How to Buy Life Insurance and Get Out of It Alive

He comes into your home with a hearty handshake, looking you right in the eye. Immediately, he gives you the road atlas his company's ad promised. He admires your place, tells a joke and laughs at one of yours. He shows you that he's an all-right guy.

Before he leaves, your friendly local life-insurance salesman expects to have your signature on the dotted line. You will have committed yourself to spending thousands of dollars over a period of years for a product you really don't know very much about. The salesman will have earned a commission of perhaps $200 or $300, plus residuals. And you will have stepped into a bear trap.

You will have stepped into it because the salesman appealed simultaneously to your sense of responsibility and your sense of greed. There's nothing wrong with either responsibility or greed; but when you try to make them bedfellows, you may be giving yourself an unintended kick in the financial nuts. Because neither your obligations nor the investment value of your policy may be what you think it is.

Responsibility. If you're married, you don't necessarily need life insurance; the obligation doesn't come with the ring. If you don't have children, your wife, if she works, might be able to manage fine on her own (financially speaking) if you were to die.

If you're single, you probably need life insurance even less. Your death might be an emotional tragedy for a number of people, but it probably won't cause anyone to suffer major financial harm.

But if you have kids, there's where responsibility really comes in. Your death would create serious financial problems for your wife and children. Life insurance can help protect them from those problems.

But kids do grow up. Once they're on their own, is it your responsibility to provide them with a windfall profit on your death? Think twice. You just might decide that it's not.

So your need for life insurance may be a temporary one. Why, then, should you buy the most commonly sold policy, which is intended to cover you for a lifetime? Here's where the greed motive comes in.

Greed. The salesman says something like this: "Look, friend, you need a certain amount of insurance. You could get just plain, temporary protection in the form of term insurance, which covers you for a limited number of years. But at the end of all that time, if you live, you get absolutely nothing back. Term insurance is the kind of insurance you have to die to collect. If you buy term insurance and you live, you're just throwing your money away. You might as well throw it down the sewer. You don't want term insurance. You want permanent insurance. Look at this whole life policy. With it, if you live, you get money back. Look at what your cash value will be in 25 years...."

So, if you're like two thirds of the buyers, you take the salesman's advice and forget about term insurance. Instead, you buy a policy that has a cash value, one that offers "permanent" coverage. It may be called whole life, straight life, ordinary life or some jazzier name. The trap has just snapped shut.

Don't blame the salesman. He really believes that permanent insurance-- "whole life" insurance--is better for you than term insurance. He's been taught to believe that. He's paid to believe that. Blame yourself, if you didn't know enough to demand term insurance or at least to consider it very seriously.

Because what you've just done, if you bought a whole life policy, is made an investment without planning for it, as you would plan if you bought stocks or bonds. That "money back" the salesman promised you amounts to an investment return, even though it's not called that.

Now, you're probably a fairly savvy guy when it comes to investments. You keep most of your cash in certificates of deposit, or real estate, or money-market funds, or somewhere--somewhere besides a regular savings account that pays a measly five-and-a-half percent interest rate. Right? But when you buy a life-insurance policy and the salesman says you should buy whole life because that way, if you live, you get "something back," do you ask what the rate of return is on the portion you get back? No, you don't. You don't because you don't know to ask. And if you asked, most companies wouldn't tell you. Rate-of-return information on the savings portion of a life-insurance policy isn't currently required by the U.S. Government, or by any state (though Massachusetts and North Carolina have been considering it). Insurance companies often act as if there were no such thing as the rate of return on a life-insurance policy. Some of them even say there's no such thing.

And that, to borrow a phrase from Jimmy Carter, is a lot of baloney. Sure, any figure you calculate as the rate of return can be disputed. But, by the same token, there are several ways to calculate the rate of return on a corporate bond. Yet you never hear anyone on Wall Street seriously maintain that the yield on a bond can't be calculated or that there is no such thing.

