Here is an article written by a financial consulting group on the subject:
http://www.legacylifegroup.com/term-cash-value.htm
Here is part of the article. There are examples in applying their ideas I did not paste because of the length of the article. There was also a flow chart (decission tree) I tried to paste but it appears it did not work.
This article is going to explain to you the in's and out's of the two main types of life insurance contracts - term and permanent cash value policies.
The argument over which of these policies is 'better' has been going on for decades. Most of what you have probably read is either biased or simply written by the uninformed.
I know this sounds arrogant but unfortunately it is the truth. Insurance companies and most agents are not going to shoot straight with you because they often have a bias toward you buying their particular product. On the flip side many so-called 'financial advisors' simply recite some flippant saying like always buy term insurance or whole life is the way to go.
The answers, as you will read below, are not that simple.
If you have been researching life insurance and what to buy for your family you have probably gone through the typical steps most of our clients went through:
Step 1. You realized you needed life insurance.
Step 2. You talked to friends, relatives, and/or local insurance agents or a financial planner.
Step 3. You went online and did some research on Google or another search engine.
Step 4. You might have read a book or heard a radio program from a financial advisor.
Step 5: You decided how much insurance you needed based on your income and familys needs maybe $500,000 or $1,000,000.
Step 6: But here is where things got tricky somewhere along the line in steps 1 through 5 you ran across information discussing term insurance and cash value insurance. You might have been told definitively to buy one or the other and been giving all kinds of reason on why one is better than the other. You probably heard buy only term and invest the difference or do not buy term - its just throwing your money away.
Step 7: After looking into this conflicting information further you might have been even more confused. So you went back online. Unfortunately there is hardly any good information on Google or elsewhere on Term or Permanent Cash Value.
Fortunately you ran across this site and will at the very least get a whole lot of information that will equip you with the tools to make a good decision.
So what do people mean when they say Term insurance or Permanent Cash Value Insurance?
The Basics: Definitions and History
Term Insurance: Term insurance is the most basic kind of coverage on the market. You pay money to the company for a set amount of years and if you die during those years your beneficiaries get the death benefit. Its like auto insurance you put money in and all you get is pure insurance. Most people nowadays buy 10, 15, 20, 25 or 30 year guaranteed term policies so we will focus mainly on these types of policies in this article.
For example, if you buy a $500,000, 20 year guaranteed term policy at age 40 for $1000/year this means you will be covered until age 60 as long as you pay $1000/year to the company. If you die between age 40 and 60 your beneficiaries get $500,000 and if you live to age 60 you generally will drop the term policy because the guaranteed term period expired. You could keep it longer but the premiums will go up dramatically. If you had bought a 20 yr guaranteed term policy your premiums were only guaranteed to stay at $1000/year for 20 years. After that they usually go up dramatically and most people cancel their policy after the guaranteed period is up or convert the term policy to a permanent policy (this will be discussed later).
There are several variations on term insurance that we will discuss later but this is a basic overview.
Permanent Cash Value Insurance: You might have heard this type of policy by different names like whole life, universal life, flexible premium life. Before getting to specific we will just focus on a broad overview of how permanent cash value policies work.
Permanent insurance combines term insurance with a cash value account. Where did this cash value account concept come from?
Permanent insurance is the original life insurance contract that has been sold since the 1800s. The original whole life policies were simple. For instance at age 40 you would buy a whole life policy for $4000/year for $100,000 of coverage. Every year of your life you would get the same bill for $4000 and as long as you had paid it you would have had $100,000 of coverage. These seemed good until the situation arose that you decided to cancel your policy while you were still alive, lets say age 55. So you had been covered for 15 years and had paid a total of $60,000 of coverage. But when you would have cancelled your policy the company would have kept all the money (your $60,000 of premium) as their profit. It was a problem that consumers eventually caught on to and in the early 1900s the Armstrong Committee began investigating alleged abuses in life insurance.
The outcome after this investigation (and to some extent even before) was that life insurance companies began to offer policies that would give you some of your premium back if you cancelled your policy before you died. So in the analogy above for a $100,000 whole life policy for $4000 of premium per year, if you dropped the policy after 15 years having paid $60,000 of premiums, the company might give you say, $30,000 back as a sort of refund of your premium. This is the basic origin of the cash value account.
Over the last century this cash value concept has evolved into any number of varieties. But the basics remain, you put premium in and some of your premium goes to the cost of insuring you and the rest of your premium goes into an account that has the potential to grow based on a certain interest rate or other crediting method generally determined by the insurance company.
