Is life insurance a good investment for leaving money to your child?
I could invest $50,000 in a universal life insurance policy with no monthly payments and a death benefit of $188,000 or I could invest $20,000 with monthly payments of $88 for a death benefit of $100,000. The policy is in force until age 119.
What am I missing here?
You are missing the time value of money. Let’s assume you purchase the UL policy when you are 40 years old for $50,000. You have an outflow in year one of $50,000. If you were to pass away the next year, at age 41, the internal rate of return (IRR) of the policy would be 276% – a great rate of return!
However, it is highly unlikely that you will die at age 41 and the insurance company knows this. What’s more likely to happen is that you will live until you are ~93 years old. If you do, the IRR for the policy drops from 276% to 3%. All the insurance company needs to do to make money is out-earn a 3% annualized return on your dollars.
Additionally, $188,000 in today’s dollars adjusted for an annualized inflation rate of 2.1% would have the purchasing power of ~$59,000 fifty-three years from now. In essence you would be paying $50,000 today to give your kids $59,000 in inflation-adjusted dollars about fifty years from now – an IRR of 0.31%. That is the time value of money.
Instead of buying the insurance policy, let’s assume you invested the $50,000 in a moderately aggressive portfolio comprised of 60% equities and 40% bonds, earning an annualized 5% return. In the same 53 years, the initial $50,000 you contributed would have grown to ~$660,000 or $215,000 adjusted for 2.1% annual inflation. So, would you rather leave your kids $59,000 or $215,000?
The same analysis applies to the $20,000 initial outlay policy with the $1,056 annual premiums, except that it’s worse. If you were to live to age 93, the IRR of the policy, unadjusted for inflation, would be 0.83%, and the $100,000 would have the purchasing power of ~$32,000 today.
Life insurance policies should rarely, if ever, be viewed as investments. They are a way to transfer the risk of your untimely death away from your loved ones by providing a means for their support and well-being. A well-diversified portfolio will serve you much better in the search to leave behind a legacy for your children.
I am concerned you are getting advice from a commissioned life insurance agent and the advice is being offered mainly to enrich the life insurance agent and not to protect you. Although life insurance is likely needed to protect your child if you were to die young, life insurance is generally a terrible investment vehicle.
The reason is life insurance has a much lower long-term rate of return when compared to stocks. And although the advisor’s sales pitch said the universal life insurance policy is invested in 'the market,' that actually isn't true. You are getting money from the life insurance company based on a portion of the market's returns.
Your lower return is then further reduced by significant fees within the policy, often between 4% to 7% of your 'investment' being charged each year. This compares poorly to a portfolio of low-cost index Exchange Traded Funds (ETFs) which should have fees in the range of 0.1% to 0.25%. Even when combined with a advisor's 1% fee, it is a fraction of the total fees of the life insurance policy.
If you have a life insurance need to protect your child, then get life insurance, but beware of mixing the idea of investing for your child and protecting your child in case of your death. If you are healthy, you can probably get a $1 million term life insurance policy for a few hundred dollars a year. That would leave tens of thousands of dollars to invest for your child's future.
Because there is such a problem with predatory sales practices for universal life insurance policy, I do a free analysis of these policies so people can know what they are actually buying. I've seen a lot of them recently from the same company, and I'm going to bet the projection they showed you assumes a 7.75% return on the stock portfolio within the insurance product.
As an alternative, say you were to invest your $50k directly in a portfolio of ETFs, assuming the same return. From that investment you could pay a $1,000 annual premium on a million dollar, 40-year term life insurance policy and still end up with $750k to give to your child after 40 years. This would mean if you were to die before 40 years, your child would get $1,000,000 from the insurance. If you died after 40 years, your child would get $750k (or more depending on how long you lived. That compares terribly with a death benefit of less than $200,000 and I bet is more than twice what they project the policy value to be at age 100.
As a side note, this article will explain what you should look for in a financial advisor to make sure you are getting actual advice designed to make you wealthy, and not the advisor.
I think it's a great idea to leave money to your child with life insurance. Think about it.
If God forbid you die tomorrow, you'll have paid one premium, and yet a substantial benefit will be left to them. If you live a good long life, then over time, the tax favored cash accumulation could be huge.
In order to choose the right policy, make sure you do the following:
1. Get prequalified for coverage, so you know the quotes you are given will be realistic.
2. Talk to a knowledgeable accountant or attorney about the taxation involved in these policies, and get advice on ownership and beneficiary designations. You don't want good money to be tangled up in your estate unnecessarily.
3. Never forget that life insurance is not a not an investment. It's a financial benefit provided at your death which can cost pennies on the dollar. Be realistic and face the fact that you could die tomorrow, even though you might take good care of yourself. That reality should shape your thinking about how to leave money to your children.
Don't take time, or your life, for granted.
You aren't missing much. If your goal is to take this $50,000 and never see it again so that your child inherits the $188,000 than that is exactly what you should do. Remember do it only if you are OK losing availability to these dollars. I don't know it is an investment rather you are purchasing life insurance with the intent to leave a legacy. People do it all the time for charities and it is an effective tool for inheritance planning. I'd also see if your agent can run the policy to be inforce to like age 100 or something to see the difference in how much more predictable death benefit that increases too. Just be careful you are ok making this decision as it is costly and difficult to reverse.
The answer isnt just this simply. There is such much more to know about your situation. A UL policy is very tricky if not funded right, it may end befor you do. You also dont want to make the contract a Modified Endowment (IRS rule 7702a)
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Brett M. Sause, LUTCF®, LTCP®, CLTC®, RFC®, LACP®, FSCP®
Principal & CEO
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