Why is Dave Ramsey Hating on Northwestern Mutual?

Today I’d like to respond a bit to a clip from Dave Ramsey’s television show on Fox Business where he talks about life insurance as being “terrible” and how buy term and invest the difference is a better strategy than using any type of cash value life insurance.  And just to clarify before I begin, I really agree with much of Dave Ramsey’s teaching and in terms of his advice of getting out of debt, cutting up credit cards and putting a stop to out of control consumerism.

But when it comes to life insurance he’s wrong and he completely attacks it willy-nilly.  In particular I’m going to focus on his attacking all things related to cash value life insurance.

There are a few main points I’d like to make about cash value life insurance:

daveThe first misconception about cash value life insurance is that it is a terrible cash accumulation tool.  Of course I absolutely agree with Dave Ramsey when it comes to the way most agents out there structure cash value life insurance.  When directed by an incompetent or unscrupulous agent (both are equally bad), it does stink as a tool for accumulating cash.

That’s why it’s important for you to understand that you need to work with a professional that knows what they’re doing, otherwise you’ll prove Dave right in that cash value life insurance is a terrible place to put your money.  However, but for the few of us who know how and/or choose to structure these policies properly there can be huge benefits for doing that.

A few important basics to always keep in mind:

1.  Remember money inside a cash value life grows tax deferred according to section 72e of the IRC.

2.  The death benefit is paid out income tax free according to section 101a of the IRC.

3.  And section 7702 of the IRC explains how the value inside a policy can be accessed without a tax consequence.   That potentially tax free income can make a huge difference in your retirement plans, especially if you think tax rates increase in the future.

So, what do you think…are taxes going up, down or likely to stay the same in the future?

I rarely talk to anyone who believes taxes are going down, especially in light of the rising deficits with which our elected officials are obviously so smitten.

If we take the numbers Dave Ramsey uses in a common example, according to a 32 year old male who’s making 40k per year, he should be using 15% of his income to:

A.   Buy term life insurance

B.   Buy mutual funds with the rest of the money.

Dave says growth stock mutual funds are the right investment with all of the money you would be using on a cash value life insurance policy.  This is the classic buy term, invest the difference advice.

So, buy a really cheap term life insurance policy and take the difference of what you would have spent on the cash value policy and plow it into growth stock mutual funds.

I forgot to mention that he always recommends you buy 10x your income in life insurance death benefit.

Sound familiar?  If not, watch a little of this video to get a taste (skip ahead to 5:21, that’s where it gets really good)

The idea is that in 20 years when the term policy runs out, the money accumulating in the growth stock mutual funds will have outpaced the death benefit and therefore the death benefit is no longer needed.

On the flip side Dave proposes that funding a cash value life insurance policy with that money is a horrific mistake.  In classic Insurance Pro Blog fashion, I intend to argue that point and actually show you the numbers because all talk and no facts equal a whole lot of nothing.

Let’s compare the two strategies and the shortcomings.

Example:

Tom is a father, 32 years old with 2 children and has an income of $40,000 per year, using Dave’s math we’ll use $6,000 (15% of his gross income) toward the retirement plan.  According to Term4Sale.com Tom could purchase a $400,000 20 year term insurance policy at a cost of about $217 per year if he’s in perfect health and doesn’t use any sort of tobacco products.

That leaves Tom $5783 to invest into growth stock mutual funds and we’ll assume that he earns an 8.0% rate of return over that that time frame.  You could obviously argue with me on that rate of return and yes it is much less than the 10% that Dave Ramsey often talks about but given recent history I think that 8.0% is probably more realistic.

In truth, we prefer to use something like 6% when we help our clients plan for the future.

If I look at the investing calculator over at Dave Ramsey’s website, it tells me that Tom should have $285,753.12 (this is the gross number) after investing $5783 per year for 20 years.  Note:  Other things that should be taken into consideration are taxes and costs but his calculator doesn’t provide those options.  With mutual funds you will have both to consider.  Now, tax rates are difficult to nail down but let’s just use a 15% federal tax rate because with Tom’s income and having two kids, that’s probably not that far off.

Wait a minute…I thought Tom would have enough saved/invested after 20 years that he wouldn’t need that term insurance anymore?  Well, I guess if we assume he really does have all his debts paid off and no other lingering financial obligations this may be true.

But…

Prudent financial planning isn’t based on a set of unrealistic assumptions.

Like what?

Well, for one thing I would never assume an 8% rate of return when helping a young guy like Tom plan for his future.  It’s just plain irresponsible.

What if he doesn’t hit 8%?  After 20 years, it’s kinda late to go back and put more money away…the genie’s out of the bottle at that point.

As Brandon and I have stated many times, chasing investment returns is a poor substitute for having not saved enough.  Not to mention, in twenty years Tom is 52 years old and has no life insurance under Dave Ramsey’s model.

How many people do you know at 52 who have no need for life insurance?

I’ve been in this industry for 13 years and I’ve only met a handful of people who were in that position at 52 and what’s more, none of them were people who made $40,000 a year.

Please don’t misunderstand me, term insurance is a valuable tool and most people like Tom should own more of it.  But I don’t think the buy term , invest the difference crowd has ever considered the reality that most people’s lives don’t move in a straight line from point A to point B.

Back to the numbers

If Tom were to use a policy structured correctly as we often do for our clients, he would pay a premium of $6,000 annually which would buy a death benefit of $400,000.  In 20 years, he could request the policy be “reduced paid-up” and his death benefit would be $558,488 with a cash value of $213,895.

