Friday, November 26, 2010

Life Insurance Primer. Part Five: Concluding Remarks

This is the fifth and final installment of my series of articles on life insurance.  Here is a quick summary of the previous articles:

Part One:  Introduction

Part Two:  Term Life Insurance

Part Three:  Whole Life Insurance

Part Four:  Universal and Variable Universal Life Insurance

There are a couple of final points that I want to make regarding buying life insurance:

1. Make sure you are comparing apples to apples:  Even with term life insurance, there are different term lengths.  The longer the term length, the more expensive the policy will be.  A one year renewable term will have the lowest rate, at least initially.  However, after a year, that rate will rise when the policy renews.  However, with a 20 year level term policy, the rate you are quoted will be the rate you will pay for the next 20 years.  If you opt for a short term policy and you plan on keeping the policy after it renews, you will want to inquire what the renewal rates will be.

2. Any quote that you get will be for the company's best rate:  Insurance companies go through a process of underwriting.  Depending upon the company and the size of the policy, insurance companies will request medical records, perform tests, take blood, and possibly do a host of other things.  The purpose of all this is to determine what type of insurance risk you are.  Obviously, if you have some risk factor which is more likely to lead to your death, the higher your actual premium will be.  Only a fraction of the overall population will qualify for a company's best rate.

3. Consider the company's financial stability:  When you buy a life insurance policy, hopefully it will be a long time before the company has to pay the claim.  However, if and when that time comes, you will want to make sure that the company will be around.  Based upon recent events, it is not beyond the realm of possibility that an insurance company might not be around decades from now.  There are several independent rating agencies which rate insurance companies based upon their claims paying ability.  Generally, it is a good idea to stick with a company that is highly rated by multiple agencies.

4. Consider how much insurance you need, both now and in the future:  There are many rules of thumb regarding how much life insurance that a person needs.  I urge readers to seek out this information so that they buy a policy that is appropriate to their need.  You might think that it is better to under buy now because you can always buy more later.  Unfortunately, that may not be the case.  You may be diagnosed with some ailment with makes life insurance very expensive.  Even worse, the condition might make you uninsurable altogether.  Therefore, if you are in good health now, you should consider buying what you think you might need now, rather than waiting.  The other advantage of buying what you need now is that, even if you remain in good health, insurance premiums rise with age.

5. Don't neglect a non-working spouse.  Some people might not buy life insurance on a non-working spouse because, well, they aren't working.  People think that if somebody doesn't work, there is no income that needs to be replaced if they die.  However, consider that if a non-working spouse dies, the working spouse now may have to pay for child care, elder care, or other items that were handled by the non-working spouse. 

Finally, here is a final summary of the different types of life insurance in one handy table:

Tuesday, November 23, 2010

The Most Absurd Article of the Week

It's been awhile since I've done a Misleading Financial Post of the Week (maybe I should replace week with month).  Anyway, I found another one that I want to bring to your attention. 

One of the big financial news stories hitting the airwaves is about a "massive" insider trading probe being conducted by the SEC.  Apparently, many of the big financial firms are involved, including the ubiquitous Goldman Sachs.  In an editorial on the CNBC website, anchor Michelle Caruso-Cabrera attempts to make the case that insider trading should be...

Wait for it...


Before you fall down laughing from the absurdity, here is a quick summary of her arguments in favor of legalizing insider trading:
  1. Enforcement is asymmetric, meaning that you can't be accused of insider trading if the inside information prevented you from making a trade.
  2. Milton Friedman said so.
  3. It is not unfair to the average investor because most people can't trade on news the instance it becomes public anyway.
The first argument basically boils down to this:  because we can't catch everyone who might have benefited from insider information, we shouldn't even try.  Voltaire said that "the perfect is the enemy of the good", and it is certainly true in this case.

