When a 5.75% Return is Better than an 8% Return


It’s not uncommon to hear an investment salesperson or financial guru looking to chum the waters for a possible comment section debate make a statement like “whole life insurance/universal life insurance is a bad investment because the rate of return is terrible.”

Though we’ve addressed this statement a few times on the Insurance Pro Blog, I wanted to distill the point many people miss into as simple a notion as possible. Also, I want to have a conversation about total return or total benefit you get from committing dollars to a specific cause.

Rate of Return…Focus your Attention Over Here

When it comes to personal finance (and all the various subsections thereof) few terms are used in a more misleading fashion than rate of return.

The mutual fund industry has enjoyed confusing arithmetic mean and geometric mean for decades. We also see financial pundits “cherry pick” specific periods of time to use as a way to illustrate their case for being invested in the market. They want you to believe that investing in the stock market is an imperative.

My problem is that they use their own lack of mathematical ability to prove their point.

Answer this question to yourself (that way you’re less apt to lie): If I could guarantee an adjustment to your savings/investment plans that guaranteed an 8% annual rate of return over the next 10 years, would you know what to do with money you made?

Most people wouldn’t, and this is the trap that most of us step into when it comes to a discussion about rate of return across various savings/investment options. It's swell to make an awesome return for a given period time but then what?

What follows is an illustration of one way that you can deploy your cash in such a way that you never have to ask the “what should I do now” question. I'm using a scenario where I'm talking about retirement income because this is the most common problem our clients and those we talk to on a regular basis are looking to solve.

A Retirement Income Case Study

When it comes to retirement income planning, we’ve been pretty vocal about our belief that there is a right way and wrong way to go about it.

The “right way” focuses on the method actuaries use for pension planning, which essentially works backwards from an income goal to determine the savings amount one needs to commit in order to realize the income goal.

The “wrong way” is pretty much any rule of thumb that relies on the use of a percentage of income (4% rule). You'll see this sort of methodology suggested often by large financial sites and/or publications (read: those who don’t actually advise and manage accounts for people).

Given this, I decided to run the numbers for the following scenario:

A 35-year-old male wants to target a retirement income of $75,000 at retirement commencing when he turns 66.

He’s going to earn that elusive 8% compounding annual return on the stock market we often hear about (though several sources don’t believe in it), and using the old 4% rule about safe withdrawal percentages (weak I know but it inflates the numbers a bit in favor of stocks) we determine he needs $1,875,000 at retirement to generate his target income.

Given these parameters, we can easily calculate the sum he needs to save each year at $15,325 (assuming he makes his investment at the beginning of the year).

Now, how much do we have to save if we want to generate this same income amount using life insurance?

I’m going to use an indexed universal life insurance policy for this. We’ll assume the policy’s average index credit earned is 6% per year.

The premium amount needed to achieve an annual income in retirement of $75,000 per year?

$13,120 per year (again assuming the premium payment is made at the beginning of the year). That’s $2,205 less committed each year than needed for the stock market investment.

For what it’s worth (not much) the annual rate of return given cash value by age 65 is 5.75% per year for the indexed universal life policy. 2.25% less per year vs. the stock investment for those keeping score.

Focusing on the Wrong thing can Cost you Money

That $2,205 difference could buy a lot of things each year. Or it could be placed into the life insurance policy and simply generate more than $75,000 per year.

The important take away here is that simply picking the option with the higher rate of return doesn’t always mean you end up with more.

But why does life insurance produce more income with less money? I hear you ask. That will be the subject of next week’s Tuesday blog post, so check back then.

2 Responses to “When a 5.75% Return is Better than an 8% Return”

  1. S says:

    Enjoy your guys blog and podcasts. You guys obviously talk about the benefits of whole life insurance beyond the mere life insurance component. With that in mind, I have a generic question about how you advise couples in the use of policies – assuming you want insurance on both. Does it make sense to fund more into the plan of the spouse that is more easily insured (e.g., a younger wife)?

    • Brandon Roberts says:

      Hi S,

      There’s sort of two legs to this (perhaps just semantics):

      1. More easily insured (which I take to mean healthier or not partaking in deemed dangerous activities that could impact underwriting) would certainly warrant a potentially higher consideration as the insured.

      2. Simply being younger or a different gender could result in a better performing policy, but it’s not absolute.

      As I’m sure you’d anticipate, there is no generic advice in this regard and individual circumstances will dictate the best course of action.

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