Thursday, November 14, 2013

Whole Life Insurance - After 20 years


This plot of cash value versus premiums paid for this Northwestern policy illustrates that life-insurance is a long-term investment, with a payback measured in decades, not years.  Click to enlarge


            1.  Chart is from June 1993 (inception date) to June 2014.  Standard Premium was $111.71
            2.  Dividends used to increase cash value and coverage from 1993-1998.
            3.  Dividends used to reduce premiums for 1999 - 2003.
            4.  Dividends used to increase cash value and coverage from 2004-2006.
            5.  Dividends were used to reduce premiums starting in 2007.
            6.  Overall Rate of Return over  20 years, approximately 58.07% (average 2.9% per year)
            7.  $1300 per year, invested over 20 years at 2% interest would produce $33,222.53
            8.  Incremental rate of return, at his point, is over 200%.
            9.  Premiums last year were about $756, while the increase in cash value was $1715.60
            10.  Dividends exceeded premiums in 2014, no premiums due for 2015 and beyond?

Conclusion:  As an investment, life insurance is no real bargain.  However, bear in mind that in addition to its use as an investment vehicle, the policy also has a death benefit of $108,432.00.  And, in the next 10 years, the cash value will continue to grow, while the premiums (currently $63 a month) will remain relatively flat.  The dividends from our other "paid up" policies more than pay for the premiums on this policy at the present time.  For every dollar invested as this point, the policy increases by more than two dollars.

Life Insurance - it is a good deal?  I have written about it before, and it is an interesting animal.   For a young family starting out, a term policy can be bought cheaply enough - and provide coverage in case a spouse dies young.   However, as you get older, the premiums become larger and larger.   By then, you should have enough set aside in case of early death - and a term policy is no  longer necessary.

Whole Life, on the other hand, acts as both an insurance policy and an investment vehicle.   The original idea was that you would pay in more than the amount needed for a term policy, and the company would invest the surplus, and eventually a nest egg would build up and the dividends from this would cover the premiums.   Your policy would then be "paid up" and you would have to pay no more premiums on the policy.

It is possible to convert a policy to "Paid up" status at any time (provided the policy has a cash value).  The policy is basically cashed in, and the cash value used to buy a "paid up" policy, which increases in cash value, over time.   The death benefit may be less than the original policy and remains fixed.   This is a good option if, later down the road, you don't want to (or cannot afford to) pay premiums - but don't want to lose all of your policy, either.  I did this for two of my Northwestern Mutual Life policies, as I could not afford the hefty premiums on four life insurance polices.   Yes, I bought too much.

Speaking of  "paid up" - most Insurance Agents will encourage you to use the annual dividend to buy additional "paid up" additions to the policy.  These add a little to the death benefit, and generate dividends of their own, which are added to the pile.   In one respect, this is like re-investing more money into the policy.   In another respect, it is like buying little tiny life insurance policies at a very, very high cost per dollar of coverage.  A better idea is to use dividends to pay down premiums.  The policy may not grow as quickly, but then again, it won't cost you as much, either!

It is also possible, of course, to lay out a huge wad of cash and buy a "paid up" policy from the get-go.   But most of us can't afford that.  Most of us just pay the monthly or annual premiums, one bit at a time, because as salary slaves, we get paid that way.

Is Whole Life Insurance a good deal?   Should you apply dividends to reduce premiums, or to buy additional "paid up" additions?  How long does it take to pay back what you have invested?    Should you buy additions to a policy if they are offered?

After 20 years, I finally have some answers to these questions - and I am finally understanding what these policies are all about.

I harp here all the time about never investing in things you don't understand fully, and to some extent, my Life Insurance investments are an example of this.   I did not understand these investments very well at the beginning, and that was a costly mistake, to some extent.  However, it was better that I bought these policies that spend the money on a Jet-Ski, I guess.

To answer the first question, the general answer is NO - Whole Life Insurance is not really a good deal.  You would likely do better investing that money in the Stock Market, or even in Bonds.   When you buy a Whole Life Policy, some of that money goes to the death benefit insurance itself (a term policy, basically) and another part goes to the investment portion.   Right off the bat, you can see this is not an efficient way to invest.   Another portion goes to company overhead and profit (profit, if it is a Stock company and not a Mutual company) so there is an inefficiency there as well (but the same could be said of your Mutual fund company as well, right?).

It does act as a forced investment scheme, as you have a regular amount deducted from your bank account every month.  I chose to keep this amount less than $100 - about what people pay for a Cable TV bill or Cell Phone plan these days.    And in that regard, I am glad I spent that money on the Life Insurance, rather than Cable TV.   One has paid off, the other would not.

As a way of diversifying a portfolio, it is not a bad adjunct to other investments.  But I would not put all my money into this one basket - or even a significant chunk of it (Life Insurance, in terms of cash value, represents less than 1/10th of my net worth).

Should you apply Dividends to Reduce Premiums?  YES - always.  If you look at the chart above, for my Northwestern Mutual policy, you can see that the "crossover" point, where the cumulative premiums become less than the cash value, took about 12 years.   Note how the slope of the premium curve decreases after about 2006 - that is when I decided to ignore the advice of my Northwestern Mutual Agent (a real piece of work, let me tell you) and apply dividends to reduce premiums.    As you can see, this accelerated the time when the policy would pay back - that is, increase in cash value by more than the cumulative premiums.

The chart below tells a different story.  This chart illustrates the same data for Mark's State Farm Whole Life policy.  