The formula for calculating the rate of return on a life-insurance policy is well known within the industry. It's called the Linton yield, because it was developed by an actuary named Albert Linton. The math is complicated, but the concept is simple to understand. Consider two 35-year-old buyers, Pat and Tom. Pat buys "permanent" whole life insurance; Tom buys "temporary" term. We'll say they each buy $100,000 worth of coverage, hold their policies for 20 years, then drop them.

Tom's term coverage costs him about $225 a year to start with. Each year, the premium goes up, because, with rising age, Tom's chances of dying are increased. By the time he's 55, Tom is paying about $1000 a year.

Pat pays $1200 a year from the start-- about five times what Tom initially pays. But Pat's premium for a whole life policy never goes up; it always remains $1200 a year. Pat can keep his coverage into his 90s if he wants to, still paying the same rate. Tom's term coverage, by contrast, probably can't be renewed after the age of 65 or so. If it can, the rates will be very steep, indeed. At the age of 75, for example, Tom would have to pay about $10,000 for a year's coverage. Pat would still be paying $1200 a year.

Pat's policy builds up a cash value. At the end of 20 years, when he is 55, that value might be about $33,000. If Pat ends his insurance coverage then, he gets back the $33,000. If Tom ends his insurance coverage at the same time, he gets nothing back, because term insurance has no cash value. So who got the better deal?

Probably Tom. You might think his rate of return was zero; but consider that for the whole 20 years, Tom was paying lower premiums than Pat. The money he saved on his premiums could have been invested. It could have been put in the bank, in a money-market fund, in stocks or in any number of other investments. The Linton yield tells how well Tom has to do with his investments to match Pat's $33,000 return.

Assuming Pat bought an average whole life policy, all Tom needs to do to come out ahead is to earn 4.12 percent after taxes. That conclusion emerges from a mammoth study of life insurance released in July 1979 by the staff of the Federal Trade Commission (FTC).

In other words, the average life-insurance policy is about as good an investment over a 20-year period as that much-disparaged vehicle, the passbook savings account!

But the FTC report has a number of other shocks in store. That 4.12 percent figure is the rate of return for policies that pay dividends--called, in the trade, participating policies. The average rate of return for nonparticipating policies--those that don't pay dividends--was 2.47 percent.

Also, life-insurance savings have a major disadvantage compared with passbook savings. On a passbook account, you currently get only about four percent after taxes (assuming you pay about 25 percent of your income in taxes), but at least you get it consistently. With a life-insurance policy, your rate of return for the first several years is negative. The FTC estimated the average return (for dividend-paying policies) at minus 8.36 percent for the first five years, and at only 1.43 percent if the policy is held ten years! (One reason is that the agent's commission is paid mainly in the early years.) In short, you have to hold the average life-insurance policy for about 20 years just to earn the mediocre rate of return available on passbook savings accounts.

After the 20th year, the rate of return usually rises a bit more but not much. The average life-insurance policy still returns less than five percent a year, even if held for 30 years.

The trap clicks shut. If you buy a whole life policy, you face a problem. You've committed yourself to pay a fixed premium, year after year. If you decide to quit early, your rate of return will be, in a word, putrid. But if you hold on to the policy for the 20 or so years necessary to earn a fairly decent rate of return, inflation will probably have made that policy's coverage inadequate. If inflation runs at eight percent a year from now until the year 2000, the $100,000 policy you buy today will then be worth only $23,171 (in today's dollars). That's if you die and your survivors get the $100,000. If you live to cash in the policy in the year 2000, the $30,000 or so you'd get would be worth, in today's dollars, about $6951.

You also have to ask yourself how all that fits into your lifestyle. Let's say you have young children now. You know that your death, in the next year or two, would mean a real hardship for them. For about $225 a year (if you're around 35 and buy term insurance), you can arrange for your wife to get $100,000 if you die. Simple and direct. In 20 years, your children may be self-sufficient, or may have joined some cult and fled to Kuala Lumpur. You might be divorced. You might even be dead. In most or all of those cases, you might well regret having decided to commit yourself to shelling out, permanently, $1200 a year for permanent whole life insurance.

But my agent says.... Life-insurance salesmen have quite a repertoire of arguments designed to get you to buy whole life or similar policies. Let's look at a few of them.

