A More Typical Scenario – Buy Term and Invest

The vast majority of Americans, however, are not in the situations I just described. Frequently, Americans who own large Cash Value policies end up cashing it out when he or she gets toward retirement age.  This typical approach ends up causing two very negative results.  This typical American has 1) almost surely had way too little death protection during those years when he or she needed it most, and 2) a less than optimum investment (the cash value investment element of the policy) to help fund his or her retirement.

So what is the alternative?  A markedly better approach is to break up the two components parts of a Cash Value policy by buying the most economical Term life insurance policy for death protection and separately investing the cash value component of the policy in a tax-deferred investment.  In other words, take the dollars you would have paid for the premium costs of a Cash Value policy and instead buy Term life insurance and invest the difference.  This is a better approach for the typical American.  This statement becomes irrefutable if you can buy Term insurance and invest the difference in a tax-favored retirement vehicle like an IRA (an alternative that is open to most of us).  Let me give you an example of the unbelievable difference this approach can make.

Example:  Dave and Sharon are both 35 years old and have three children.  Sharon works part-time but primarily is at home taking care of the children.  Dave is the primary breadwinner.  The couple's total combined Gross Income (see pages 9-10) is about $65,000.  After consulting with a life insurance agent, the couple decides to buy $100,000 of life insurance protection.  The agent convinces Dave and Sharon that a traditional Cash Value policy with a $2,000 annual premium cost will best fit the bill.

The agent illustrates to Dave and Sharon that the policy will therefore cost a total of $60,000 over the next 30 years until Dave's anticipated retirement at the age of 65.  At that point in time the kids will be long gone and educated and the policy will have accumulated close to $100,000 in cash value.  Therefore, the agent logically points out there will be $100,000 death benefit available for the next 30 years until retirement at which point the couple can cancel the policy and draw out a nice little nest egg to supplement their retirement income.

What the agent does not fully explain to Dave and Sharon is that the cash value accumulations will provide only about a 4% rate of return.  Additionally, the agent does not explain to the couple what their alternatives would be under a "buy Term life insurance and invest the difference in an IRA" approach, which was an investment available to the couple for all the years at issue.

How would the facts have changed if the buy Term and invest the difference approach had been followed?  Let's assume that $250,000 of term insurance, rather than a total $100,000 death benefit, was maintained for all years prior to Dave's retirement.  Remember that with Term insurance, the premium cost starts low and increases as the insured ages.  Using some of the rates available from the Web sites referenced below, 10-year Level Term rates for $250,000 of coverage for a 35-year old male start out at $140 per year.  Using current rates, the annual premium would rise every 10 years to $250 by the time the insured reached the 45-54-age bracket and $600 per year for the 55-64 age brackets.  Therefore, cumulative premium costs for a 35-year-old male for 30 years would be about $10,000.

Also presume that Dave was taking the difference between the cumulative $60,000 premium cost on the Cash Value policy and the $10,000 cumulative 10-year Level Term premium cost just described and investing the difference in a Roth IRA.  Recall from our discussion of Roth IRAs under the Retirement Planning section on page 75 that a contribution to the Roth is not currently tax deductible but when wealth is withdrawn from the Roth on retirement nothing is taxable.  Dave invests the IRA money in a relatively safe stock mutual fund, like the TIAA-CREF Growth and Income Fund described on page 90, where a long-term annual 9% - 10% rate of return is very realistic.  By age 65, the Roth IRA would have accumulated about $325,000 of wealth – all of which would be available tax-free, whereas the cash value in excess of the total $60,000 premium expense over the life of the policy would be taxable to Dave an Sharon under Scenario 1.

You see in the Example how short changed you would be under the traditional Cash Value life insurance approach.  Under that approach, in your younger years when you really need more insurance (the kids are at home and aren't yet through their college years), you are significantly under-insured in terms of what you need by way of death protection (we will try to more exactly quantify the amount of death protection you actually need below).  Also, as is the case with the vast majority of us, you do not die before your retirement years and end up cashing in the policy at retirement as a supplemental retirement benefit.

Under the buy Term life insurance and invest the difference approach, we see a markedly better result, as illustrated in the Example.  During the years when you need more life insurance (and the cost of Term life insurance is cheaper) you are able to buy an appropriate, and much larger, amount of death protection.  As icing on the cake, the growth and wealth in your IRA will likely provide you with significantly more wealth accumulation by retirement age than the cash value element did under the traditional Cash Value life insurance policy.

NOTE:  Although this is the better approach for the typical American, a saving grace with regard to the traditional Cash Value life insurance policy is that it is a "forced savings" program: you must pay the entire premium and on paying it you have both the life insurance protection and your cash value build up.  On the other hand, the buy Term and invest the difference approach requires the discipline to devote the same total cash outlay in two directions.  If you break down and pay the Term life insurance premiums but not the contribution to the IRA, the whole logic of the preferred approach breaks down.  Like many things in this book, a basic budgeting and disciplining process is necessary to reap the reward.  Remember that it's simply not that difficult to accomplish.  You can do it-and in doing it will make your life immeasurably less complex and stressful.