This State Farm policy has taken longer to pay back its premiums, largely because we didn't apply dividends to premiums early on.   Underlying performance of the company is also an issue, although as illustrated here, State Farm has exceeded its guaranteed values.  Click to enlarge


            1.  Chart is from November 1994 (inception date) to November 2014.  Standard Premium was $91.25
            2.  Dividends used to increase cash value and coverage from 1994-2013
            3.  Overall Rate of Return over 20 years, approximately 4.3% (average 0.21% per year)
            4.  $1095 per year, invested over 20 years at 2% interest would produce $27,137.73
            5.  Incremental rate of return, at his point, is nearly 200%.
            6.  Premiums this year were about $800, while the increase in cash value was $1558.32

Conclusion:  As an investment, life insurance is no real bargain.  However, bear in mind that in addition to its use as an investment vehicle, the policy also has a death benefit of $106,390.11.  And, in the next 10 years, the cash value will continue to grow, while the premiums (currently $800 annually) will remain relatively flat.

For every dollar invested as this point, the policy increases by about two dollars.  Might as well keep it, now.

Here, I did not use dividends to reduce premiums until about 2009, and as you can see, once I did, the slope of the dividend curve decreased and crossed the cash value line that much sooner.   This chart differs from the one above in that it illustrates the guaranteed values from the State Farm Policy, whereas in the Northwestern chart, I projected cash value over time.

These charts illustrate graphically how using dividends to decrease premiums really is the way to go.   Your payback, in terms of cash value exceeding total premiums paid, will accelerate.   Buying additional "paid up" insurance with your dividends may increase the overall size of the policy over time (in terms of both cash value and death benefit) but it also means that this crossover point (where cash value exceeds the amount paid in) will take longer - or may never occur.   Note how the slope of the two lines in the graph above is nearly identical - until I opted to apply dividends to premiums.

At this point, both policies are worth more than I paid for them.  The Northwestern policy clearly is the winner - returning an average pf about 2.9% a year over 20 years.   That doesn't sound very good right now, but at this point, every dollar I pay into the policy increases the cash value by two dollars - a return of 200%.   So at this stage in the game, it pays to hang onto the policy.   The overall rate of return will increase from here on out.

The State Farm policy is not doing as well - returning a pathetic 0.21% on the premiums paid since inception.  But like the Northwestern Policy, at this point, every dollar put into it increases the cash value by two dollars.   From here on out, it is worth keeping, and the overall rate of return will go up over time.

Bear in mind there are two other aspects of Whole Life I have not addressed here.  First, there are some tax advantages to Life Insurance.   You can structure the policy such that you can borrow against it when you retire, and thus have no tax consequences at all (when you die, the policy pays off the loan). 

Second, there is the death benefit.    Both policies have death benefits over $100,000.    So in addition to getting an investment vehicle, you are getting a term policy thrown in - but a term policy that will never expire, as long as you live.

How long does it take to pay back what you have invested?    As you can see from the charts above, this depends on whether you apply dividends to reduce premiums or not.  If you do, the payback will be more rapid - perhaps as little as ten years.  If you do not, you might wait forever.
Should you buy additions to a policy if they are offered?  No.   Our State Farm policy had a provision allowing us to buy $25,000 additional policies at five year intervals  - up to four such policies.  These policies were worth less than the original policy, but cost far more in terms of premium for insured amount, as the rates for the insurance part were higher (we were older, so the risk of death is higher) and since you are re-starting the clock on these new policies, they remain "upside down" for several years.   

You need less and less insurance as you get older, so buying more makes no sense - except in one circumstance.  These add-on polices required no medical exam.   So, if I was diagnosed with terminal cancer, then yes, I would have bought these polices - they would be a sure bet.   Other than that?  Walk away.

And that illustrates why Life Insurance for Older People is such a costly mistake.   Many folks wait until they are 50 and then think "Gee, can I buy Life Insurance?" 

And the answer is "Yes..." but the complete answer is, "....but it is a rip-off".   Insurance companies aren't dumb, and you can't get $100,000 of coverage, at age 50, for any trivial amount.   Even a term policy will be costly, as you are closer to the age of death and the odds of you dying are huge.

When you see an ad for "Life Insurance for Seniors!  No medical exam necessary!" just walk away.   Why?  The Life Insurance companies are not giving out free ponies this week - or next.   You can't get something-for-nothing, so stop looking for it.

Life Insurance is a Young Man's Game.   If you are in your late 20's or early 30's and have a steady job and are thinking about long-term investments, a modest policy with an affordable premium is not a bad option.   We bought our policies in our early 30's, and that is about as late as you want to buy.   It is a long-term investment that takes decades to pay off.   You can't buy whole life at age 50 and hope to make out at all.

Do I regret buying these policies?  Yes and No.   Yes, I regret not applying dividends to reduce premiums.  I regret buying the "add on" policies from State Farm (which I have since cancelled or cashed in).   And I regret buying the additional Adjustable and Variable Life policies sold to me by my Northwestern Agent (which I have since converted to paid up policies)

But, in terms of a $99-a-month expense, I am glad I bought these polices instead of having 500 channels of Cable or a new leased car.   Some folks say saving money may be for chumps, but in the end, the person with money saved - no matter what the rate of return (provided it is not negative) - ends up ahead.

As the projections on these polices show, by the time I am retired, each will be worth about $50,000 or more, in terms of cash value.   That's over $100,000, not counting the two other paid up policies I have, which will add another $100,000 to the pile.   This is more than the average American retires with, these days.

I also think that one advantage of these policies is that they got me to think about my net worth, my overall estate, and where my financial life was heading.   Life Insurance is a long-term investment, where you pay a little in at a time for a long period of time, with a payoff decades in the future.   Having these policies forced me to think about my investment strategies and to invest more in my IRAs and 401(k) plans.

Looking back 20 years, I am glad I saved money over time - and wished I had saved more.   There are a lot of people in this country, older than I am, who have saved nothing and are headed for retirement, whether they want to or not.  And that is both scary and sad.