You think term always beats whole life insurance? Think again!
This post is by Brian Poncelet, an insurance specialist and independent certified financial planner (CFP) who has been working in the financial services industry since 1994.
For years some financial experts have suggested the most cost effective way to protect your family is to buy term life insurance and invest the difference. For the average Canadian who earns $46,000 per year this strategy probably makes sense. However, if you have a yearly salary of $100,000 or more you should seriously consider supplementing your term coverage with whole life insurance. The benefits are many – not only will you be able to spend your hard-earned money freely, you’ll pay lower taxes with lower risk for loved ones and yourself. Let’s walk through an example.
At first glance good friends Allen and Bob are very similar. Both are 35 year old males and breadwinners of families with a solid annual incomes of $100,000. Both have similar insurance needs – they have a wife and child to provide for and protect. This is where the similarities end – Allen and Bob select totally different insurance strategies.
Allen: Buys Term and Invests the Difference
Allen thinks short-term and buys a $500,000 term 20 policy at $42.75 per month. Allen intends to drop the coverage at age 55 since the rate renews for a whopping $572.40 per month. He has $1,000 cash to invest every month for the next 30 years. Assuming he achieves a rate of return of 7% he ends up with $1,227,087 at age 65.
Bob: Buys Term with the “Forced Savings” of Whole Life Insurance
Bob also buys a $500,000 term 20 policy at $42.75 per month. However, Bob wants to own a permanent whole policy which he pays $400 per month for 20 years. This policy starts at a death benefit of $180,000 with no cash value. With his $400 being spent on whole life, Bob only has $600 left to invest each month for the next 20 years.
Who comes out ahead at age 65?
Based on Allen and Bob’s plans above you might think Allen who invests $1,000 per month might have more net worth than Bob. Remember, Bob is only investing $600 per month for 20 years and $1,000 per month for 10 years. However, when you do the math (and this is what a professional insurance agent can help you with) Bob comes out ahead in death benefit coverage but also overall net worth. If Bob passed away at age 65, his family would receive $1,280,803 ($788,889 from his investment portfolio and $491,914 death benefit).
Not only would Bob’s family receive $53,716 more than Allen’s family (who no longer has insurance coverage by the way) Bob’s family would pay at least $100,000 less in taxes and fees!
| Allen – Term Life Policy | Bob – Term + “Forced Savings” | |
| Coverage | $500,000 term 20 year policy | $500,000 term 20 year policy;Whole life policy starting at $180,000 |
| Premiums | $42.75/month | $42.75/month (term);$400/month (whole life) |
| Investment | $1,000/monthfor 30 years @ 7% | $600/month for 20 years and $1,000/month for 10 years @ 7% |
| Net Worth@ Age 65 | $1,227,087 | $788,889 |
| Death Benefit @ Age 65 | $0 | $491,914 |
| Total Net Worth | $1,227,087 | $1,280,803 |
OK, I know what you’re thinking: 7% was a realistic rate of return a decade ago but times have changed. What about a 5% rate of return?
Allen will have a portfolio worth $1,220,000 while Bob will have a portfolio worth $1,288,000 ($788,000 portfolio plus $500,000 death benefit).
Does term and invest the difference always sound like the better choice now?
Nobody hopes to pass away at age 65 but it’s nice to know your family is financially protected in the worst case scenario. Hopefully you consider the pros and cons when you hear the phrase “buy term and invest the difference.”
Brian Poncelet is an insurance specialist and independent certified financial planner (CFP) who has been working in the financial services industry since 1994. Along with insurance, Brian Poncelet focuses on mortgage and retirement planning. Check out www.rightinsurance.ca for more information.
My Own Advisor: I’m sure this post might be a bit controversial to some readers. In fact, I don’t agree with buying whole life insurance for the most part. Buy term and invest the difference. What’s your point of view – comment away!
Hi,
You mentioned that whole life policy coverage mentioned above is $180,000. I understand that it became $491,914 because of the accumulated cash value that was added on top of the coverage. But most of the policies that I carefully reviewed from most Insurance companies will only pay the death benefit and not the cash value during claim. Can you please mentioned some companies that will actually pay the cash value + death benefit upon death of the Insured so I can review the actual policy if it’s really like this.
Thanks for the question but I’ll have to defer to Brian P. on that one!
@Financial Uproar
If you used your RRSP and TFSA effectively, you wouldn’t have to pay a nickel of those $210,000 worth of capital gains you quote. $1000 a month doesn’t even max out the RRSP contribution room of someone making $100k per year.
You forgot probate fees and legal fees.
The story is an example using $1,000/month. The problem with the TFSA (which has its limits) $5,000 limit per year. Early death who funds the TFSA? If one is disabled the TFSA contribution is stopped, the insurance policy can be covered to age 60 or 65.
If you cash say $25,000 out of the TFSA you earn $0. On the cash value insurance if you pay back the $25,000 you are credited as if you never took the money out.
The insurance strategy is really saying if you have some to protect, like a family or partner… trying to save money is no guarantee of a lump sum of money when you need it most.
Part II which should be submitted soon will address why one would want (insurance) based on taxes, risk, market corrections, better protection. inflation etc. in retirement vs. not been covered. Think of it this way should you have all your money in stocks or should you have some money in cash and bonds.
Insurance is a transfer of risk. Since taxes takes a big bite out of returns insurance can lower anyone’s tax bill in retirement…which increases real returns without risk.