Besides, let's think about this scenario for a moment.  Let's say that you obtain some insider information which is going to cause a company's stock to go down once the information is made public.  In a world where insider trading is legal, if you want to maximize the benefit of that information, you wouldn't refrain from trading.  You would sell the stock short.  For those who don't know, short selling is a way to make money by "betting" that a stock will go down.  However, in the world we live in, this is illegal and enforceable.  Therefore her argument that enforcement is asymmetric holds no water.  You can get busted for insider trading for taking advantage of negative information, as well as positive information.

The second argument is just lazy and dumb. Milton Friedman might have been a Nobel prize winner, but we can't just take his word for it. Instead of telling us that he said so and leaving it at that, Ms. Caruso-Cabrera ought to tell us what Mr. Friedman's arguments were. Instead she uses it as a segue to plug her book, which I won't be buying anytime soon!

The third argument is also wrong because it confuses equal opportunity with equal outcome.  When people are only allowed to trade based upon public information, everybody is on a level playing field.  Everybody has an equal chance to benefit from that information.  Some people choose not to pay attention to it, because they are working or whatever.  However, that is each person's choice.  People are free to choose to stay home and watch Ms. Caruso-Cabrera on CNBC for the latest breaking financial news.  Unlike what she says, this is perfect fair because it guarantees all investors, both big and small, with an equal shot to take advantage of the information.

The main reason why insider trading is illegal and should stay illegal is that it undermines the public's confidence in financial markets.  If insiders have an unfair advantage because they are privy to information that the rest of us don't have, it leads to a situation where the public feels that they can't trust the stock market.  If people don't trust the stock market, they won't invest in stocks.  If they don't invest in stocks, the stock market collapses.  If that happens, then people's retirement savings disappears, companies go under, people lose their jobs.  Most importantly for Ms. Caruso-Cabrera, nobody will watch CNBC, and she'll be out of a job, too!

The bottom line is that insider trading is illegal for a reason, and nothing that Ms. Caruso-Cabrera has said has convinced me otherwise.

Saturday, November 20, 2010

Lessons From the Deficit

Over the past few weeks, I've posted a number of articles discussing the Federal deficit and what needs to be done in order to balance the budget.  Many people are facing a similar situation in their personal life.  Maybe they get caught up pursuing a lifestyle they can't afford.  Maybe they lost their job and the only way they could survive was to borrow.  Maybe a life event like an illness or a divorce or a death threw their finances for a loop.  Whatever the reason, there are many people in our country who are staring down the barrel of thousands or even tens of thousands of dollars in debt.  I can understand how scary it might be to open up credit card statements and see a balances in the four or five figures accumulating interest at double digit rates.  How does one even start to pay down that debt, let alone pay off the entire balance?

Fortunately, there is a tried and true method for doing this.  If you follow this one simple step, you can be debt free:

Spend less than you make.

You can pay hundreds of dollars to buy books, attend seminars, and hire debt consultants who claim to have the formula for getting out of debt.  However, all of their methods are just variations on this one rule.

Now when you have thousands of dollars in debt, it may seem like paying it down is like spitting into the wind.  However, just as every journey begins with a single step, the journey to being debt free must start somewhere, and the only way to start this journey is to spend less than you make.

Now there are two components to this formula.  First is the spend component.  Many people have written about many ways to curb spending.  My advice is to approach it two ways:

Look for the low hanging fruit:  These are things that are relatively easy it give up.  The most famous example is the daily latte at the premium coffee bar.  Examine your spending and cut out the frivolous things on which you are just throwing away money.

Look for the big ticket items:  To get the most bang for the buck, you need to look at the items on which you spend the most money.  For most people, this is housing and transportation.  If you have the means, downside your living quarters.  That will not just save you on your rent/mortgage payment, but also utilities, repairs, and upkeep.  Smaller properties generally cost less to maintain.  If you are underwater on your mortgage and you can't sell, consider renting as an option to cut your housing bill.  As far as transportation goes, consider downsizing your vehicle.  If you have two cars, sell one if you can.  Cutting back in these two areas will yield big savings.

