In my last post on the true reason to choose term life insurance over a whole life, I explained that in order to obtain adequate coverage for a typical family person, it will be quite challenging to do it with solely whole life insurance.
I have gotten a range of feedbacks but generally, some readers were unhappy that my views were so slanted against whole life. There were also comments that stated there were some nuances that I should have considered.
I decided not to sit on the fence because I got sick hearing of all friends and ex-colleagues that were underinsured because they have $XXXX and their personal planners recommended them policies that take away all their cash flows yet not covered enough.
I think I have explained my stance and if whole life is really that great here is something to try.
You know, a common risk of pre-mature death is when a spouse passes away, the surviving spouse will have to take on the burden of the home mortgage.
A common solution is to purchase a mortgage insurance. These mortgage insurance tends to be… a decreasing term insurance.
Now suppose we have a person with $1.7 million in the outstanding mortgage. If you wish to insure such a risk, why not buy whole life insurance that covers you $1.7 million?
Perhaps that is excessive and a spouse should cover 50% of the outstanding mortgage ($850,000 in this example) with cash-value whole life insurance.
Some may argue: “But Kyith, there is a difference between the needs of mortgage insurance and typical life insurance.”
I struggle to see the difference:
- The trigger for both needs is pre-mature death
- The monetary need is a lump sum to alleviate the future cash flow of your dependents. In a mortgage, it is to offset future mortgage payments by paying off the mortgage in a lump sum. In your dependent’s needs, the sum of money offset their future expenses and perhaps some savings
The needs are pretty similar. This is why there are some who may choose to use mortgage insurance to cover the income replacement for their dependents.
If whole life insurance provides adequate coverage, then try covering $1 mil for income replacement and $850,000 outstanding mortgage with whole life insurance.
It is weird why you would choose to use term insurance to cover one aspect of pre-mature death and find it tough to accept treating insurance as an expense for the income replacement portion.
But let’s not discuss this anymore but to more interesting stuff.
The Compounded Return You Get for Using Term Life Insurance As a Savings Plan
One of my friend who happens to be a financial planner wishes to find out what I think about the concept of using term life insurance as a savings plan.
The idea is this:
- The person does not have any dependents already. Thus, he does not need such coverage to hedge the risk of premature death
- He will pass away. It is only a matter of when.
- However, he wishes to set aside money for his heirs.
- His heirs know of #2 and wish to take advantage of this “peculiar human attribute that we will one day passed away”
- So he will buy a term life insurance for 99 or 102 years old with the purpose of leaving money for his estate to be distributed to his heirs
- He will pay for the premiums or his heirs will pay for the premiums
This is basically using the term insurance as a legacy planning tool instead of the traditional universal life plan.
Term plans are generic with a certain set of features.
You can use them to address different needs and your mileage will vary depending on how you use it.
My friend appropriately calls this a “savings plan” and it is funny why he uses that term because traditionally, whole life insurance was framed as a savings plan.
I think he is trying to play down the role instead of treating it as a legacy plan. Usually, people buy universal life because they may want to make sure they “die die” have $5 million to split among their heir.
If you treat this as a savings plan, it makes me feel like the final sum when the policyholder passed away is less important.
What is more important is the rate of return you will get.
- If the policy holder passed away soon, the compounded rate of return is going to be higher
- If the policy holder passed away very late, the compounded rate of return will be lower
- If the policy holder passed away at age 110, there will be only cost and no return!
So this is a bet that the policyholder will pass away before 100 years old. If the policyholder passes away later, then it is “a waste” to have paid all those premiums for that purpose.
How Do the Compounded Returns Look Like?
Let us use back the example of John, a person who is pretty similar to Kyith. John is a 40-year-old non-smoker.
John will buy a term life insurance covering him from 41 years old to 99 years old. His annual term life insurance premium is $5,190.
The table below shows the premiums paid over time and the compounded returns measured in XIRR:
The premiums paid by John is constant over the 60 years. If he passes away at any point, his heirs will get a $1 million payout.
If he passes away before 60 years old, his returns are astronomically high relative to the stream of premiums he paid.
What is interesting is that even if he passes away at 99 years, the XIRR return is 3.55%.
If you ask a lot of people today, they wouldn’t mind a savings account that gives 3.55% compounded return over 59 to 60 years.
The return of this payment is contingent on the insurance company issuing the term insurance.
- The higher probability phase would be after 75 years old
- If you look at the return it is still decent
- Your heirs will claim the money back for you
- It is a sort of legacy planning
Additional Things You Need to Take Note of Framing Term Life Insurance as a Weird Savings Plan
There are caveats to this plan though. Usually, there is a maximum entry age for term life insurance like this.
For NTUC’s Term Life, the maximum entry age is not more than 75 years old (I tried submitting an older one but they will only allow 60 and below for the system).
Your mileage may vary at different entry age. Here is the compounded returns profile if John purchase a $1 million term life insurance at 60 years old:
Some how the returns are less lucrative compared to buying earlier.
If John passes away after 100 years old, then this is not such a good investment.
In general, the premiums are much more expensive. Here are the annual premiums if John (age 40) insures until the following age:
|Insure until this age starting from 40 years old||Annual Premiums||Number of times Premium from $1626|
In order to do this, you need to be willing to commit additional free cash flow from work income into doing this. Your return will depend on when the policyholder passed away.
The premium difference will be different if the policy holder is younger. Here is the annual premium differences:
|Insure until this age starting from 20 years old||Annual Premiums||Number of times Premium from $680|
The absolute premium looked much lower! But you have to remember that this policy holder also paid 20 year longer in premiums than John.
Lastly, this savings account has a maturity only at the end of a person’s life. You cannot withdraw your money from this savings account at any time.
Thus, it is only applicable if you really know what you are getting yourself into.
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