Yeah, the cash value isn’t as much as the $285,753.12 he would hypothetically have if he invested the difference and managed to net 8% compounded.  However, he can take his insurance cash value income without a tax consequence if executed properly.  Also, if he chooses to leave the cash value alone, it will continue to grow and his policy will continue to earn dividends.

Does that seem like a fair exchange of value to you?

It does to me and this is the power of cash value life insurance if done correctly with an agent who cares to do the best for their client.

If you’d be interested in learning more of how this works and how it might benefit your situation, contact us.


5 Responses to “Why is Dave Ramsey Hating on Northwestern Mutual?”

  1. Jeff Hexter says:

    What? No mention of the access to the cash value without penalty via policy loans?

    Comparing that little feature to IRA penalties, loss of principal appreciation due to emergency fund use, and those computed taxes will really make the insurance plan look better.

    I totally agree – Ramsay is so right when talking about debt reduction and credit card control, but so wrong about properly structured cash-value insurance. I’ve thought that ever since I read his book Total Money Makeover. It’s as if he got bad advice once and assumes all similar advice is bad.

    Great post. Care to run the numbers with tax assumptions included? Perhaps calculating what the tax would have to be for breakeven?

    • Brantley Whitley says:

      Honestly, had a hard time posting today, at this point, we’ve covered so many things, it gets a little harder each week to come up something fresh unless someone or something has provided us with something worthy of discussing.

      You certainly bring up a great point about policy loans and I probably should add more about how you actually access those cash values. For what it’s worth, the example I used was actually a participating whole life which I probably should have mentioned as well.

      There are so many ways to favor any type of properly structured cash value life insurance vs. a buy term invest the difference strategy. I suppose what bothers me most about Dave Ramsey and Suze Orman is that they talk about everything in absolutes. One thing I rarely do is to say that something is ALWAYS one way or the other. That sort of thinking is incredibly small-minded and gets us into all sorts of trouble.

      As for the tax discussion, that’s a good one to have and perhaps one that we can address in the future, thanks for the idea! The difficulty in getting deep into the numbers regarding taxes is whether Dave is talking about investing in a traditional IRA, Roth IRA, or a plain old taxable brokerage account. Additionally, mutual funds can have so many different types of taxes–short term capital gains, long term capital gains and plain old income tax if you are withdrawing from a traditional IRA, 401k, 403b, SEP IRA, 457 or PSP. And so many different state income tax rates as well (for those of us who have a state income tax).

      It shocked me to hear him say something about Northwestern Mutual so specifically…never heard him mention them in particular.

  2. Jeff Hexter says:

    I read your response Brantley, and then I saw an article from the LA Times reprinted in my local Cleveland Plain Dealer: Retirement accounts raided – 25% of Americans use money now.

    I didn’t see in the article what average amount was used, or what the average tax rate on those amounts was, or even what the average retirement savings accounts held… But if 25% of US Workers are raiding their retirement accounts, isn’t there at least a significant worry that access to money per-retirement ought to be considered.

    This may be a MUCH bigger deal than Ramsay thinks. And may make his advice less useful.

    • Brantley Whitley says:

      Jeff, Brandon and I talked about one of the big problems with 401ks in episode 25 of the Financial Procast. It seems that so many people have been led down the path to believe the 401k is some sort of divine retirement gift and have plowed money into the plans without thinking about the need for liquidity outside of their qualified plan. Don’t get me wrong, the 401k can be a useful tool in your retirement planning arsenal, however, the problem is that a great many people pour money into the 401k without having adequate savings elsewhere and then when they have a financial crisis, they raid the retirement plan. We all know that accessing qualified money before you’re 59 1/2 is terribly inefficient and really hits people hard…especially if they find themselves unemployed.

  3. Andy says:

    Brantley,

    While I know you and Brandon are in no way “anti-investing”, the scenario outlined here leaves nothing for those willing to take a bit of risk. Others could complain that 15% is just too much. Even I can see a couple of counterpoints to take some of this heat off but they may be worth mentioning anyway.

    First, at 32, it’s reasonable to expect Tom’s income will increase in the next 20 years. As his cash value safety net is now set, he can invest a portion of his increased income if he so chooses. If he is concerned about needing more insurance, he can opt for a rider allowing him to do so periodically. This can answer the first concern at least in part.

    Then there is the problem of savings. If one has a 15% tax bill, tithes 10% and invests another 15%, this only leaves 60% or $24,000 per year to live on. It can be done but no one’s living high on the hog here. The “good” news is, Tom’s wife, Mary, is likely to be working at least part-time. Either way, it seems most families end up living paycheck to paycheck… they spend what they have and buy the rest with the old credit card. Savings? What’s that? You mean the change in the couch that gets harvested now and then?

    Enter the cash-value insurance emergency fund. The cool thing most people can relate to is the monthly payments (premiums in insurance-speak)are paid each month like any other bill. This removes the discipline necessary to build that savings account. If you can stash some cash in a bank account, all the better, but isn’t nice to know you’re adding to a nice pile every month automatically? And, by the way, that pile gives you a far better return on your money than any stingy bank.

    Naturally, if that 15% figure is uncomfortable for insurance, I doubt if putting it at risk in the markets would raise that comfort level much. On the other hand, not only does cash-value insurance provide a reasonably secure, easily accessible source of cash, it also protects a family financially should tragedy strike.

    Yes, Ramsey’s BTID also offers protection, but at significantly more risk. Not just the risk that comes with investing, (Remember the mantra for investment people is always ‘Don’t invest anything you can’t afford to lose.’) but also the risk of needing affordable insurance in 20 years. Add to that the risk of “just not having the money to set aside right now” — something many of us Baby Boomers are coming to grips with right now — and you’ve lit the fuse to a potential powder keg.

    Andy

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