1. Whole life helps you save money. "All right," the salesman might say. "Theoretically, you might be better off (continued on page 144)Life Insurance (continued from page 136) buying term insurance and investing the difference. But let's be realistic. You wouldn't invest the difference; you'd blow it. At least with a whole life policy, you have some systematic savings."

That is an argument you'll often hear. Within its cool, Calvinistic heart, it actually contains several propositions: (1) Money is a good thing to have. (2) You shouldn't "fritter your money away"--i.e., you shouldn't spend it. (3) In particular, you shouldn't spend it while you're young. (4) Most definitely, you shouldn't spend it on some passing pleasure. Therefore, (5) the best thing to do with money is to save it; but (6) most people lack the necessary will power. (7) You are one of those people who lacks will power. (8) So you need something to force you to save. (9) Whole life insurance is just what you need.

This chain of logic seems to have a few weak links. It also involves some strong value judgments. Take $100 and leave it to accumulate at five percent interest for 20 years and you'll have $265. Take the same $100 and spend it on an incredible evening with a beautiful blonde and 20 years later you have a memory the value of which is hard to quantify. The memory will probably be unaffected by inflation, though, while the $265 may be worth (assuming eight percent inflation) only about $57.

Thus, the pursuit of happiness is not without value, though its value may be hard to measure. A case can be made not only for (as the saying goes) "buying term and investing the difference" but also for buying term and frittering away the difference. With the money you save by buying term, you might be enjoying a new stereo, a ten-speed bike or a number of other nice things.

Suppose, though, that you buy the chain of logic up through step eight. You really do have trouble saving and you think some kind of forced-savings vehicle might be good for you. That still doesn't necessarily mean you should buy whole life insurance. What about a payroll-deduction plan or a thrift plan where you work? Its rate of return might be better than that on a whole life policy. But even if you explain all this to your insurance salesman, he still has other arguments.

2. Whole life lets you carry insurance after the age of 60 or 70. Since the publication of the FTC report, attacking the value of whole life as an investment, a lot of insurance people have been protesting that their favorite product has been misunderstood. It was never supposed to be an investment, they say. Well, at least not primarily an investment. The real point of whole life all along, they say, has been that it allows you to carry insurance in your later years.

There's some truth to that argument, but it contains quite a few weak points as well. Why will you want to carry insurance during your retirement years? To benefit your children? But by then, they may well be self-sufficient. To benefit your wife? At that point, what she'd probably prefer is greater retirement income, so your annual expenditure on life insurance might be counterproductive. To pay estate taxes? Probably no big concern, unless you're rather wealthy. In any case, half of your estate can be left to your wife free of estate taxes.

Of course, there's always a chance that you'll find yourself single again in your early 60s, meet a 19-year-old Hollywood starlet and proceed to have six children by her. Possible but not too likely.

In any case, if you do happen to need life insurance during your retirement years, you still don't have to pick a whole life policy at the start. Most term policies are--up to a certain specified age--"renewable and convertible." Renewable means that you can continue your coverage each year by paying the increased premium. Convertible means that you can convert the term policy to a whole life policy if you want to. The conversion process is usually expensive. But it is there, as a hedge against the rather remote chance that you'll really need life insurance in your later years.

3. Whole life comes with a low-cost-loan privilege. Let's say you buy a $100,000 whole life policy and in ten years it has a cash value of $15,000. Most policies being sold today have a loan rate of eight percent, guaranteed. Let's say that 1990, like 1980, happens to be a time of high interest rates. It's tough to get a loan, and if you do get one, you'll have to pay about 18 percent interest. You can earn 14 percent on a savings certificate. In times like these, that eight percent guaranteed loan rate could come in handy. You'd borrow the $15,000 cash value at eight percent instead of taking out a car loan at 18 percent. Or you'd borrow the cash value and reinvest the money. It would cost you only about $1200 in annual interest and you'd earn $2100 by reinvesting the money at 14 percent.

