For many of us, a big attraction of buying Life Insurance is because of cash value. Specifically, its the absolute value of the policy if we cancel it, or let it mature. 9 out of 10 insurance agents will recommend that you buy plans that accumulate cash value, such as Whole Life and Endowment plans, because “you get something back”. (They get a lot more commissions too, if you didn’t know already.)
The argument is: “You pay 100 dollars now, you can get back 150 dollars x years down the road. If you buy term, you won’t get a single cent back if you don’t make any claims.”
Fair enough, if you already have plans accumulating cash value, or if you are considering buying those type of plans, here are 3 important facts you need to know.
It is not free!
You heard about the day where Life was handing out free lunches? Yeah, neither did we. Economists call this concept opportunity cost. While it’s tempting to think of cash value as a bonus feature of a policy, it is anything but. Here’s the explanation.
For 30 year old John, a 100k Term Plan costs $15,000 in total to cover him up till age 74. A similar 100k Whole Life Plan costs $60k, with a NON GUARANTEED Death Benefit (aka Cash Value) of $92k, representing a net “gain” of 32k if nothing happens to him.
If John went for the Term plan, he would have had $45k extra. Last we checked, $45k is worth more than $32k. So just by choosing a different plan, John is already ahead.
But assuming John took this money to the stock market to invest for the longer term, say 10 years at a rate of 2.5% per annum. The market has its ups and downs, but 2.5% is a really low estimate.
After 10 years, John’s 45K savings would have turned into … $57.5k. After 20 years, its turns into $74k.
And that is with a shitty rate of return. Using a more reasonable 4.5% yearly rate on the stock market (long term), John gets $70k and $108k back after 10 and 20 years respectively.
Furthermore, there is flexibility in which John can use his excess money. Cash value isn’t free now, is it?
It will not be available immediately (nor without cost)
We are so used to the idea of instant gratification now, we turn away from a web page if it takes longer than half an instant to load.
Cash value is anything but instant gratification. In fact, most plans with cash value only have it available at the end of the 2nd policy year, and would take a long time to grow even before it catches up and surpasses your initial outlay in premiums.
Should you want to access your cash value in the policy before the plan’s maturity, it will also cost you. Known as a policy loan, the insurer charges you an interest rate for “borrowing” your own money on your loan.
Please put down your pitch fork and listen to the explanation. To generate returns, the insurer has to invest your money. And since you withdraw the cash value before the policy matures, the insurer has to give up some of the investment returns (you effectively lower their investment capital). Ergo you pay for it. (We never claimed it was a fair trade)
It is immune to changes in the stock market (or any market)
Enough with the bad news, now let’s cross over to the positive side. Yes, your cash value is not subjected to changes in the stock market as is with most other things we need. This is because cash value is declared yearly, and once it is declared (“given”) by the insurer, its value cannot decrease beyond the declared amount.
So what this means is that your account will continue increasing each year despite what is happening in the stock market, so your cash value is safe. This is a good thing since you can be able to estimate how much your beneficiaries will get in the end so that you can make sure that they are well covered after you are gone.
It is important to note that the stock market still impacts the cash value in another way. Good years in the market translate to higher investment returns, which in turn means higher cash values. Vice versa for the bad years. Insurers try to make the cash value payouts steady from year to year in a process called smoothing.
It’s just a fancy way of saying: We keep part of the profits in good years and not pay everything out, so that we have something leftover to give in the bad years.
All in, plans with cash value do have a place in most people’s financial portfolios – just step in with your eyes wide open, and you will sleep soundly at night. If you have any extra tidbits to share about cash value, we would love to hear from you in the comments below!
www.ClearlySurely.com aims to eradicate the knowledge gap between consumers and Life Insurance. Our Vision is that one day, every Man, Woman, and Child will be properly insured.