the wrong way of thinking about return and premium insurance. The mistake here is failing to acknowledge that the bulk of your premiums are still going toward your term in life, in turn life insurance coverage, that is irrelevant. You are still paying extra money toward this thing that is going to give you all your money back while it is the only difference in premiums between the two policies that should be thought of as cashflow driving the investment that provides a lump sum of all your previously paid premiums at the end of your term coverage. So in other words, you’re paying a premium, you pay a little extra and that extra that you pay is what gives you all of your money back at the end of like a thirty-year period.
If you have a 30-year term, for example, you know, you can have an insurance policy for thirty years that the premium stays level that’s, that’s what we would call a 30-year term to illustrate the potential value of return of premium term insurance. As an investment, I ran some quotes for a thirty-year old male in excellent health and Maine to purchase $1 million worth of 30-year term. And I actually ran, as my little homework as I was doing this article, I actually ran a quote as well to make sure his numbers were accurate. And they were, that was within a couple of dollars of what I found.
So it was very, very accurate with a comparable return of premium policy that costs about $1,070. So the regular term policy was $643 a year for a million dollars worth of coverage. 30-year term on a thirty-year old male versus $1,070 for this product. So the difference is you’re paying $427 per year for thirty years extra to get all your money back, which in this case is $32,100. If at the end of the contract, you haven’t had the good sense to die.
You get all your money back on the premiums that you paid on the policy and you aren’t out any money. Again, very enticing if from a buyer’s perspective, this sounds really good. Now we calculate the internal rate of return and he says it yields about 5.4% is basically what he’s saying here. And given that a contractually provided return by the insurance insurer is not an investment that is subject to potential market risk. This is a strong return in an environment where 30-year treasuries are paying less than 2%.
What is the problem?
Well, it is. I would agree that that does sound really, really good if, that’s a really high rate of return compared to a treasury paying 2% and furthermore, it’s tax-free. He says, “Now what’s wrong with this.?” These are the points I want to make that this person missed. I mean, it’s, it’s, you know, it does sound good and I can see why somebody that, why somebody would be pulled in by it. But here’s the issue. Number one, it’s not liquid money. When you make these extra payments toward this policy, it’s not money that you can get back out.
Let’s say, if you’re disabled, you lose your job, your whatever name, all of the things that could happen in thirty years where you may need some money, some extra money. Yeah. So this is not liquid money that you can get back. Another thing you have to think about is what if you cancel early, what if you don’t leave and keep the policy for an entire 30-year period? It’s another thing you gotta think about. Do you get all that money back? None. other than you’ve got to think about, well, if you do have the good sense to die tongue in cheek, basically, all that money has gone, right?
Because you, you died, you don’t get the return premium because you died. So basically what I’m answering here, folks is why is the return seemingly so good because actuaries that insurance companies aren’t stupid. They know how to price this stuff. Another thing is what if you forego a match on your 401(k) because you’ve done this instead and maybe, or what if you just forego putting extra money in your 401(k), what you would be doing, right?
What if you forego that because you decide to do this instead, and you miss out on a tax deduction. If you use a traditional 401(k) or you miss maybe a Roth IRA where you could have put the money in and it would have grown forever, tax-free forever. Now another thing to think about is what if the benefit, what about the benefit with 401(k)s and traditional IRAs and those types of things, where you, when you put money in them, you will avoid taxes right now at a higher marginal tax rate.
So in other words, some of your income is taxed at 0 summit, 10 summit, 12 summit, 22. So I’m at 24. So on those, the highest number that you are subject to is your marginal tax rate. Well, what if you go and pay taxes now, in order to buy this insurance at the higher marginal bracket, you’ve got to earn more money to pay the premium on this thing. In other words now. So let’s say if I have a $800, I’m just using a nice round number. Let’s say I’ve got a 20% tax bracket.
I’ve got to earn a thousand dollars to pay $800 in premiums. Just to give you an idea what I’m talking about there. Now finally, let’s say that you put this money in a taxable account instead. Looking at the average historic return of the S&P 500, which is the lowest returning asset category. Out of all the things typically that I would invest in, small companies would have a higher expected return, small value, higher large value, higher international value, higher, small international value. So in emerging markets, all of these asset categories would have a higher expected return.
So I’m using the S&P 500 just to use what would be something that’s familiar. Number two, it would have the lower expected return of all these things let’s net down. Let’s say that you have a 3% return from dividends. Let’s say you just have that and you pay taxes on those dividends. So basically you net you’ll lose a half a percent of return. Let’s just use that. We’ll knock it down to 9.5%. We’ll drop the return down because you pay taxes on dividends and you pay them from the account.
Now, what happens is your $427 per year, which is the extra money that you paid over and above the term insurance cost into this product, it grows to about $70,000. Okay? Now we take that money and what if can take that? And we say, well, you know, our premiums, the gain on our premiums on all of this stuff. So I’m taking all of this money and putting it all together and say, well, the gain of the premiums, you know, $12,810 in premiums, the gain is $57,090, tax at 15%.
That’s $8,500 in taxes and less. And I’m assuming, let’s say you paid it all at once. You paid all the taxes at once. Then next down to $61,000, out of pocket cost was $32,000. So you’re basically $29,000 short in doing what this person is talking about. I’m telling you, insurance companies are not dumb. I’m still of the opinion behind the term. In most cases, there are a few cases where permanent insurance makes sense, but most cases, it isn’t a great deal for the investor. Usually better for most people to buy term insurance and invest the difference elsewhere rather than locking it up in an insurance company.
Paul Winkler, you’re listening to the Investor Coaching Show here.
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