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Life Insurance Myths and Facts:

Are These Common Life Insurance Myths Keeping You From Maximizing Retirement Income?

Introduction

My business deals primarily with fairly sophisticated real estate investors. I show them how to invest in real estate with Life Insurance. It’s important to understand that they you can literally put your money to work in two places at one time by leveraging the cash value of a maximum over-funded life insurance policy: The Double Play.

Smart investors immediately see the value proposition. They can earn dividends on the Cash Value of their policy while borrowing against that Cash Value to invest in Real Estate. The sum is greater than investing directly.

However, many others have a preconceived notions about Life Insurance. They have fallen for one of the many Life Insurance Myths. They may have heard them from a media pundit (Dave Ramsey, Suze Orman) or just people repeating them on investing forums. The goal of this post is to debunk the top 5 most common Life Insurance Myths.

The following five Life Insurance myths are the first “Buts” I hear from people who have negative opinions about life insurance or just don’t fully understand how it works. Many of these Life Insurance myths are perpetuated by personal finance gurus who do their audience a massive disservice by perpetuating these myths.


Myth 1: “Whole life insurance is a rip off!
: Buy Term and Invest The Difference”

You should realize that you will almost certainly get your money back when you purchase a permanent Life Insurance Policy.

  1. If the insured dies, the beneficiary will receive the Death Benefit. This will be much more than the Premium that was paid into the policy.
  2. If you hang on to the policy long enough, the Cash Value will exceed the Premium that was paid into the policy.

The only way you will lose money is if you become impatient and surrender the policy.

It’s important to understand that Permanent Life Insurance stands on it own merits just based on these 2 points. But, when you consider that:

  • The Cash Value in a Properly-designed Policy is ~85% of the Premium, and
  • The Cash Value can conservatively be expected to grow at 6-7% (1), and
  • You can borrow against the Cash Value to invest in Real Estate,

The Double Play is a no-brainer.

Buy Term and Invest the Difference

The most common thing that I hear is: Buy Term and Invest the Difference. The idea being that you should buy an inexpensive term policy to cover your life insurance needs and then save the difference between the premium for the term policy and the premium from the Whole Life policy. I have written several blog posts on this subject, but I’ll summarize the conclusions here.

Policy Design: Not all life insurance policies are the same

It’s crucially important to understand that policies for Tax-free Retirement Income and The Double Play are known as Maximum Over-funded Policies. Thus, anyone making a claim that “Life Insurance is a ripoff” doesn’t understand how powerful Life Insurance can be. These policies are completely different from Traditional Life Insurance policies. Most people buy a Life Insurance policy for the Death Benefit protection. They want to get as much Death Benefit protection as possible for their money.

On the other hand, a policy owner buying a policy for use as a Life Insurance Retirement Plan is going to want as much Cash Value as possible. Policy Design is what allows me to tailor a product to fit a clients specific needs. I can design a policy with the highest possible death benefit for the Premium. Or I can design a policy with the lowest possible Death Benefit and maximum Cash Value. I’ll explain the differences in the paragraphs below.

I cover the basics of Policy Design in my free Life Insurance 101 e-Book. If you follow the links spread through the text, you can find more detailed articles on Policy Design.

Minimally Funded Policies (Traditionally-designed Policies)

I just want to repeat that most people want Life Insurance policies for the Death Benefit protection. This means they want the protection at the best price possible. They are likely to shop around for the best price. As a result, Insurance Companies need to be competitive with their pricing. The Premium is just high enough for the policy to perform over the life of the Insured. Guarantees are much more important in a Minimally-funded policy.

The key thing that you need to know about permanent life insurance is that the Cash Value essentially represents the Policy Owner saving up the death benefit over the life of the Insured. The insurance company collects as little in premium as possible and makes a worst-case assumption about what they will earn on that savings. Its a fairly straightforward problem to solve for the premium necessary to reach the Death Benefit at a defined point in the future. It is simply a function of the Savings Amount, Interest rate, and Time.

Minimum Funding, Maximum Charges

It’s also important to point out the second key component of a Life Insurance policy: the Mortality Costs. This graph shows both components together over time. You can see that the Cash Value is increasing over time. The Death Benefit remains constant at $1 Million. The key takeaway is to recognize that the gap between the two lines is the risk borne by the Insurance Company. Notice that the risk declines over time. We’re going to come back to this.

The real risk to the insurance company is in the early years (bracket on left) when there is very little savings (Cash Value). The mortality costs are the monies set aside in a pool to pay the expected claims. By the Insured’s Age 79, you can see that the risk has shrunk to only $500,000. That means the Policy Owner has saved up half of the Death Benefit already. All permanent insurance works like this: Whole Life and IUL.

It may also help to think of the cost of insurance as like a 1-year term policy that is purchased every year.

