Analyzing Costs in a High Cash Value Life Insurance Policy

me“But what is the cost?” This is question that I often get before I’ve sat down with someone and showed them an actual insurance illustration. It’s a difficult question to answer without looking at numbers and understanding the actual dividends of a life insurance company.

On top of this, because we are putting money in to gain a return on our investment, it makes the conversation of cost an even much more difficult subject to tackle.

However, let’s look at some numbers from an actual insurance illustration and see if we can’t analyze cost better.

Let’s take a look at a 40 year old male who is putting in $10,000 a year until he is 70 years old. This will be a high early cash value policy. [Understand that in a high early cash value policy, we will be getting a slightly lower dividend, in exchange for an early cash value (I’m planning on writing a follow up to this next week on the topic of high early vs long term policies. So stay tuned if you want to understand more on that).]

The Early Costs

A cash value life insurance policy builds more like real estate than a stock or other type of investment. When you put money into a stock, IRA, or other investment like that, let’s say 10k, you are going to have 10k in that investment. Then as the investment moves, your balance goes up and down.

Not so with life insurance. Life insurance is more long term. It will build equity over time. But what is the initial cost of insurance going to buy? Well, life insurance. So, a portion of the money we contribute is going to pay for life insurance. This cost is more easily distinguished in the early years.

So, our guy puts in 10k the first year of his life insurance policy. He has $9,197 in his cash value. He has $418,255 of death benefit. What does this mean? It means that a portion of his 10k, roughly $800, went to cover the death benefit cost.

If he had a long term policy, the upfront cost would be much greater (probably around 5k). However, he would have more growth in the long term which I will explain.

The early years is where your “risk” is. What I mean is, if you start down this road, and you decide early on not to continue, then you are losing money that went to pay for death benefit.

Also, his cost is the use of his money. In a high early policy, he will have more money he can use immediately. This becomes a good product to use for a business owner, or someone who needs to use their cash early on.

Someone with a long term type policy will have much less money up front he/she can use. However, the benefit there is more growth in the long term.

For this example, I’m going to stick with the higher early cash value policy just to keep it simple. I’ve also found many of my clients drawn to high early policies because they like to have more immediate use of their money.

To continue, the $9,197 that he has in his cash value, is also called “surrender value.” This means, if he decides in the first year to quit his policy. He can walk away with $9,197. Not a total loss, but he has lost money.

That $9,197 is also the amount he is able to borrow against. Once the money clears in his life insurance policy (usually within 30 days), he will be able to immediately borrow against that money.

The Benefit of the Cost

Now, early on, what is the benefit of this cost? Well, the easy answer is, the death benefit he is buying.

With life insurance, when would you receive the highest rate of return. Well, if you died day 1. If the insured here died on day 1, his family or heirs would receive $418,255 in death benefit. Not bad compared to the 10k he put in.

So, he received a death benefit for that cost. It wasn’t just a cost going to pad someones pocket, most of it was going to pay out death claims to others who were insured and died during the year. A cost that will come back to him, if he sticks to the system, when he dies. This is what life insurance, by nature, is designed to do.

Understanding the Flexibility of Life Insurance Premiums

Quickly, I just want to add in here that, if at any time after the 1st year our insured decides he doesn’t want to put as much money in, we can reduce the amount he is putting in. If he decides to go from 10k after the first year, to say 7k (because his life changes), he is able to do that easily, and the scenario would adjust accordingly.

As the Policy Grows

Now, as this policy rolls along, let’s look at 3 things. How much he has contributed, how much he has in cash value, and how much he has in death benefit.

—-Year—- —Contribution Total— —Cash Value— —Death Benefit—
Year 10
$100,000
$110,500
$560,173

 

10 years in, we have started to see some growth. He also has a growth in the death benefit as well. You may think the growth is insignificant. You may be right. A life insurance policy is designed to get better over time. As time goes on, more of your death benefit is allotted to you in your cash value. Therefore, more of the growth is realized in your cash value.

—-Year—- –Contribution Total– –Cash Value– –Death Benefit–
Year 20
$200,000
$292,401
$759,876

 

By 20 years in, when he is 60, there is starting to be a good amount of growth. He has 100k in growth from 200k in contributions. But, the life insurance policy is just starting to really pick up.