The second component is the make component.  The most common advice in this area is to take on on additional work part time, or sell items on eBay or Craigslist.  However, as Free Money Finance says, the biggest way that you can make more is to manage your career.  Look for opportunities to make yourself more valuable at work so you can get that raise or promotion.  Consider going back to school to get training that will allow you to get ahead.  Those things will give you more return on investment than working a second job at Walmart.

In closing, there are many reasons that people get into debt.  However, getting out of debt is simple if you remember to spend less than you earn.  Maybe our politicians can remember that when they tackle our Government's debt!

Thursday, November 18, 2010

You Fix the Budget

The New York Times has an interactive tool on their website where you get to fix the budget.  You are given a set of options for either saving money or increasing revenue.  You choose the options you like, and the tool shows you how it will affect the budget both now and in the future.

This site should be required viewing for Republicans who want to cut taxes and for Democrats just want to keep spending.  You really get a sense of exactly the amount of sacrifice we will all have to make if we want to balance the budget.

Wednesday, November 17, 2010

Life Insurance Primer. Part Four: Universal and Variable Universal Life Insurance

This is the fourth installment of my series of posts on life insurance.  In Part One, I gave a general overview of the different types of life insurance.  In Part Two, I discussed term insurance, the most common form of life insurance.  In Part Three, I discussed whole life insurance, which combines term insurance with a cash value savings account.  In this fourth article, I will discuss two of the more exotic forms of life insurance:  universal life and variable universal life insurance.

Just to recap, the motto of these series of articles is:

Most people should buy term insurance and forget the rest.

This statement is never more true than in the case with universal life insurance.  Even for the most seasoned financial professional, this form of life insurance is downright confusing.  Insurance companies compound the confusion by offering a dizzying array of options designed to pry additional premiums from an unsuspecting customer.  I could shorten this article by saying that most people should steer clear of universal life since it is beyond the understand of mere mortals.  However, I will make a valiant attempt to explain it.  Even if you end up not understanding a word I say, at the very least that will reinforce my statement that most people should forget this form of insurance.

For those of you that I haven't scared off, read on!

Review of Whole Life:

First, let's recap how whole life insurance works.  With whole life, you pay a premium that is higher than an equivalent term policy.  Part of the premium pays for the insurance and part goes into a cash value account.  This cash value account helps to offset the rising cost of insurance as you get older, and you can cancel the policy and withdraw the cash value at any time.  There are two key characteristics of whole life:
  1. The premiums are fixed.
  2. The cash value is guaranteed.
Point #2 requires a little more discussion.  When you purchase a whole life policy, the insurance company guarantees what your cash value will be after one year, five years, ten years, and so forth.  The company's actuaries look into their crystal ball and predict how much interest they think they can earn on the cash value.  If the insurance company does better than these assumptions, the company can either pocket the gain themselves (if the policy is non-participating) or give back some of the gains to the policyholder as a dividend (if the policy is participating).  All is right with the world if that happens.

However, let's say that the insurance company does worse than how they assumed they would do.  Well, since the insurance company guarantees what the cash value will be, they have to suck it up and make good on the guarantee.  Put another way, the insurance company takes on the risk, and they take the hit if they don't do as well as they expected.

How Universal Life Works:

Universal life insurance reverses the two characteristics of whole life:
  1. The premiums are variable.
  2. The cash value is not guaranteed.
With universal life, the consumer gets to choose how much they want to pay each month.  However, this flexibility is somewhat limited.  Usually there is a minimum payment that you have to make in order to keep your policy from being cancelled.  However, beyond that, you are free to pay more than that minimum amount.  Why would you pay more than the minimum?  We'll get to that in a moment.

The second characteristic is that the interest rate that the insurance company uses to grow your cash value also changes from year to year.  If in one year the insurance company does better than expected, they will apply a higher interest rate to your cash value.  If they do worse than expected, they will apply a lower interest rate.  Therefore, you as the consumer get to pocket the reward but you also take on the risk.

