Chapter 12: Advice from a Pro - Cengage



Chapter 12: Advice from a Pro

Don’t Be Fooled by Vanishing-Premium or Return-of-Premium Policies

Life insurance agents often pitch vanishing-premium life insurance, which is designed to allow policyholders to cease making premium payments after just a few years. In these plans, cash-value accumulations are used to pay premiums that no longer must be paid. While attractive at first glance, these policies contain a significant hazard. If the growth in cash-value accumulations proves insufficient to pay the premium, the owner of the policy will be billed for the premium shortfall—possibly after many years of having not paid premiums. Always assume any life insurance charge that can be imposed will be imposed.

A similar type of plan is called a return-of-premium policy. Here the policy promises to return all the premiums paid if the insured person maintains the policy and lives past a certain number of years—usually 30. These policies cost more so that the extra funds can be invested to provide for the return of premiums. Insurance companies promote these policies as a way to avoid “wasting” your money. In reality, what they are trying to do is entice you to keep the policy in effect for a long time even if you do not need the coverage anymore. Instead buy term insurance and decide for yourself when it is best to drop a policy.

Hyungsoo Kim

University of Kentucky, Lexingtion, Kentucky

Buy Term and Invest the Rest

The principle behind the strategy “buy term and invest the rest” is simple: If you invest the money difference between the cost of premiums for a term life insurance policy and the cost of premiums for a far more expensive cash-value policy, you will always come out ahead financially. To see why, consider the buildup of protection shown in the accompanying table for Seth Cameron, a 30-year-old who is considering life insurance policies. Seth could pay an $870 annual premium to buy a $100,000 whole life policy. Alternatively, he could spend $130 for the first-year premium of a $100,000 five-year renewable term policy and invest the $740 difference ($870 - $130) in a mutual fund account and earn a 5 percent after-tax rate of return.

If Seth dies tomorrow, the policy’s beneficiary would receive both the $100,000 in insurance proceeds and the $740 in savings. After five years (age 35), Seth’s annual $710 in savings would have grown to $4293; if he dies at that time, the total death benefit would be $104,293. If Seth dies years into the future, the estate is even further ahead because of the growing principal in the account. By age 60, Seth’s mutual fund investment would have grown to $58,052. If the fund earned higher than 5 percent annually, the amount would be much greater.

By the time Seth reached age 60, the term insurance premiums would exceed the premiums for the cash-value policy. However, his need for life insurance would presumably be eliminated or greatly reduced at that point. If Seth’s children were self-supporting by then, he could probably drop the term insurance policy altogether. Nevertheless, his mutual fund account would remain to provide a financial nest egg of $58,052 or more to his heirs.

With the “buy term and invest the rest” strategy, Seth would have been insured more than 30 years at total premium cost of just $7350. By contrast, the cash-value policy would have required total premiums of $26,100 ($870 x 30) and the policy’s cash value at year 30 would be about $44,000.

For “buy term and invest the rest” to work, however, the difference between the term and cash-value policy premiums must, in fact, be invested on a regular basis. Many people say that they will invest this money but then fail to follow through on that promise. You can succeed with a little discipline. The easiest way to ensure that your money is actually invested is to set up an automatic investment program (AIP) in which a mutual fund is authorized to withdraw money from your checking account, perhaps monthly, to buy mutual fund shares. When you agree to invest the “difference” automatically, the strategy will work well for you. (See Chapters 13 and 15.)

Advice from a Pro…

Estate Buildup if a Term Life Insurance Buyer Invests the Difference

|Age |Premium for Five-Year |Difference (Not Spent on |Total Investment and |Total Estate |

| |Renewable Term |Whole Life) |Earnings* at 5% | |

|30 |$130 |$740 |$740 |$100,740 |

|35 |150 |720 |4,293 |104,293 |

|40 |180 |690 |9,657 |109,657 |

|45 |210 |660 |16,328 |116,328 |

|50 |240 |630 |24,668 |124,668 |

|55 |590 |290 |35,139 |135,139 |

|60 | | |58,052 |58,052 |

*This illustration makes the following assumptions: The whole life policy premium for the same $100,000 in coverage is fixed at $870 every year; the buyer pays the five-year renewable term premium at the beginning of each year; and the difference is invested. Those amounts stay in the investments account all year, as does the previous year’s ending balance. Investments earn a compounded 5 percent after-tax annual rate of return. Upon the insured’s death, the beneficiary would receive the $100,000 face amount of the term life insurance policy plus the amount built up in the investments account earning 5 percent.

Source: Jordan E. Goodman, “America’s Money Answers Man” (), author of Everyone’s Money Book and Everyone’s Money

Book series.

Advice from a Pro…

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download