Does all that sound attractive? Sure it does. In fact, in early 1980, people were borrowing like mad from whole life policies issued ten or twenty years ago, to do exactly those sorts of things. (Strangely enough, people in the life-insurance industry weren't overjoyed to see people taking advantage of the loan provision that way. Instead, they were beginning to think about hiking the loan rate or instituting a variable rate.) But if you think the loan privilege is such a major factor that you should base your buying decision on it, you're probably the kind of person who'd like a date with Bo Derek because she has nice elbows.

4. The cash value of a life-insurance policy is shielded from creditors. True, but hardly a big deal when you stop to think about it. If you got really hard pressed, you would probably drop your policy.

5. Whole life is a tax shelter. It is, for two reasons. You don't pay any tax on the cash value until you actually cash in your policy. At that time, you may be retired, and thus in a lower tax bracket than you are now. Also, the cash value is taxed only to the extent that it exceeds the sum of all the premiums you've paid (minus all the dividends you've gotten back, if it's a participating policy).

Whether or not this matters to you depends on what tax bracket you're in. Let's assume for a moment that the accumulation of cash value is completely tax-exempt. And let's assume that the whole life policy in question has a better investment yield than most--around six percent. If you're in the 70 percent tax bracket, that's arguably the equivalent of a 20 percent pretax return, so whole life might well be worth considering for Mick Jagger and David Rockefeller--assuming, of course, that they need life insurance at all. But if you're in the 33 percent bracket, a six percent after-tax return is equal to a nine percent pretax return, which isn't hard to find today.

Whole life is a good, conservative tax shelter. Unlike other tax shelters, it involves virtually no risk of losing your money. It's even safer than municipal bonds. Is it the best tax shelter for you? Only your personal financial advisor knows for sure--and you're lucky if he does. But unless you're in a high bracket, this isn't a major factor.

6. Whole life can help you save up for retirement. Of course, this is inconsistent with argument number two, which presumes that you're going to hold on to your policy during retirement, not cash it in.

In any case, this pitch is a spitball. It's not likely that the cash value of a whole (continued on page 211) Life Insurance (continued from page 144) life policy will mean much to you when your retirement comes, unless inflation stops the steady surge it maintained during the Seventies. Suppose you buy a $100,000 cash-value policy now and retire in 2010, by which time the policy's cash value has reached $60,000. What will $60,000 buy in 2010? If inflation over the next 30 years is six percent (a fraction of the recent rate), it will buy what $10,446 buys now. That's not enough for a major contribution to retirement.

For that matter, buying term and investing the difference won't prepare you for a royal retirement, either. If you're going to retire in style, you'll have to plan for it separately.

If a salesman tells you that a life-insurance policy--any life-insurance policy--is the perfect way to plan for retirement, tell him to take a running jump into an economics course.

Ok. So now you've managed to counter all the salesman's arguments in favor of whole life insurance, and he's ready to sell you a term policy. What are you getting?

If you buy term. Buying term insurance means protecting your dependents now, while making a minimum of commitments for the future. If life-insurance prices continue to decline, as they have in recent years (mainly as a result of increased competition and rising interest rates), you may be free to switch term policies with a minimum of hassle. Switching whole life policies is a more complicated business, since the low rate of return in the early years tends to lock you in.

If you decide to buy term insurance, you need to be aware that there are several kinds. Usually, you should look for a level term policy--one with a fixed death benefit. The premium for a level term policy usually goes up every year, or every few years, because of your increasing age and risk of death.

People who don't like that rising premium sometimes opt for a decreasing term policy--one in which the premium remains fixed and the amount of the death benefit gradually lessens as years pass. Decreasing term is cheaper than level term, but that's because it provides less protection. To cover a mortgage, decreasing term makes sense; in fact, many decreasing term policies are designed just for that purpose. But if you have young children, think twice before you opt for decreasing term as your basic insurance policy.

Whatever kind of term policy you choose should probably be guaranteed renewable, at least to the age of 65 or so. You may also want it to be convertible to a whole life policy, in case it turns out you need life insurance in your retirement years. Most renewable term policies are convertible until you reach 60 or so, but some are convertible only for a shorter period, such as 15 years.