The Controversy: Term or Cash Value?
I have read almost every piece of information and I dont think I have ever read on a financial subject that had more bad advice and misinformation than this one. Here is the problem: This Buy Term or Cash Value? is a terrible question!
Its like asking if you should rent an apartment or buy a house and someone telling you they have the exact answer for all people in every situation.
The answer is simple:
Question: Buy term or a cash value policy?
Answer: It Depends!
Anyone who tells you otherwise and says you should always buy term or always buy a cash value policy simply does not know what they are talking about it - and you can have them contact me directly if they want to debate my basic argument. In fact I offer many clients the opportunity to do a 3 way phone call with their other advisor who is saying something opposite than what you are reading in this article. I am that confident in what you are reading in this article, not simply because Jon and I wrote it, but because this information is a compilation of not just ours but a lot of intelligent professionals opinions on this subject.
Here is a real simple way to know what type of policy you should buy. Is your need for life insurance temporary (meaning at some point in the next 20 or 30 years you will no longer need any life insurance) or is your need for life insurance going to last for the rest of your life i.e. past age 75 or so?
If you have a temporary need you probably need term and if you have a permanent need you probably need a cash value policy. Why? Because if you need life insurance past age 75 or 80 you almost have to buy a cash value policy because term policies expire around age 75 or 80.
Term: If you buy term you have a few options:
Annually renewable term
5, 10, 15, 20, 25 or 30 year guaranteed term
Return of premium term
Most people go with 5, 10, 15, 20, 25 or 30 year guaranteed term because they like the thought that they are locking in a guaranteed term for life.
Permanent life insurance works on a relatively simple concept. They overcharge you now so that your premium will not increase later so that your premium will stay level for life. This overcharge of premium when you are younger is another basis of the cash value account. The overcharge is credited to your cash value account and has the potential to grow.
If you are on a tight budget but think you might need permanent insurance later you could buy a term policy with a guaranteed conversion option. This means you can convert the term policy to a permanent cash value policy any time during the guaranteed term period with no health questions asked. It will be more expensive because you will be older and will be converting to a permanent policy. But the main thing is you will lock in your health rating while you are young. So if you got a preferred rating when you first bought the term policy and 10 years later contracted cancer or had a heart attack you would be able to convert the term to a permanent at the original preferred health rating you got 10 years earlier. This can prove invaluable if your health changes.
The big controversy has always been should one buy term and then save the difference in a side fund instead of buying a more expensive permanent cash value policy. But this simplistic line of thinking avoids the real nuisances of life insurance.
Before know the answers you have to look at two figures to see which goal you are comparing against:
1. Are you trying to have your side fund that you put the savings from the lower cost of term insurance beat the return on the death benefit?
2. Or are you trying to beat the return on the cash value inside the policy.
I have run repeated mathematical calculations and it is clear that at todays lower cost of permanent life insurance (because of longer life expectancies):
Conclusion #1: It is very difficult to beat the return to your beneficiaries/heirs on the death benefit portion of a life insurance policy; i.e. a cash value policy is more effective than buying term and saving the difference in a side fund if you are trying to pass on money to the next generation.
To save enough money to beat the return on the death benefit of a permanent life insurance policy you will have to be pretty aggressive in your savings plan. I just did an analysis for a 58 year old on a $2 million dollar policy and if he bought term and lived until age 88 he would have to have his buy term and save the difference side fund grow at 14% per year to match the $2,000,000 guaranteed death benefit from a permanent cash value universal life insurance policy savings.
The reasons that permanent cash value policies can be so effective are multi faceted. Without going to much off subject insurance companies can offer relatively generous death benefit payouts compared to the amount of premium you have to put in because:
The government gives life insurance companies tax breaks when they invest your premiums that are not available to regular consumers.
Life insurance passes to heirs income tax free (and estate tax free if properly structured as regards ownership of the policy).
Insurance companies are often using Tontine or Semi-Tontine price modeling for their policies, especially permanent cash value Universal Life policies. This basically means that they are under pricing their policy premiums to you because they know that a certain percentage of people will cancel their policies before they die and the death benefits will never have to be paid out. So if you actually keep your policy inforce until you die you benefit from the fact that others dropped their policies early which allowed the insurance company to offer you a lower premium over your lifetime.
