Dave Ramsey has become a star in personal financial planning circles. One of the things he constantly comments on is life insurance. But should you listen to him? It depends. While Ramsey’s message of paying off debts is generally good, his advice about life insurance is, well, hit or miss. Sometimes, he can’t get his facts straight and only tells you half of the story.
Ramsey’s pat answer for life insurance: just buy term. He is really good at talking people into buying it too. For many young families without a lot of cash, and a lot of debt, this makes a lot of sense most of the time. A term policy is cheap, it gets you the coverage you need, and it allows you to continue paying off your debts in an orderly fashion.
Dave Ramsey is also generally right about variable life insurance. These are fairly expensive policies due to the fact that insurers pile insurance charges on top of mutual fund fees. If the mutual funds in your policy don’t perform well, then you could end up losing your insurance policy. Ouch.
Finally, Ramsey’s figures on the internal rate of return (IRR) on cash values for whole life and universal life are technically correct. If you pay just the base premium for whole life, and the target premium for universal life, you should usually average 2.6 percent annually and 4.2 percent annually, respectively.
Ramsey makes some pretty bizarre claims and, to this day, refuses to acknowledge the entire story behind permanent life insurance. For example, while it’s true that whole life insurance only averages under 3 percent, this is only true when life insurance agents structure the policy as 100 percent base.
A well-defined segment of the market exists that blends whole life with term insurance, thus lowering the cost of the entire policy. Some agents also use paid up additions riders to further enhance cash value accumulation. This naturally boosts policy returns. How high? It’s hard to say because it depends entirely on the company. Mutual insurers, for example, tout IRRs on cash values of between 4 and 6 percent. Not too shabby.
The same holds true for universal life. All UL policies have an option to “minimize death benefit/maximize cash value.” This minimizes policy costs while maximizing the IRR on the policy.
Finally, Ramsey has argued on his own website that “The only benefit paid to your family is the face value of the policy“. He’s referring to the fact that, when you buy a cash value policy, the cash value doesn’t get paid out to your family.
In the case of whole life, this is true. But it’s true because the cash value represents part of the money being set aside to pay for that death benefit. As cash value builds up inside a whole life policy, the amount of insurance you purchase (called the “net amount at risk”) decreases. That also means that you’re not paying nearly as much for insurance as you were when you first started the policy.
That’s why, in every whole life plan, you will see something to the effect of: “the policy’s cash value will grow until it equals the face amount of insurance. At that point, no further premiums are due and your policy is ‘paid up.'”
You can’t have your cake and eat it, too. Since the cash value replaces the death benefit over time, you don’t get the death benefit (i.e. the remaining face amount + the accumulated cash value) plus more free death benefit that you didn’t pay for – somehow Ramsey thinks it’s unfair that you’re not getting a free lunch.
With universal life insurance, you either structure the policy so it functions more like whole life (i.e. cash value replaces the death benefit) or you pile cash value on top of the death benefit. In the latter case, Ramsey is fundamentally wrong because you do actually get the cash value as well as the face amount, not just the face amount.
Dave Ramsey’s solution to the problem of permanent insurance is to purchase term and ride the wave of mutual fund returns to the tune of 12 percent annually. But is this realistic? Hardly. Once you get past the fact that, sometimes,12 percent doesn’t actually mean 12 percent due to something called “variance” in your returns, you have to deal with the fact that you have to pay commissions and fees to brokerages and salespeople.
Ramsey’s website states that “The current average annual return from 1926, the year of the S&P’s inception, through 2011 is 11.69%”. This is a little misleading because you always pay a fee for investment transactions – one when you buy, one when you sell. You also pay taxes on all of the money you invest at some point.
Even Roth IRAs have a tax cost – all your contributions are after tax. If we’re being totally honest here, that does have a real effect on your rate of return. Finally, you never hold your investments into perpetuity. You have to sell off some of them, or stop reinvesting, when you retire to draw income.
That can dramatically affect your rate of return.
So, what Should You Do?
It’s not as easy as “just buy term” or “just buy permanent insurance.” Life insurance is part of a larger financial plan. The type of policy you choose, and the amount of coverage, is driven by your financial goals, your personal values, your investment time horizon, your debt load, your expected future financial liabilities, and your disposable income. In other words, you should never take advice from a T.V. or radio personality. You should take it from a real financial professional.
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