You ought to be wary of a product called deposit term. With it, you plunk down a fat deposit at the time you buy the policy and get your deposit back, "with interest," ten years later. The trouble is that the high so-called interest rate on the deposit may hide the fact that the underlying insurance is often costly. Regulators in a number of states have been cracking down on deposit term. The product should be bought, if at all, with great care. If whole life can be a bear trap, deposit term can be a bear trap with poison in it.

Should your policy pay dividends? If you're buying a term policy, don't lose any sleep over the decision: Dividends on term policies are comparatively small, anyway. If you're buying a whole life policy, the historical record since World War Two has generally been that dividend-paying policies have cost less.

Dividends are small in the early years after purchase but gradually grow until, by the time a policy has been in force for about 20 years, the dividend may offset a substantial part of the premium.

On some very old policies, the dividend actually exceeds the premium. You can take dividends in cash, use them to reduce the next year's premium or to buy more insurance.

Naturally, you don't get something for nothing. On a participating (dividend-paying) policy, the company sets the premiums higher than it anticipates will be necessary to cover claims and company expenses. If it anticipates correctly, there will be surplus money to be returned to policyholders in the form of dividends. Dividends, then, are refunds of your own money. In that way, they differ significantly from stock dividends. And that's why dividends from stocks are taxed, while insurance dividends aren't.

In one important way, though, life-insurance dividends do resemble dividends paid to stockholders: They're not guaranteed. That point should be stressed, since the economic conditions of the past 30 years have caused many people to lose sight of it. A salesman may give you the impression that the "dividend illustration" he shows you is as solid as the Rock of Gibraltar. He may hint that the dividends actually paid to you will be larger than those illustrated to you at the time of sale. Based on history, that's likely to happen. But the company has no legal obligation to pay any dividends if economic conditions (or death rates) turn sour.

How do you spot a good price? Let's face it; shopping for life insurance is harder than shopping for a set of golf clubs or a color TV. The price of those items is plain and simple. The price of life insurance depends on a number of variables: how long you keep the policy, what you pay in premiums, how much you get back in dividends, what the cash value is if and when you cancel the policy, and so on. In fact, the "true cost" of a life-insurance policy can never be known in advance. It can be known only after you've died or canceled the policy.

How, then, do you compare the cost of various policies? You have to use a cost index. An index makes assumptions (sometimes arbitrary) about the variables mentioned above. For example, most cost indexes are based on the assumption that a policy will be kept in force for 20 years. It's unlikely you'll hold your policy exactly that long, but making that assumption allows you to compare policies.

Any good cost index also reflects the timing of payments and refunds. For example, two policies may pay the same sum of dividends over 20 years. But if one policy pays them earlier than the other, it's a better buy. Reason: If you, rather than the insurance company, have the money, you can invest it and earn interest on it. This important factor was ignored in cost comparisons until the early Seventies.

Most popular of the new breed of indexes is the interest-adjusted index. That is the figure on which you should base your cost comparisons. If you ask an agent to provide you with the index, he's required to do so in some 36 states. Even in the 14 other states, you can simply say that you won't consider buying a policy without knowing its interest-adjusted index.

For term policies, there's only one interest-adjusted index. For whole life policies, there are two--one for net cost (which measures the cost if you cash in a policy) and one for net payment (which measures the cost if you die while the policy's in effect).

Don't worry about the name of a policy. Insurance companies love to decorate them with words like executive, president's and special. The truth is, any ditchdigger can buy some companies' "president's preferred" plans, while only good risks can buy other companies' standard plans. What matters isn't the title; it's how much the policy costs. And the best way to measure that is by the cost index.

If you're going to be shelling out thousands of dollars in premiums over the next decade or two, you have every right to check out the projected costs. There can be differences of thousands of dollars among similar policies, as the chart on page 214 shows. That's more important than which company offers the best road atlas. With some planning, you can buy life insurance that meets your needs, and keep your feet clear of the life-insurance bear trap.

"With the money you save by buying term, you might be enjoying a new stereo or a ten-speed bike."

"What will $60,000 buy in 2010? If inflation is six percent, it will buy what $10,446 buys now."