It’s interesting to note that the insurance company is “Buying Term and Investing the Difference” for you. This means that the Cash Value is just like “The Difference”. But here’s the thing, the Policy Owner can do other things with the Cash Value. It’s important to realize that they could have been borrowing against the Policy and investing in real estate: The Double Play. Now realize that this is just a Minimally-funded Policy. Let’s take a look at a Maximum Over-funded Policy.

Maximum Over-funded Policy Designs

Here is a graph showing a Maximum Over-funded policy design:

A Maximum Over-funded Policy design. Death Benefit and cash values..

This policy design is also for a 45 year old. This time we are showing $100,000 per year of premium for only 10 years. The initial death benefit is about $2.5 Million. One thing that you should see is that the death benefit is kept to an absolute minimum. This means that at no time is the Policy Owner ever purchasing any more Death Benefit than legally necessary. You can also see that after the 10th year, the death benefit is reduced. What this does is drive the cost out of the policy and to preserve the cash value. It’s surprising to know that the total cost of insurance after the 10th year, is less than 0.25% of the cash value. [Learn More: Policy Charges and Expenses]

Maximum Funding, Minimum Charges

I would also like you to take note of the tiny sliver of “Risk” between the Death Benefit and the Cash Value. Compare this to the amount of risk in the Minimally-funded Policy above. I’m going to circle back to this and dispel another Life Insurance myth. You should also understand that this is what a properly-designed, maximum over-funded policy looks like. This is true for both Whole Life and IUL.

You can clearly see that this is a very efficient savings vehicle. Now imagine your Death Benefit needs being met AND having plenty of Cash Value to leverage for your Real Estate Investing. This is the beauty of The Double Play. It doesn’t take a rocket scientist to realize that this is vastly superior to “Buy Term and Invest the Difference“.

Its all about the income!

Another way to realize that Life Insurance is superior to “Buy Term and Invest the Difference” is to compare retirement income potential. I have a few articles that show the advantage of a Life Insurance Retirement Plan (LIRP). Let’s just summarize the benefits here.

The best way to compare “investing the difference” with life insurance cash value is to look at the income. It’s important to point out that financial advisors estimate the safe annual withdrawal rate from retirement savings by using the 4%-Rule. This means that if you had $1-million in a 401(k), the safe amount to withdraw each year would be ~$40,000. It’s also important to remember that 401(k) distributions are taxed at Ordinary Income Tax rates. That means you might only net ~$30,000 or less after tax.

Tax-free Retirement Income

It’s crucial to understand that the cash value of a life insurance policy can generate tax-free retirement income at a rate of 7-8% of the cash value. That means a policy with $1-Million in Cash Value can safely produce income of ~$80,000 per year. If we compare Life Insurance to Traditional savings, you can see that Life Insurance can produce nearly 3 times as much income from the same amount of savings!

Notice how closely the Cash Value tracks a hypothetical investment earning 9% but in a 25% tax bracket. Which one is going to provide more after-tax income at Age 65? Can you see that the “Status Quo” would have to be TWICE as much to generate more income?

The “Status Quo” is based on $20,000 savings per year to age 5 earning 9% in a 25% tax bracket. The “Cash Value” is from a Life Insurance Retirement Plan with $20,000 premiums to age 65. The cash value is assumed to be earning only 6%, but growing tax free.

This graph is doing the conversion for you. I’m applying the 8%-Rule to the Cash Value and the 4%-Rule to the Traditional Savings. This graph clearly shows that a Life Insurance Retirement Plan will provide almost twice as much income at retirement age. Just realize that total accumulation is just a number on your account statement statement. It doesn’t pay bills. Income pays bills. The savings needs to be converted into income.

This graph shows the income resulting from the previous graphs. This assumes the “4%-Rule” for income from the “Traditional” retirement plan and 8% for the Life Insurance Retirement Plan (LIRP). At age 65, this client could take about $60,000 per year from their “Traditional” retirement savings and about $100,000 from the LIRP. Ripoff? I don’t think so.

So how can the cash value generate so much more income?

It’s important to understand that the reason Life Insurance can generate much more income is that you don’t take withdrawals. This means that you get income by borrowing against the policy by taking a policy loan. The way that a life insurance retirement plan works is this: you borrow against the policy’s cash value to get tax free income. At the end of the year, when the interest is due, the insurance company, knowing that the collateral securing the loan also went up in value, loans you the money to pay themselves the interest and tacks it onto the loan balance. This continues year after year with the loan balance getting ever larger each year, but the loan balance is always secured by the offsetting increases in cash value. You have a compounding loan balance that is secured by the compounding cash value of the policy.

When the policy owner dies, the death benefit satisfies the policy loans and the balance is paid to the beneficiary. A LIRP is the coolest thing in the Financial world.

When you remove money from a brokerage account, it is no longer there and no longer appreciating in value. That is not the case with loans against the cash value. THIS is the reason why you can get so much more income from a Life Insurance Retirement Plan.

Since dollar for dollar, the Life Insurance Retirement Plan can generate more tax-free retirement income, the advantage goes to the life insurance. Myth: Busted.