Conclusion #2: It is possible to beat the return on the cash value account in a permanent cash value policy by buying term and saving the difference in a side fund i.e. a term policy may be more effective. But the one caveat is your tax bracket and income level because of the tax deferred growth of a cash value policy. You have to be sure that you are comparing apples to apples. If the life insurance policy cash value account grows at a guaranteed rate of 3-4% then you should not compare it to an aggressive side fund that grows at 10% unless you are sure that your side fund will grow that much each year on average.
I have developed a basic flow chart that, although not perfect, can be an initial guide to help you on your decision as to what type of policy you should research and potentially buy. Take a look at this flow chart and follow the arrows based on your answers to each question to come up with a basic answer. Pick one of the two main purposes (either for death benefit or to accumulate cash value) to the right or left side and then just follow the flow chart down to the answer.
Now as you go through this flow chart you probably have some questions on why we recommended term or permanent insurance in the given situations. Here is a quick summary of the advantages and disadvantages of term or cash value insurance.
Pros and Cons of Term and Permanent Insurance:
TERM INSURANCE OVERVIEW
PROS:
Relatively inexpensive compared to cash value insurance. Low price allows you to buy lots of cheap insurance.
Easy to understand.
Can be cancelled with no penalties.
Can usually be converted to permanent insurance later (depends on insurance company and policy).
CONS:
Designed to be dropped before your actual mortality age meaning it will most likely only pay out if you die unexpectedly. Not likely to pay out any benefit to your beneficiaries.
If you drop the policy you get none of your premium returned to you (unless you purchase a more expensive return of premium term policy).
PERMANENT CASH VALUE INSURANCE OVERVIEW
PROS:
Guaranteed to pay out to your beneficiaries not matter what age you die to create instant assets for your heirs.
Has potential to build cash value that will be returned to you if you drop policy at later date.
If policy builds sufficient cash value there can be the potential to first take tax free withdrawals of your cost basis and the pull out tax free loans.
Cash value grows on a tax deferred basis.
Has ancillary benefits -is an asset that can be pledged as collateral or sold later for value. Also can be used later in life in pension planning to optimize pension pay outs or for estate planning.
IRS allows you to transfer life insurance cash value to another life policy or annuity with a tax free 1035 exchange.
Has an element of forced savings since you will have to pay premium and hence build cash value even if you would not be disciplined to save money on your own.
Depending on your state there could be significant asset protection of your cash value from creditors. This is highly variable and should be researched with the help of a good lawyer for your particular state.
Insurance company generally guarantees you a minimum interest rate growth on your cash value in a fixed policy.
Your cost basis in the policy includes all the premiums you paid into the policy which in effect gives you a sort of retro tax relief. Term insurance premiums are not tax deductible and so no such benefit exists. Neither policies give you up front tax deductions but since the premium into a cash value policy build tax cost basis you could enjoy some tax benefits in the future if you ever took withdrawals or surrendered the policy.
You can design the policy to not need any future premiums after a given amount of years of paying premiums.
CONS:
More complicated to understand.
Surrender charges if you drop the policy in the initial years of the policy.
Extra fees and loads incurred on your premium and cash value.
If policy not structured correctly by an experienced agent it could be excessively expensive or have the potential to have the premium increase in the future.
In some types of cash value policies the insurance company can increase the internal charges or lower the rate of interest they are crediting on your cash value. The strength of the insurance company is important.
In some types of cash value policies your cash value is included in the insurance companies general accounts and could be frozen or forfeited if the insurance company became insolvent. Again, the strength of the insurance company is important.
FROM A POSTING BY JAMES ON THE TOPIC
By obtaining a permanent insurance policy, one is able to make more aggressive investments outside of the policy. (He may not have said exactly that, but that is the essence of what I derived from his post).
FROM THE ARTICLE I POSTED
One can "invest the difference," but should not attempt to compare the results in something that may earn 12 or 14%
MY OPINION USING JAMES' AND THE ARTICLES INVESTMENT ADVICE
Very astute observation on James' part. Having the "sure thing" from LI/CV, one can afford to take on a different investment profile and style outside the policy knowing one has that "ace in the whole."
This article states that to invest the difference between term and permanent, one should compare the results with a similar investment outside the LI that has the same returns as inside the LI.
Well, merging the two thoughts, any investor knows they need to divesify between stocks, bonds, cash (money market) real estate (REITS?), commodities.
Thus, one could use the permanent LI as the vehicle for the portion of their poprtfolio they would otherwise use for a combination of short and intermediate term bond holdings; in essence the LI would give them ersatz bond holdings or characteristics.
Buy Term And Invest The Difference
Linear Mode
