This month, our Personal Finance Friday guest blogger is a long-time friend of Sound Mind Investing, Mike Cave. Mike has more than 30 years of professional experience in financial planning and insurance, and he is also a Registered Investment Adviser.

SMI-PFF-logo.pngFor a number of years, Mike has been our go-to guy for articles on insurance topics in the SMI newsletter.

In addition, SMI founder Austin Pryor and others on our staff have used Mike’s “Life Insurance Checkup” service for help in making choices about how much insurance is necessary (for example, see the June 2009 article: How I Saved a Ton of Money on Life Insurance.)

Below, Mike tackles an important question: Is buying lots of life insurance the best way to provide for your family?

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A good husband and father wants to care for his family. That’s a given. But what is the best way to do that? Should he:

    A) Buy more life insurance, or

    B) Spend that same money to build an emergency fund, accelerate payments on a mortgage, or fund a Roth IRA?

We frail mortals are often more fear-driven and emotional than we would like to think. In the area of insurance, this often leads to overbuying — such as buying a $1 million policy when $500,000 would do. Or buying $500,000 when only $250,000 is needed.

Sometimes, as suggested above, such purchases may be motivated by the noble intentions of a husband. Or the overbuying might be related to anxiety on the part of a wife. Or it may be driven by the oft-repeated rule of thumb: “Buy 8-10 times your salary in life insurance.”

Typically, those who make life insurance purchases do so without considering their overall financial picture. That picture may include other survivorship benefits, such as a death benefit under a pension plan. And, of course, there are Social Security Survivor’s benefits.

Often, insurance agents (whose compensation is a percentage of premium collected) fail to explain to clients how much they are insured already (through other benefits). Nor do they explain how unlikely a client is to get a return on his or her premium dollar. And it is a rare agent indeed who will explain how those dollars could be better deployed to build long-term financial stability.

The paradox of overbuying is that, while having lots of life insurance creates an illusion of financial security, in most cases overlarge insurance purchases don’t help the family. Indeed, more than 95% of 10-, 15-, and 20-year term policies expire before the insured does. They are paid for, the policy term ends, and the policy ends up in the trash can. It’s somewhat like playing the lottery: for most people, it’s a very bad bet.

This is not to say there isn’t a genuine need for life insurance. To be sure, actuarial tables tell us that a man’s wife is likely to become his widow eventually. On average, the life span of a man is five years shorter than that of a woman. And since wives are often slightly younger than their husbands, many women are likely to live quite a few years as widows.

The question is: what is the best way to address this financial need?

Ironically it’s not through buying increased amounts of term life insurance. Look at some simple probabilities:

mike-cave-paid-received-Feb2011.PNG

What’s the source of these numbers?

  • Let’s assume a $500k 20-year level-premium term policy for a 40-year-old costs $375/year for 20 years — totaling $7,500. Most consumers who buy such a policy will receive nothing. Out of 1,000 insureds, there may be only 15 deaths over a 20-year period. It is this small likelihood that accounts for the low average return on premium dollars.
  • An emergency fund doesn’t earn much at today’s rates, so you essentially get out what you pay in, perhaps a bit more or less, depending on interest rates and inflation.
  • A typical mortgage rate, after the tax deduction, costs about 4% compounded for 20 years.
  • The Roth IRA numbers shown above assume a 10% return — close to the average market return over time. (Actually, 10% is quite low compared to SMI’s historic Sector Rotation return, which is more than 17% annualized since 1990. Admittedly, Sector Rotation is a more volatile approach that using Just-the-Basics, Fund Upgrading, or investing in either of the Sound Mind Investing mutual funds, SMIFX or SMILX.)

Here is what I’m getting at: if you were to pay just $50/month for term insurance rather than $100/month and put the difference in one of these alternatives, the result would be 50 to 150 times more likely to benefit your family (based on the numbers in the table above). Expressing it another way, an alternative approach would likely benefit them 50 to 150 times more!

Example: Suppose a 50-year-old husband, after a careful assessment of his “should-I-die-today” scenario, could save $50/month in premiums, either by reducing his death benefit or finding a less-expensive policy that has the same benefit.

Compounding $50/month savings at 10% annually for 20 years (which would yield about $38,000), and then compounding that total for 10 more years without further premium contribution (these 10 additional years put him closer to normal life expectancy) equals $103,000 in a Roth IRA for his wife’s (or his) ultimate use, versus a term policy in the trash can.

Which do you think would be more beneficial to his future widow?

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Thanks, Mike.

As noted above, Mike’s fee-only (i.e., no policies sold) Life Insurance Checkup helps people “right size” their insurance coverage, so they can lower costs and deploy their dollars more effectively.

You can learn more at CaveFinancial.com.

Well, that’s our Personal Financial Friday post for this week. Have a great weekend!

Correction: An earlier version of this article misstated the statistical probability of death occurring between the ages of 40 and 60.

Joseph Slife

By Joseph Slife

Former SMI staffer Joseph Slife is now the senior producer and co-host of The World & Everything in It, a weekly radio program produced by WORLD magazine that can be heard here. He spent 15 years with Crown Financial Ministries, co-writing articles with Larry Burkett and serving as executive producer for broadcasting.


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