"Buy term and invest the rest." That's the mantra among many experts who see term insurance as the only smart way to protect yourself and your family.
The unfortunate thing, however, is that insurance-based investments have a lot of untapped potential. Tax laws favor them, and if you need life insurance anyway, attaching investments to a policy can have some real benefits. But just as it took discount brokers like Charles Schwab (Nasdaq: SCHW) and TD Ameritrade (Nasdaq: AMTD) to take advantage of deregulation in the financial industry and challenge the expensive commission structures of big-ticket brokers like Morgan Stanley (NYSE: MS) and Citigroup's (NYSE: C) Smith Barney, it will take a new generation of "discount" insurance companies to wrest control of the profitable insurance market away from the big players, such as Prudential (NYSE: PRU) and MetLife (NYSE: MET).
The perfect insurance investment
Insurance policies enjoy benefits that many standard investments lack. Earnings within a policy grow tax-deferred, and death benefits paid to beneficiaries aren't subject to income tax at all. Some states provide limited protection from creditors' claims for insurance policies, meaning that they can be used for asset protection strategies. In addition, the federal student aid form excludes the value of life insurance policies from your assets when determining financial aid eligibility.
With these benefits in mind, we can create the perfect insurance investment. It would have the following characteristics:
* Life insurance coverage at the same cost as equivalent term policies;
* Access to low-cost investment options across the full range of asset classes and subclasses, with depth of choices similar to those offered by mutual funds;
* Loan options that give policyholders access to their money at no cost, since it's the policyholder's own money that's being used for the loan;
* Minimal administrative fees and associated costs; and
* Cash values that rise in proportion to the premiums you put in, without holdbacks for sales commissions or surrender charges.
In theory, there's nothing difficult about creating a life insurance investment vehicle like this. In reality, though, nothing currently available comes close to this ideal.
Unfortunately, you just can't find insurance-based investments at a reasonable cost. The closest you'll get is in the variable annuity realm, where traditional discounters like Vanguard and Fidelity have offerings that cost around 0.25% more than comparable mutual funds. That's well below the average charge for mortality and expenses of about 1.2%.
Variable life insurance carries even more costs. One variable policy I looked at carried monthly administrative charges of $35 and mortality and expense charges of 0.9% for the first 10 years the policy is in force, and it charged an extra 2% for policy loans during those first 10 years. Another firm, in its 412-page prospectus, reveals monthly fees of $30 and up, 1% extra for policy loans, and 0.45% in mortality and expense charges. And in neither case do those numbers include the expenses charged by the respective investment subaccounts, which in one case ranged from 0.37% to 1.29% more.
Wait for the new model
Just as brokerage firms had to adapt to new conditions in the financial services industry, so too will life insurance companies eventually have to offer more competitive products. Although a patchwork of state regulations makes it difficult for insurance companies to evolve quickly, once customers realize how much of their money goes toward unnecessary sales and support costs, the ensuing revolt will leave insurers no choice but to create more beneficial products.
Of course, there's no guarantee that existing insurance companies will be the innovators in this arena. After all, you can still pay big commissions at some brokerage houses, so there will always be a place for high-commission life insurance. Until permanent insurance comes with a reasonable price tag, however, most people will be better served by sticking with term.
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