So why would you pay more than the minimum?  There are a couple reasons:

To keep the policy from being cancelled:  If the cash value falls below some minimum level, the insurance company cancels the policy because the premiums won't be able to support the cost of the insurance.  Therefore, if the investment results of the insurance company fall below expectations, you might need to pay more towards the premium just to keep the policy from being cancelled. 

To prepay your premiums:  You may decide that you want to pay more than the minimum so that in future years you can reduce your premium payments or even stop paying premiums altogether.

To increase your insurance amount:  Let's say that you originally bought a $250,000 policy, but at a later point in time you decide that this amount isn't enough.  You can pay a higher premium into your policy and any excess cash value can go towards buying more insurance.

To save more money:  Instead of having excess premiums go towards increasing your insurance amount, you can keep the same insurance amount but build up more cash value.  This additional cash value grows and compounds, so you can think of it as another type of savings account.  However, there is a catch.  There is a limit to amount of extra money you can put into the policy.  If you put too much, the policy is no longer considered to be insurance by the IRS, but a Modified Endowment Contract (MEC).  Unlike life insurance, interest earnings in a MEC are taxed.  Usually the insurance company will tell you what the maximum premium amount is to avoid this from happening.

Confused yet?  If not, read on!

Variable Universal Life:

Variable universal life (VUL) is another twist on the universal life insurance concept.  Instead of crediting interest on your cash value at a single rate, you as the consumer can choose the type of investments in which your cash value will be invested.  Similar to a 401k, you can choose a stock fund, a bond fund, a real estate fund, and so forth.  The investment results of your cash value are totally dependent upon your choices.  If you are aggressive investment, you can invest your cash value in 100% stocks.  If stocks do well, you may not need to pay a premiums for years.  If not, you might find that your policy is cancelled for insufficient funds.

As you can see VUL can be an extremely risky proposition, and it isn't for the faint of heart!

You Should Consider Universal Life Insurance If:

The benefit of universal life is its flexibility.  By adjusting your premium payments, you can prepay the policy, give yourself an additional way to save money in a tax deferred way, or increase your insurance benefit.  For families whose needs are changing, this flexibility to adjust premiums and benefits is a big selling point. 

However, on the flip side, in order to take advantage of universal life's flexible nature requires a certain amount of financial sophistication.  Understanding all of the nuances of this type of life insurance often requires the aid of a professional.  Unfortunately, professionals who sell these policies may not have your best interest in mind.  The allure of the almighty commission creates an obvious conflict of interest.

Also, it is very important the realize that you, not the insurance company, bears the investment risk.  If the interest rate is lower than expected, you take the hit.

There are lots of other options related to universal life, but explaining those tries even my patience, so I'll leave that as an exercise to the reader if you are interested.

I'll probably write one more article in this series to summarize everything that I have written.  However, the main message that I want to convey is that life insurance is one of those things that seems simple (you die, your beneficiaries get paid), but it isn't.  There are a dizzying array of variations and options that are enough to make you turn green.  The bottom line is that if you stick with simple term insurance, you should be fine.  Don't be pressured into buying something that you don't fully understand.  At the end of the day, it's your money, not your insurance agent's money!

Sunday, November 14, 2010

Politics! Politics! Politics! Politics! Politics! (Part Two)

In the first part of this series, I talked about one huge economic problem that vexes politicians:  the deficit.  In this second installment, I will discuss a second thorny economic problem:  getting the economy back on track.

Technically, the American economy is no longer in a recession.  The economy is growing.  Yes, it is growing slowly.  However, it is growing.  However, if you asked the nearly 10% of the population that is out of work, they would tell you a different story.  From their point of view, we are still in a recession.  One of the talking points during the past election was that not enough was being done by our government to create jobs.  There was much debate over what the best way to do this would be.  Should we cut taxes, raise taxes, extend unemployment benefits, build bridges, send everybody a check for $1000, or something else?

To figure that out, we have to understand why recessions happen in the first place.  By definition, a recession is a reduction in economic activity:  factories closing, stores shuttering, businesses declaring bankrupcy, and so forth.  Why does this happen?  To understand this, you have to understand the economic concept known as the multiplier effect.

