You've perhaps seen or heard the ads. But is this a good idea? Is this really something that is "completely different" than the Whole Life insurance that Dave Ramsey and Suze Orman disparage as a bad deal?
No, it's not completely different. Unfortunately, the way that it's similar also is what makes it a bad deal. Consider this chart showing how "Policy 3" is such a wonderful thing according to author of the book that advocates this technique:
The policy shows someone in good health purchasing it at age 35. Like all policies other than Term Insurance, this plan combines the insurance with an investment aspect. It is this investment that builds "cash value."
I will copy some of the sales spiel here for rebuttal:
Getting back to Policy 3, you'll notice several interesting items. First, look at the circled amounts on the line for Policy Year 1. At the end of the very first year, Policy 3 has almost eight times more cash value than in Policy 1 (the policy with no riders at all). A properly applied Paid-Up Additions Rider and term rider provide that powerful super-charging effect.
Now check out the circled amount on the line for Year 4. The PUAR and the term riders have caused Martin's annual cash value increase to exceed his annual premium beginning in the fourth year – one year earlier than Policy 2, and three years earlier than Policy 1. (His $12,337 cash value increase is greater than his $12,000 premium.) Go, Martin!
It's true that Policy 3 builds much more cash value than Policy 1. But this is like pointing out how a broken arm is so much better than terminal cancer. This is one of the many fallacies you'll encounter with this—the idea that something being better than something else means that is "good." Losing 4% instead of 10% is better, but it's still a loss, and not good when the idea is gain.
Look again at the cash value in Year 4. The total cash value is $43,608. Now, "Martin" has paid $48,000 in premiums over that four year period. Now, depending on the cost of the "insurance" aspect of these policies, the return of the "investment" portion can vary a lot. This is where they deceive you. The return on the "investment" goes up as the cost of the "insurance" aspect goes up. The more you overpay for the insurance, the better the "return" on the investment part.
Let's demonstrate this by exploring two extreme cases. Let's say that "Martin" is paying $100 a month for the "insurance" part, so his "investment" part is paying in $900/month or $10,800 per year. After four years, Martin has paid in a total of $43,200. His total cash value from the non-insurance part is $43,608. This calculates to a yearly rate of return of 0.48%. $100 a month buys a LOT of term insurance for a healthy 35 year old, so this is still somewhat overpriced insurance.
Let's crank up the cost of the "insurance" part. Instead of paying $100 a month for insurance, let's make it $300/mo, with the other $700/mo going to his "investment' in building cash value. After four years, he's now paid in $9600 for insurance and $33,600 for "investment" to get the same cash value of $43,608. This equates to an excellent 12.83% annual return.
But that return is bogus, because you had to get ripped off on your insurance to get it! For a healthy 35 year old, $300 a month is several million dollars worth of coverage in term insurance (about $4million). Whole life? About $400,000. TEN TIMES less insurance coverage.
In order to get the 12% annual return in the "Bank on Yourself" scenario at year 4, we had to pay 10x more than we needed to for life insurance. If we return to the less-crazy premium of only $100/mo, we can see how investing in term insurance is superior. Had "Martin" invested $900/month for four years in something getting a modest 5% yearly return, he'd have $47,713 instead of $43,608.
We return to the sales pitch:
Your reward for patience in the early years of your policy is a growth curve that gets steeper every year you keep the policy. Even the supercharged policies used for the Bank on Yourself concept grow more slowly in the early years. It takes a while for your cash value to equal the premiums you paid, though from day one, your premiums are immediately providing you with the full death benefit of your policy and the peace of mind this brings.
Go back to the chart and look at the line for Year 20 in Policy 3. Beginning this year, Martin's cash value increases by more than twice the amount of premium he pays ($26,077 cash value increase, compared to $12,000 premium paid). And beginning in year 30, his cash value increases by more than three times his premium ($37,994 cash value increase, compared to $12,000 premium paid.) Martin's doing his happy dance now!
The bold is in the original. Because of compounding interest, *any* investment should have a growth curve that gets steeper with each year. The question is how fast does it get steeper, and from where does it start?
Let's indeed go back and look at Year 20. The total cash value at the end of 20 years of payments is $349,956. To get this amount, Martin has "invested" no less than $900 a month for 20 years. His annual return on this investment is 4.52%. This is not too bad, but it's barely beating inflation. He'd could instead invest with very low risk and achieve 6% or better. And even a small percentage change matters a lot. Going to 6% would give Martin $415,837. At 8%, he'd have $530,118. At the historical stock market average of about 10%, he'd have $683,432.
It's bogus to compare the "cash value increases" because the annual gain in a long-term investment is overwhelmingly a product of the previous years' contributions and gains. Who cares if the "gain" after 20 years goes up $26k—Martin has already invested $216,000! A "gain" of $26k in cash value isn't necessarily impressive in year 20. After all, if Martin had invested in something else that returned 8% his gain in year 20 would be about $50k—almost DOUBLE what the "BoY" program would give him.
Finally, there's the 40 year point. At this point, Martin has accumulated $1,139,545 in cash value inside the policy. He's paid in $432,000 over 40 years. He return per year remains at about 4.27%-- even worse that it was at year 20.
I've illustrated thus far that the "cash value" even a souped-up Bank on Yourself insurance scheme is a poor return relative to other investment options. But here's the final nail in the coffin. You cannot compare cash value to cash.
Accessing the cash in the life insurance policy requires me to either 1) surrender it and forfeit all coverage for death benefit, and 2) borrow against the cash value. When you surrender it, you will have to pay fees, repay any loans, and pay any unpaid premium. So you're not going to get all the "cash value" out of the policy. Then, we you DO get the money from it, all money over and above what you actually paid in is considered taxable income, so you'll pay your income tax rate on top of that. This is all *after* you've earned a pretty meager return on investment.
If you borrow against the policy, you will have to pay it back (with interest). Yes, after paying you only 4% or so for the right to use your money, the insurance company will loan you back your own money and charge you for it! What's worse is that if you die with any loans outstanding, the death benefit goes to repay the loan first. So if you have $100k in outstanding loans, the balance would be repaid from the death benefit.
A quick note on insurance: a lot of people don't know how insurance companies work, but it's really rather simple. Insurance companies collect a lot of money, invest that money in relative safe investments to make money. Insurance companies pay actuaries big money to use advanced math to manage the flow of money in and out, which is the key to insurance. Since insurance companies can't make riskier investments, then can't achieve more than 4%-6% return on all their invested capital over the long term. Which means that the only way they can offer a client more than that return on investment is for them to lose money!
There are ways to use probabilities to game this out. I can offer you a 20% return on "investment" in building cash value, but if there's only a 10% chance of you getting all that cash value out, then the real actual risk to the company is 2%. (10% of the 20%). Insurance companies pay very close attention to these probabilities, carrying them out to 6 or 7 decimal places, because when you are talking about very large numbers, even tiny changes in probability matter a lot.
Large numbers and small probabilities—those are the essence of insurance. Keep in mind that Wal-Mart generates billions in profit every year with less than 3% actual profit margin. Over a long term, an insurance company may make only 3% on its investments, and pay out 1% in claims. That modest 2% residual can become billions in profit when applied to a large pool of money over a long period of time.
If you truly wish to "bank on yourself" then don't do it with overpriced insurance schemes that shortchange you multiples of thousands of dollars. Instead, be your OWN investment advisor and only let insurance be insurance.