A great site to check out is
http://www.moneychimp.com/features/market_cagr.htm
“Average” return is always less than “Annualized” return.
If one looked at Jan 1 2001 to Dec 31 2011 the annualized return was 1.42%
This assumes no fees charged, no taxes, all dividends are reinvested.
Other periods of time returns are much better.
The odds of dying at age 65 are less than 2%
@Brian Poncelet,CFP
If you used your RRSP and TFSA effectively, you wouldn’t have to pay a nickel of those $210,000 worth of capital gains you quote. $1000 a month doesn’t even max out the RRSP contribution room of someone making $100k per year.
@jeffrey
Hello Jeffrey,
You may want to read https://www.myownadvisor.ca/?s=annuities
The the idea is the end game (retirement) if you are 65 today or say your parents could get say 6.6% guaranteed for some of their money for life would they? Could you find anything out in the market today?
Insurance is really a tool one could use if they die early or or live a long time.
If one lives a long time they have the opportunity to spend down their nest egg down to zero and leave their partner or family cash when they are gone.
The problem today is many are trying to get high returns (higher risk, with their money) or they are getting poor rates of return and really don’t have enough money to retire comfortably.
Inflation, taxes, fees, and market corrections in retirement is something that can not be avoided. This may include their house which they maybe considering to sell to “downsize” to get money to live off of.
@Ram
Hi Ram,
I hope to get part two up in a short time.
In a nutshell, the person who lives lets say to age 75 or 85 (who has permanent life insurance) will be able to spend more money in retirement, have better protection and pay less taxes.
Hello Financial Uproar,
Insurance is a transfer of risk.
The one thing many people seem to forget or understand is how taxes can chew up one’s estate as well. The $100,000 less in taxes is probate and legal fees.
On $1,200,000 @ 5% this is $60,000
On $800,000 @ 5% this is $40,000
Capital gains on $1,200,000 is ($1000 X 12 X 30 years=$360,000)
So $1,200,000 -$360,000 = $840,000
$840,000 X50% =$420,000 X 50% (taxable amount)=$210,000 …that is CRA’s amount.
$210,000 + $60,000 (probate, legal,etc.)= $270,000 gone.
The $491,000 (life insurance) no tax or probate or legal fees tax free.
The $800,000 – ($600X 12 X 20 years= $144,000) + ($1000 X12X10 =$120,000) =$264,000 = $536,000 X 50% = $268,000 X50% = $134,000 tax owed to CRA
$134,000 + $40,000 = $174,000
So even rounding the numbers up for the person who has insurance and using a low 5% cost for probate fees, legal, accounting etc. the difference is $96,000. (close to the $100,000)
Brian
Thanks for sharing your numbers Brian, great stuff.
One of the things no one is talking about is that people say that they will invest the difference, but how many actually do.
I worked in the life insurance industry in IT and wrote specification to computerize the handling of insurance products. When I bought insurance, I bought plain vanilla whole life. I did not need term insurance as I got work benefits that included term insurance at 3 times my salary. My husband also had a term insurance benefit from his work.
I would have to agree with Ram — the other thing to remember is that life insurance it insurance — it isn’t supposed to be looked at like a lottery. It’s needed when couples are younger with children when there will be expenses that need to be taken care of if someone dies and the other wouldn’t be able to work. As we get older and children are on their own, these financial obligations diminish (thus term life insurance would be stopped at 55 because it just isn’t needed as it was when younger)
Hey Jeffrey – thanks for stopping by! To play devil’s advocate, insurance can be looked at for comprehensive protection, and some people may want more than necessary to feel “safe”. That said, I’m of the mindset that you only buy what you need, insurance is no different.
Do you own term now?
This is a classic example of fitting a set of data points to a theory.
What the odds of this scenario happening amongst a lot of other possible ones? Possibly very low. It could be argued that another scenario where Bob wins is dying in just a couple of years after taking the insurance
How does the two compare if the person were to die after 65? after 70? after 75? I think the insurance value isn’t going to grow as much as the investment does even if the premiums stop at 65.
Insurance can never be savings. Any data point that disproves this is more an anomaly than a norm. The odds of a person falling in the anomaly scenario is pretty slim.
Thanks for your detailed comment Ram. What is a blog if it cannot be a bit controversial sometimes? 🙂
If the two were to die after 65, you definitely have different numbers. I think Brian will provide some data on this when he reads these comments.
I’ve always thought the whole point of insurance was to hedge against a financial disaster.
Having a $1.2M nest egg at age 65 is a pretty enviable position, and I’d argue nobody in that financial position needs insurance.
I also disagree entirely with the statement “Bob’s family would pay at least $100,000 less in taxes and fees!” Sorry, but each family’s tax liability depends on all sorts of factors, including asset allocation, tax credit carry forwards, and so on. Yes, whole life insurance can minimize the tax liability, but good planning by Allan can also do the same thing.
Whole life thrives in an environment where people are uncertain of future returns. From my perspective, the situation you’ve pointed out is pretty much the best case scenario for returns, considering North American stock markets have easily beaten 7% returns over the past 100 years.
Hey Nelson,
I agree with some of your points, definitely the 7% comment. I asked Brian include the 5% ROR which is much more realistic going forward.
I definitely see the use of insurance as a hedge against a financial catastrophe, ala Glenn Cooke’s line of thinking. Personally, I suspect we’ll only need a minimal amount of insurance once our house is paid off.