Consider a man who find a $100 bill on the sidewalk.  The man is so happy with his found money that he decides to use it to treat his wife to a nice dinner.  Some of that money goes to the cook, the wait staff, the busboy, the farmer who supplied the food and of course the owner of the restaurant.  The owner is so happy that he had a successful evening that he buys his wife a bouquet of flowers for his wife his way home.  The waiter uses the extra money that he got on tips to treat himself to a latte at the local coffee shop.  The farmer who supplied the food invests his extra money by paying his helper overtime to plant more seeds.  The helper, in turn, uses his extra overtime pay to buy his son a gift from the toy story.  You can imagine that this story continues to multiply until that $100 has rippled through the local economy.  Now imagine this flow of money multiplied thousands and thousands of times from all of the money that changes hands every day.  That, in a nutshell, is the multiplier effect.  It is the effect of a single transaction rippling through the economy.

Now imagine a different story.  Imagine that the man has heard on the cable news channels that banks are failing, companies are going out of business, and people are losing their job.  Now the man find that $100 bill.  The man is lucky to have his job, but because of all of the bad news he keeps hearing about, he decides that he is better off just pocketing the money in case he might need it for a rainy day.  He doesn't take his wife out to dinner.  The owner doesn't buy his wife flowers, and maybe he cuts back on purchases from the local farm.  The farmer doesn't need to plant as many seeds so he cuts back on help.  The helper, in turn, can no longer afford to buy his son toys.  That $100 that the man didn't spend doesn't filter through the economy.  Imagine this story multiplied thousands of times.  Maybe the restaurant goes out of business because everybody is looking to save $100.  Now the wait staff is unemployed.  Now the farmer can't sell as much so he lays off his employees.  And so on, and so forth.

As you can see, recessions are as much about psychology as they are economics.  If people believe that their jobs are in jeopardy, they will stop spending.  If they stop spending, businesses close.  If businesses close, their workers are unemployed.  If people are unemployed, they can't spend money.  It is a vicious negative feedback loop. 

How does cycle get broken?  One way is for the government to intervene.

There are two methods that the government can use to intervene.  First, government has the power to keep interest rates low.  How does this help the economy?  Businesses and individuals who need to borrow money can do so at a lower cost.  A couple looking to buy a home might decide to pull the trigger on their purchase if lower interest rates reduce their monthly payment.  A business looking to modernize its equipment might be more likely to do so if they can get a cheaper loan.  Of course, because of the multiplier effect, any purchase by an individual or business flows through the economy.

The problem is that interest rates are pretty much as low as they can go, and the economy is still sluggish.  This lever has already been pulled, and it won't move any further.

The second way that government can intervene is by spending money.  In effect, they fill the role of the consumers and businesses who are afraid to spend money on their own.  However, in order for this spending to have any effect on the economy, it has to be spent in a way that multiplies the effect as much as possible.  If they just give away $100 to the person who is just going to stick it in their wallet and not spend it, it doesn't have much effect on the economy at all.  On the other hand, if they spend it in a way that will cause the recipient to spend the money, then it will have more of an effect.

Here are a couple of ways in which the government can spend money:

Enhanced Unemployment Benefits:  On the one hand, there is a good chance that unemployment benefits are going to be spent.  If you are out of work, your unemployment check may be your only source of income.  Therefore, you will spend it on the necessities:  food, clothing, shelter.  You aren't in a position to save that money, since given the choice between saving and starving or spending and eating, most people would choose the second option.  This seems like a good way to make sure that the money ripples through the economy.  However, the better the unemployment benefits, the less likely somebody is to actually look for a job.  Why work when somebody is paying you not to?

Tax Cuts/Stimulus Checks:  Tax cuts and stimulus checks amount to the same thing.  Basically, the government is handing out found money to all taxpayers.  This only helps the economy if people are spending the money.  If people are just pocketing the found money and not spending it, it does little good.  Generally speaking, if you are poor, you might be more likely to spend it, since it could make the difference between eating or not eating (see above).  If your basic needs are being met, you might just save the money.