—-Year—- –Contribution Total– –Cash Value– –Death Benefit–
Year 30
$300,000
$614,428
$1,072,594

 

By 30 years in, his money is really getting good growth. But the best years are still ahead. At this point, he stops putting money into his life insurance policy, exercises his reduced paid-up option, and now the policy will start in it’s best years.

—-Year—- –Contribution Total– –Cash Value– –Death Benefit–
Year 40
$300,000
$994,799
$1,309,290

 

Now, we stopped putting money in at year 30, so the contribution amount hasn’t changed. By the time he is 80 (40 years in), he has about 1 million dollars in his account. Also, if he dies, his family will have a substantial chunk of money, minus any money he has used for retirement.

The benefit here, in reality, is the extremely low risk he took to turn 300k into 1 million dollars. In a stock, mutual fund, or any other investment vehicle, the risk would have been extremely high.

Also, remember, he has always had access to take loans from his cash value for business and investment opportunities that he wanted to take outside of his life insurance policy.

—-Year—- –Contribution Total– –Cash Value– –Death Benefit–
Year 50
$300,000
$1,545,489
$1,777,037

 

These last years have amazing growth. The value went up by another half million in 10 years. These last 2 examples show how the majority of the growth comes in the prime years.

Now, it’s important to note that these numbers, and the growth, is based on his life scale. Had he started when he was older, the time frame would have been crunched down. The policy will adjust with time frame. It’s not unlikely for many people to start these policies in their 50’s or even 60’s, and still see some good benefits in their 70’s to the end of their lives.

So, the Costs Are…

Let’s look now at an analysis of all this, and the costs associated.

By choosing a high early policy, he had more cash value immediately available, however, understand that the growth in this policy was less than it would have been in a long term policy. More on that next time.

But, what are the costs?

The first cost is, if you quit early, right? I mean, if he put in 10k the first year and then stopped putting money in, he would have lost money. Plain and simple.

The second cost is death benefit. Here is what I mean…

Right now life insurance policies pay around 4.5% to 5% interest. The companies, however, are paying around a 7% dividend.

So, if the company is paying 7%, and you only see 5%, then aha! There is your real cost. The company is earning more money on your money than you are.

Where does the cost go, to cover death benefit and other administration fees, right? Because if you are getting 5% growth on your money AFTER COSTS, then your costs must be whatever growth would have been received above and beyond that. And that cost is going to pay for your death benefit.

I’ve always liked the way Dan Thompson, my mentor and father, has put it. You can have that cost go to buy you a death benefit in a life insurance policy, or you can invest your money somewhere else, put it all at risk, and have that 2% cost go to Uncle Sam in taxes where it will give you no added benefits.

Pay IRS or buy death benefit? You choose.

Not to mention, on top of taxes as a fee, mutual fund and money managers are going to take a fee regardless of if you make money in your account or not. Fees on top of losing years will kill your money.

I can’t ever be mad at a someone for taking a fee if I am making money on my money. Especially if they are promising to take care of my family after I die.

Summary

Life insurance costs are, in a dividend paying company, basically coming out of your growth. When we say a life insurance policy has a historical growth rate of 6.2%, this is AFTER costs.

It can be difficult to compare these costs. Why? Because a life insurance policy is growing. As long as the company is paying dividends, you will have some policy growth.

Lastly, I want to mention time. It may take some time for the life insurance policy to show growth that you can use. However, our cash value is always accessible. And this has always been the most important part to me personally. Access to money.

In a 401k, IRA, or any other investment, borrowing against it can be difficult. So, if you put money in a 401k or other investments, you lose out on your ability to make other decisions with that money.

I’ve seen it time and time again where someone locks money into a 401k, then later in their lives they have an investment opportunity come up, or unexpected bills, and they can’t access the money. The losses in this scenario are sometime impossible to calculate.

The cash value of our life insurance can always be borrowed against. So, by investing in life insurance, I have not lost out at all on my ability to borrow money out and invest in my business, Real Estate, Stocks, Bonds, or any other investment I may find a better rate of return in.

My life insurance policy will still grow, whether I am using the money or not.

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Josh

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