My friend Brandon is a very big advocate of Permanent Life Insurance. Him and I have gone the rounds on many occasions about permanent versus term. I decided that to be fair, I would present his argument in a series of posts here in Rabbit Funds. The series begins with a post about challenging the pre-conceptions about permanent life insurance. You can find links to the other posts in the series at the bottom.
Here is the reality of investment returns – 12% isn’t likely
Why? Because the markets haven’t supported that.
Also, there is a little thing called Average vs. Actual returns. It’s pretty easy to use a financial calculator and plug in a certain return, and a certain investment every month, and a time period and get a number saying how much money you will have in the future. That’s how I just came up with a $500,000 nest egg is what you will get if you invest $505 per month for 20 years and get a 12% interest rate.
But the market does not return a steady growth, year in and year out. Every year the market is up 20%, or down 18%, or up 4%; it moves all over the place. And that movement costs you money.
If you have $1,000 invested and have a 100% gain, you now have $2,000. But if the next day you have a 50% loss, you are down to your original $1,000—even though you had an average return of 25%. The movements of the market every day cost money when losses happen; not just the losses themselves, but the losses that occur because the ensuing gains now have to play catch up.
To project an average return and expect the results to be there is not realistic. For example, from 1995 through the end of 2004, the Dow Jones averaged a 10.89% return. According to averages, if you invested $100 per month in that time period you would have $21,566. But, since the markets move every single day, every single second even, and that movement causes losses that aren’t reflected in averages, you would actually only have $15,697.
I got this number by downloading the Dow Jones historical data from Yahoo.com’s finance section. The report shows the daily openings and closing every market day since 1928. A little bit of excel work later and I have a spreadsheet showing actual vs. averages.
I took 10 year periods every 5 years, meaning 2000-2009 and 1995-2004 and so on, all the way back to 1928 and compared average results to actual daily results. That means you lost out on 27% of your portfolio and your actual return was only 5.2%. You lost out on over half of your return because of something you couldn’t control.
When I compared all of these various 10 year periods, the actual return ended up averaging less than 6%. Hardly the 12% that is hyped.
And then there are taxes
If you have money invested, unless you have it all in a Roth account, you will owe hefty tax sums. And many people will not have it in a Roth, because of the contribution limits. Plus, if you have it in a Roth and need it because it replaces the life insurance when a breadwinner dies, you could have to pay some penalties to get it.
If we are very conservative and say you are in a 30% tax bracket, you automatically lose 30% of your nest egg/return. All things considered, according to historical data, you are safe estimating a 4% average rate of return (6% actual return less 1/3).
Now I sure hope this isn’t the case in the future and that everyone gets more than this, but if you choose to buy term and invest the difference, wouldn’t you want to plan your numbers very carefully? We are talking about the future financial stability of your family here. This is nothing to be anything but extremely cautious about. Even if you decide you don’t like the 4% number and want to assume a higher rate of return, you would be doing your family an injustice to assume an after tax, actual result of anything higher than 5%. In which case, to get your $500,000 self insurance fund, you need to invest $600 per month for 30 years, or $1216 per month for 20 years. A far cry from the 12% that many people are purporting.
My intention here isn’t to scare people out of investing money
But I do want each of you to realize that just because someone says a 12% return is realistic, or even if lots of people say it, doesn’t mean you can get it.
The biggest problem with people who so adamantly push the buy term and invest the difference strategy is that so few, if any, of them really understand the implications.
Another is that it is pushed with such fervor that everyone acts like it is the only financial strategy someone should consider. And when it comes to finances no two people have the same financial situation, so how can you possibly prescribe the same financial strategies to everyone alive?
Just know that if you do choose to buy term and invest the difference, you could potentially be forcing yourself into a situation in which the money you have to live off of will be whatever you can invest in 20 years, possibly at a much lower rate of return than initially anticipated.
Now what about the death benefit itself?
Is there a reason to have that? There could be depending on your situation.
The owner of the Miami Dolphins passed away in the early 90’s. Now as you can imagine, he was a very wealthy individual. So wealthy that his family had to sell the Dolphins to pay his $47,000,000 estate tax bill.
Very few people have a significant amount of cash on hand relative to their wealth. Most wealth is in the form of property or businesses. If you have an estate tax due, you might have to fire sell something in order to foot the bill.
If this person had permanent life insurance, the death benefit could have stepped in and paid this bill, preventing his family from having to sell assets quickly.
As an individual grows wealth, the purpose of life insurance changes from family protection to estate tax payment and estate preservation, among other things.
Another thing to consider is how one gives wealth to the next generation. While not everyone will have an issue with estate taxes, many people will have valuable and sentimental things to pass along.
Take for example if someone owns a home when they pass away. If there is more than one heir, then an issue of who gets the home comes up. If the home has sentimental value, then at least one of the heirs could want to keep the home, while the remainder will want the home sold and the proceeds split. These are the kinds of things that can really destroy family relationships, too.
It gets even uglier if someone owns a business and wishes to leave the business to one heir to continue on. If other heirs are involved, they will likely want the business sold in order to get their share of the wealth, while others might want the business to continue on since it is their livelihood. With a death benefit in place, one heir can have the asset and the others the cash from the life insurance.
The issue of debt and final expenses
An average funeral runs around $10,000 and in many instances, people do not have that kind of cash readily available.
Even more important though is the issue of debt. There are many assets that an individual would wish to pass on that might carry a debt. Homes, businesses, rental properties, vehicles; the list goes on and on. Whenever there is debt on an asset, it must be satisfied. And many times a potential heir will simply not have the financial resources to pay off the debt or even take over the payments.
In these situations some of the assets might need to be sold quickly, even at prices lower than fair market value, in order to complete the transfer of assets. Or consider if a business owner dies and has business partners. All of a sudden, the business partners are now in business with the spouse or kids—not a fun situation for anyone involved.
It is easy to say “Well, I plan to live debt free and have no debt when I die”, and that is an excellent goal. However, there is no way to guarantee that because sometimes life comes up and gets in the way of our plans.
Here are all of the posts in this series:
- Challenging Pre-conceptions
- How Term Life Insurance Works
- Is 12% Realistic when “Investing the Difference”
- Returns, taxes, death benefit and debt
- Achieving Financial and Spending Freedom
For more money saving tips, follow RabbitFunds on Twitter.