Capital Projects:  This includes spending money to build bridges, fix roads, and the like.  The good thing about this is that it guarantees that the money is going to be spent.  Building a bridge requires hiring construction workers, buying lots and lots of steel and concrete, and so forth.  Also, once the money is spent, we have something tangible to show for it.  The downside is that you can't just write a check and, poof, a bridge appears.  This type of project takes time, so the money might not flow through the economy right away.

These are just a few options for how the government can spend money to stimulate the economy.  The problem with all of them is that they are incompatible with the goal of cutting the deficit.  The money has to come from somewhere.  Most likely, it will have to be borrowed.  On the other hand, it is likely that if the economy does improve because of this spending, it will lead to more people working and thus more people able to pay taxes.  Therefore, one can think of it as an investment in the future. 

Of course, politicians will have to weight the short term effect of a stimulus on the deficit versus its longer term effect on the overall economy.  Given the fact that many members of Congress were elected by campaigning to be more "fiscally responsible", it seems possible that any additional spending will be frowned upon.  It will be interesting to see how our elected officials balance their desire to balance the budget with the impact this might have on the ability to stimulate the economy. 

Wednesday, November 10, 2010

Tough Medicine for Cutting the Deficit

In my most recent post, I discussed the Federal budget deficit and the tough choices that would be necessary to curb it.  It looks like that is exactly what a bipartisan commission is recommending that we do.  Here is a summary of what they say we need to do to reign in our debt:

Reform Social Security:  The plan calls for raising the retirement age, reduce annual benefit increases, and reduce benefits and increase contributions for the rich. 

Reform Medicare:  The plan calls for limiting health care spending on these plans by paying doctors for quality rather than quantity, reducing payments to drug companies that want to participate in Medicare, and increasing cost sharing for participants.

Overhauling the Tax System:  The plan raises additional revenue by increasing the gas tax, eliminating deductions such as the mortage interest deduction, health care insurance deduction, and the child tax credit.  At the same time, it lowers tax rates and simplifies the tax code.

Cut Spending:  The plan cuts the Federal workforce by 10%, freezes salaries for three years, and cuts or eliminates various spending projects.  This includes serious cuts to the defense budget, farm subsidies, and foreign aid.

Overall, I like the plan.  It takes on the heavy hitters (Social Security, Medicare, defense), it eliminates the special interest tax breaks and spending, and it simplifies the tax code to boot.  Most importantly, the plan has drawn boos from both Democrats and Republicans so they must be on the right track!

Saturday, November 6, 2010

Politics! Politics! Politics! Politics! Politics! (Part One)

"Politics, politics, politics, politics!  Politics! Yes!
The Roman Senate.  The Roman Senate is the best legislature
that money can buy!  Corruption starts in the streets with the
little peddlers.  They bribe an assemblyman, he bribes a councilman,
the councilman bribes a senator, and the senator...
It goes all the way to the Emperor!"
- Comicus "History of the World, Part One" 

Unless you've been living under a rock, you probably know that we've just ended the election season here in the United States, or as I like to call it, the silly season.  You have all sorts of politicians from both sides of the aisle making statements that are not based in any facts, making promises that they can't possibly keep, and generally making a mockery of good sense in order to get themselves a few votes.  The big issue on the mind of voters this time around was the economy.  Specifically, there were two aspects of the economy that were on people's minds:
  1. How do we cut the deficit?
  2. How do we improve the economy and reduce unemployment?
I will attempt (with an emphasis on attempt) to discuss each of these questions in a rational, non-partisan manner.  We already have enough Glenn Beck's and Keith Olbermann's out there spewing verbal diarrhea that I don't want to add to the cesspool.

First, let's talk about deficit reduction...

