Cash Accumulation Method

What Is the Cash Accumulation Method?

The cash accumulation method is a common technique for comparing the cost-effectiveness of different cash value life insurance policies, a form of permanent life insurance that features a savings component.

The cash accumulation method assumes that the death benefits for the policies are equal and unchanging. The aggregate difference between the premiums paid into the two policies is then evaluated over time.

Key Takeaways

  • The cash accumulation method is a common technique for comparing the cost-effectiveness of different cash value life insurance policies.
  • It assumes the death benefits for the policies are equal and accumulates the differences in the premiums paid at a given interest rate over a specified timeframe.
  • The one that has the most cash value at the end of the trial period is considered the best.

Understanding the Cash Accumulation Method

Cash value life insurance provides a guaranteed payment to selected beneficiaries when the policyholder dies, together with a built-in type of savings vehicle. A portion of the premiums is allocated to the cost of insurance and the remaining deposited into a tax-friendly cash value account that earns interest.

The cash value component serves as a living benefit for policyholders from which they may draw funds. The policyholder can tap into it for many purposes, using it to get a loan, access cash, or pay insurance premiums.

One way to find the most suitable cash value life insurance policy is to use the cash accumulation method. This technique ranks policies according to their cost effectiveness, with the one that has the most cash value, or largest accumulated value, at the end of the trial period considered the best.

To make these comparisons, the premiums paid for each policy during the comparison period should be equal. If that’s not the case, then the difference between the two must be set aside, in order to make an apples-to-apples comparison.

Example of the Cash Accumulation Method

If the annual premium paid on the first policy is $1,400 and the annual for the second is $1,100, then $300 must be set aside under the cash accumulation method. An interest rate also should be applied to this set-aside account. If the interest rate was 4%, for instance, then there will be $312 in the set-aside account at the end of the first year.

Next, the face value of the policy with the lower premium must be adjusted. Assume both policies are for $250,000. Take the policy with the lower premium and subtract the Year 1 value of the set-aside. In the example, the premium on the first policy remains at $250,000, while the second must decline by 312 to $249,688.

Once these adjustments are complete, the cash value of the first policy for a specific term now can be equated to the cash value of the second. The policy that has the most cash value at the end of the specified term period, say 15 years, is the better value.

Advantages and Disadvantages of the Cash Accumulation Method

The cash accumulated method is a useful way to compare cash value life insurance policies. This approach allows you to pit contrasting policies against each other that would otherwise be difficult to compare. It works, as long as the same rate of interest is paid into each policy during the comparison and can be applied when evaluating whole life, variable life, and universal life.

Though effective, the cash accumulation method is not without flaws. Like other comparison methods, results might be misleading if the information inputted isn’t completely accurate. For example, if the interest rate chosen is unrealistically high, the policy with the lower premium will appear as the better buy, even if that’s not really the case.

The cash accumulation method also cannot determine whether term life insurance may be a better option altogether.

Important

For accurate results, it’s pivotal to enter a realistic interest rate and appropriate term for the policy.

Special Considerations

Cash value insurance won’t appeal to everyone. These policies generally charge higher premiums than term insurance because of the cash value element. And the cash value account earns only a modest rate of interest, with taxes deferred on the accumulated earnings.

It’s also important to consider fees and, in some cases, hidden expenses associated with cash value policies. After taking all these factors into account, you may well find that it’s a better option to buy term and invest the rest.

Article Sources

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  1. U.S. Securities and Exchange Commission. "Investor Bulletin: Variable Life Insurance." Accessed April 11, 2021.