Is Life Insurance REALLY the Best Investment?
Life Insurance Beneficiary vs. Will Beneficiary
What happens to your family after your death is a sad but important question to think about. Let’s talk about two popular approaches: life insurance and a regular will. In both cases, you designate one or several beneficiaries, and you can always change your decision later. The main difference is in the amount that is paid out when you die.
Types of Investments
Life insurance policy requires that you make regular premium payments to the insurance company. When you die, the policy pays out a fixed amount to the beneficiary. The required premium depends on your age, health, and, of course, the size of the final payment you desire.
A will just transfers to the beneficiary whatever wealth you accumulated by the time of your death. The exact amount depends on how much you were saving, and how good your investments turned out to be.
To make a fair comparison between life insurance and a regular will, let us use a concrete example. Suppose you are 30 years old, and you buy $500,000 whole life insurance. (“Whole” means that it lasts forever, as long as you keep making the premium payments.) Your premium may be around $6000 per year.
Now suppose that instead of buying life insurance, you write a will. You take the same $6000 per year and invest it on your own. If you invest in a traditional combination of 60% stocks and 40% bonds, your average annual return may be around 8%. If you run a calculation in Excel, you can easily see that by age 56 you should already accumulate $500,000. Since your life expectancy is normally far greater than 56 years, you will easily beat the whole life insurance with your own investment. If you die at a typical age of 75, you will have approximately over $2,500,000 in savings that will transfer to your family! Refer to the Investment Growth chart below for a visual understanding.
Sounds simple? To some extent, it is. Whole life insurance is usually a way for insurance companies to make money off you. However, there are a couple of problems with your own investment.
Potential Problems with Investments
First, what if your investment does much worse than you expected? You have just seen the stock market crash to half of its former value. And bonds can fall in price too if inflation starts in earnest. If you portfolio returns only 5% per year instead of 8%, you will not achieve the $500,000 target until you are 67. With such pessimistic projections, the whole life insurance doesn’t look that bad. Remember though, that the insurance company itself may suffer from the same problem; if the stock market does not do well, there is a chance that the insurance company itself won’t be able to meet its obligations and will default. If you think this can never happen, remember that a couple years ago nobody believed General Motors, Lehman Brothers, Bear Stearns or AIG could ever go bankrupt. And all of these companies have had a close call with bankruptcy (and Lehman actually did go bust).
The second problem is even more important. What if you die early? Sure, it is unlikely to happen, but accidents and illnesses are unfortunately part of daily life. Most Americans face the greatest risk of death when they drive to work every day, since car accidents cause more fatalities than any other cause. If you die before your investments had a chance to grow to a reasonable amount, your family may be financially destroyed, especially if they have to pay for an expensive mortgage. The biggest benefit of the life insurance is that it will provide the same payout regardless of when your death occurs.
Taxes create a lot of complications, and there is no simple advice that can be offered without reviewing your individual situation. You need to consult a tax expert before you make any decisions. But generally, the use of IRA, 401k and other tax-exempt savings programs are definitely worth considering.