We should always treat our hard-earned income with the respect that it deserves.
Marlon, 40 years old, is married with two teenaged daughters. With the changes in the economy his employment status was uncertain for a while. Several months his employer cut his salary while other months his pay was withheld.
Marlon accepted these conditions in light of the difficult employment situation in his particular industry. Recently, though, he landed a permanent job with a stable and profitable company and a remuneration package that is significantly better than what he earned previously.
As a result of the salary challenges Marlon missed several payments on his whole-life insurance policy, but because the account had accumulated cash values the coverage remained intact. He is now ready to resume payments and even wants to increase his level of coverage to ensure his family has something more to fall back on in case of premature death.
Marlon was also thinking that he might leave a cash-inheritance even if he dies long after his children have moved out to start their own families. He is, however, not too concerned about the family’s present income needs should he pass as his wife is gainfully employed and they own a debt-free rental property that he inherited from his father.
His current whole life insurance policy has a sum assured of $500,000 and monthly premiums of $600. He also has a decreasing-term-life policy attached to his $1,000,000 mortgage and pays $875 per month; this plan expires at age 60 or when he pays off the mortgage.
From shopping around he was presented with three different options for $1,000,000 in coverage:
1. A standard whole-life policy to age 100 costing $1,161 per month
2. A special whole-life policy to age 100 costing $1,453 per month but the premiums stop at age 65 when the policy becomes fully paid up.
3. A term-life policy to age 80 costing $416 per month
Marlon is a bit confused as to which of these is best in light of his particular financial situation. He also wants to know if he should drop any one or both of his existing plans in favour of what is being proposed.
As far as Marlon’s two most basic needs for life insurance, he seems to be comfortable with his levels of insurance protection.
Firstly his home mortgage is covered with a decreasing term-life policy and the family’s income needs are somewhat secured with his wife’s salary and the rental income.
The existing $500,000 whole-life plan should put extra money in the family’s reserves but as to how much is needed for goals such as education; we will assume the proposed $1,000,000 coverage would be adequate.
These plans provide the insured with protection to age 100 at which point the policy matures with a cash payout usually equivalent to the sum assured is made.
Of course, because there is money to get back from the policy the premiums would have to incorporate savings and some investment returns to deliver future cash values. This means what the person pays monthly is usually greater than what the plan actually needs to cover mortality costs.
The interesting difference between the “standard whole-life” policy (the existing or the proposed) and the “special whole-life” plan being proposed is that premiums for the “standard” continue until age 100 whereas those for the “special plan” stop at age 65 when the policy becomes “fully paid-up.” That is no more payments are required to provide the $1,000,000 coverage to age 100.
At age 100 the sums assured of all three whole-life plans should endow and are paid out in cash at maturity.
Now even though the “special” plan carries a higher cost of $1,453 per month whereas the proposed “standard” policy only $1,161 per month, we noticed that overall, the “special” plan would cost less ($1,453 x 12 months x 25 years = $435,900) whereas the “standard” plan is almost double ($1,161 x 12 months x 60 years = $835,920).
Seeing that the “special” plan is comparably superior to the “proposed standard” plan, perhaps Marlon would want to do away with the “existing standard” plan in favour of this plan and even increase the proposed coverage to compensate.
The challenge with comparing these two is that the existing plan has a sum assured of only $500,000 whilst the special plan has a sum assured of $1,000,000; the respective monthly premiums are $600 and $1,453.
Though the “special” plan has twice the sum assured of the existing plan, its premium is more than double. For a more meaningful comparison of monthly cost we can look at the cost per month per $1,000 of coverage (Existing Standard: $600 / $500,000 = $1.20, Special: $1,453 / $1,000,000 = $1.45).
Even though the monthly cost per $1,000 of coverage is lower with the “existing” plan the real comparison should again be the overall cost as influenced by how long premiums will be paid.
Marlon’s existing plan will run for another 60 years to age 100 which translates to an overall cost of $432,000 ($600 x 12 months x 60 years). We compare this to the overall cost of the “special” plan of $435,900, which provides double the coverage of $1,000,000.
It would seem that Marlon might be better off adding an extra $500,000 to this new “special whole-life” plan to replace the existing coverage.
Using the monthly cost per $1,000 this extra $500,000 on the “special” plan should cost $725 ($500,000 x $1.45) per month. It may seem counter intuitive to pay $125 more per month for the same level of coverage but this would only be for 25 years ($725 x 12 months x 25 years = $217,500) versus 60 years. Very interesting!
Once the new plan is in place, Marlon can then cancel the existing plan and probably dump its accumulated cash values on the replacement policy as an investment or a prepayment of premiums.
Note on Cash Values:
In many instances, whole-life or other cash value plans afford the policy owner access to his or her savings from time to time, either as an outright withdrawal or as a policy loan with or without installments or interest charges. With whole-life plans such utilisation of cash values will ultimately reduce the maturity value of the plans.
In some cases the accumulated cash values could also be used to make a policy paid-up by ceasing premiums and reducing the level of coverage until maturity.
As Marlon stopped paying premiums for some time, if he were to restart—rather than clear up the arrears and then continue—the maturity value would have to be adjusted downwards to account for the outstanding payments.
These plans run for a specified period of time, for example: five-year level-term or level-term-to-age-80.
There are term-life plans that have sums assured that increase over time and then there are others that decrease such as his existing mortgage protection plan.
Remembering Marlon’s objective—to have insurance coverage primarily as a “cash-inheritance” for his children, before if he dies prematurely or after they move out of home—the “special-whole-life-paid-up-to-age-65” plan may (in the context of this case only) be the most appropriate solution. This seems to make the proposed “term-life-to-age-80” for $1,000,000 seem irrelevant, especially as it provides no future cash values at maturity or rather expiry.
What this “term-life-to-age-80” lacks in future cash values it makes up for in monthly cost savings. It may even be said that it would be better to buy cheap term-life insurance and invest the difference in premium between that and a whole life plan elsewhere to achieve greater future values at maturity. But such a discussion may be more appropriate if we had been given different variables to evaluate.
The proposed term-life insurance to age 80 with a sum assured of $1,000,000 has a monthly premium of $416 or a monthly cost per $1,000 of cover of $0.42.
Purely from a cost standpoint this policy would be the outright winner for insurance coverage but for our purposes we will compare the proposed level-term-life with Marlon’s existing decreasing-term-life plan for $1,000,000, which costs $875 or $0.88 per month per $1,000 of coverage.
Apart from being more expensive than the proposed “term-life-to-age-80” plan, the decreasing-term plan expires either when the mortgage is repaid or at age 60 whichever is sooner.
The other point to note is that Marlon is paying more for something that is diminishing in value. If this were the proposed level-term plan, as the mortgage balance declines the difference between the debt and the sum assured would be paid to his family—at his death—until the plan expires or until Marlon discontinues payments.
Nicholas Dean (CertFa) is a certified independent financial adviser and is the managing director of The Financial Coaching Centre Ltd. If you have any questions or need advice on today’s subject please email: [email protected] or visit website: www.FinancialCoachingCentre.com