Myth 2: “It takes forever to build up cash value”

It’s important to realize that when ~85% of the Premium is Cash Value, you have Cash Value IMMEDIATELY. Let’s be realistic, if you are only putting $100 per month into a policy, it will take a long time to invest. However, if you use larger amounts like my example above, you have a significant amount of cash value available immediately! I want to stress that a Maximum over-funded policy is an entirely different animal from a typical minimally-funded policy. That means that the Cash Value accumulates much more quickly.

Cash Value available immediately. Myth: Busted.

Myth 3: “The returns on life insurance are too low”

Compared to what?

Properly Accounting for Risk

Real Estate? Stocks? It’s important to consider risk when comparing returns. Returns alone do not tell the whole story. Safety and liquidity translate into low returns. Think about the interest on your bank account. You should realize that high returns often come with a high risk and low liquidity.

It’s important to realize that Life Insurance dividends occupy a unique spot in between these two extremes. Life Insurance Companies invest their reserves in secured debt instruments. Think Bonds, Treasuries, Mortgage-backed Securities, Preferred Stocks, etc. The most important thing to keep in mind though, is that they are matching their investments to their planning horizon. That means they may purchase and hold bonds for 30-years. The great thing about this is that they can capture a premium for giving up some liquidity. Remember that insurance companies are matching up their liabilities with their investment decisions. They are in it for the long run.

Life Insurance Allows A Liquidity Premium

You know that this benefits you because your Policy’s Cash Value earns above average debt market returns even while you have full liquidity. You can borrow against the policy to access the Cash Value at any time. It’s important to realize that one of the great advantages of the cash value of a life insurance policy is liquidity. A policy owner has access to their cash value via policy loans at any time. The cash value securing the loans is growing at long-term interest rates.

Current dividend rates around 5% to over 6%.(1) The annualized interest crediting rate on an indexed universal life should average 6 to 7% given today’s interest rate climate and a look back at historical index returns. It’s also important to consider the tax advantage of Life Insurance. Since it is not an investment, there are no taxes. And because you access the Cash Value with

Dividends and Guarantees are Different

It’s also important to realize that many people have a tendency to confuse the Dividend with the Guarantees. The Dividend represents an allocation of the net gains on the Insurance Company’s investments to each policy. The Guarantee is only the Actuarial requirement, not the amount that the insurance company is actually crediting.

6-7% growth on the cash value in a principal-protected asset class. Myth: Busted.

Myth 4: “Why would I borrow money from myself?”

It is absolutely crucial to understand that policy loans are loans from the Insurance Company secured by your Cash Value. This implies that the harshest critics of Life Insurance don’t really understand how it works. Take a look at the Florida Insurance statutes:

The Statutes clearly and unambiguously state that Life Insurance companies must make loans secured by the Cash Value. This means that you have access to a Line of Credit equal to your Cash Value balance.

You might also notice Section (2): If you don’t pay the interest when it’s due, the insurance company will loan you the money to pay themselves the interest. This is the secret sauce that makes a Life Insurance Retirement Plan possible. You don’t have to repay the interest!

One of two things are going to happen:

  1. You pay back the loan plus interest due, or
  2. Two, you die and the loan is paid back from death benefit reducing the net amount of death benefit available to your beneficiary.

You’re not borrowing from yourself. Myth: Busted.


Myth 5: The life insurance company keeps the cash value when I die

It is important to understand that the Cash Value is an integral part of a Life Insurance policy. That means that it is part of the Death Benefit. It might be helpful to look at the graph from earlier. [Learn More: What happens to the Cash Value when I die?]

The cash value is literally part of the $1-Million death benefit. It represents the policy owner saving up the death benefit over the insured’s natural life expectancy. The death benefit is the combination of the cash value and the additional risk covered by the life insurance company. The additional risk is the gap between the Death Benefit and the Cash Value.

If the Insured passed away at Age 81, the Beneficiary will receive $1-Million. $500,000 comes from the Cash Value and $500,000 comes from the risk pool.

It’s important to point out that the insurance company settles outstanding policy loans before paying the death benefit to the beneficiary. For example, if the policy owner had a $500,000 policy loan, the beneficiary would receive $500,000 from the death benefit. To make this point abundantly clear, if you are borrowing your own money, how could the insurance company keep it if you pass away? Just to make the point abundantly clear, if you are borrowing your own money, how could the insurance company keep it if you pass away?

Conclusion

Life insurance is a very powerful financial product. There is much more to it than just a death benefit. The fact that the insurance company must make policy loans to the policy owners mandated by statute makes it a unique financial product.

It is an absolute shame that life insurance receives such a bad rap and that these myths manage to persist. But that said, it is a very sophisticated financial product and it is very easy for an agent to unknowingly design a bad policy and worse, to tell a client something that simply isn’t accurate. I hear agents use the phrase “take money out of the policy” all the time. That is just not the case!


Notes:

(1) This article was updated May, 2024. Several Mutual Whole Life companies are offering dividends over 6% right now.

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