Let's clear up what is meant by the deficit.  The deficit is simply the amount of spending which exceeds revenue in a single year.  If the Government spends $100 but only takes in $90, the deficit for that year would be $10.  The debt is the accumulation of all of the deficits over time.  If the Government runs a deficit of $10 each year for ten years, the total debt would be $100.  According to the U.S. Treasury web site, the current public debt as of the writing of this article is somewhere between $13 and $14 trillion.  That is $13 followed by 12 zeros, or $13 million million.  Bottom line is that it's a lot of cash!

In order to eliminate this debt, the Government not only has to balance its budget, but it needs to run a surplus that adds up to $14 trillion.  That is a tall order.  However, most people agree that this accumulation of debt cannot continue indefinitely.  At some point, we will have to pay it back, and the longer we keep running deficits, the more we will have to end up paying back.  The $13 trillion question, of course, is how do we pay it back.

In 2010, the U.S. Government expects to take in $2.381 trillion and spend $3.55 trillion.  That means that the Government must cut a total of $1.169 trillion in order to balance the budget.  Obviously, that means that either the Government needs to increase the amount of money it takes in, or reduce the amount of money it spends.  Let's look at the spending side first.

Here is a breakdown of how the Government is spending its money this year:

$677.95 billion – Social Security
$663.7 billion – Department of Defense
$571 billion – Other mandatory programs (welfare, unemployment, veterans' benefits, etc)
$453 billion – Medicare
$290 billion – Medicaid
$164 billion – Interest on National Debt
$78.7 billion – Department of Health and Human Services
$72.5 billion – Department of Transportation
$52.5 billion – Department of Veterans Affairs
$51.7 billion – Department of State and Other International Programs
$47.5 billion – Department of Housing and Urban Development
$46.7 billion – Department of Education
$42.7 billion – Department of Homeland Security
$26.3 billion – Department of Energy
$26.0 billion – Department of Agriculture
$23.9 billion – Department of Justice
$18.7 billion – National Aeronautics and Space Administration
$13.8 billion – Department of Commerce
$13.3 billion – Department of Labor
$13.3 billion – Department of the Treasury
$12.0 billion – Department of the Interior
$11 billion – Potential disaster costs
$10.5 billion – Environmental Protection Agency
$9.7 billion – Social Security Administration
$7.0 billion – National Science Foundation
$5.1 billion – Corps of Engineers
$5.0 billion – National Infrastructure Bank
$1.1 billion – Corporation for National and Community Service
$0.7 billion – Small Business Administration
$0.6 billion – General Services Administration
$19.8 billion – Other Agencies
$105 billion – Other

One thing to note is that even if the Government were to cut everything except Social Security, Medicare, Medicaid, Defense, Interest on the Debt, and other mandatory programs, we would still have about a $400 to $500 billion dollar deficit.  Of course, that would mean that we wouldn't have an FDA making sure our drugs were safe, or a Justice Department to investigate Federal crimes, or a Corps of Engineers to keep another Katrina from devastating New Orleans.  Obviously, if we truly want to reduce spending, we have to take on the heavy hitters (Social Security, Medicare/Medicaid, Defense).  However, with terrorists trying to send us bombs in boxes, cutting Defense is a hard sell.  Cutting health care costs conjures up images of "death panels".  Finally, there is a reason why they call Social Security the "third rail" of politics:  any politician who tries to reform it ends up being a one-term elected official. 

My point here is that it is easy to say that you are going to reduce Government spending, but actually figuring out how to do it is the hard part.

If cutting spending along isn't going to balance the budget, then how about increasing Government revenues.  Of course, that means raising taxes.  If Social Security is the "third rail" of politics, then raising taxes has got to be the lightening rod.  President Bush Senior ended up being a one-term President because he raised taxes.  Besides raising taxes usually isn't a good idea in times of economic malaise.  By taking more money out of the pockets of the American people, they have less money to spend for themselves and less opportunity to "stimulate" the economy with that spending.

The other solution to increasing Government revenues is to improve the economy.  When the economy is going well, people are making more money.  When people are making more money, there is more tax revenue even without raising tax rates.  How does the Government improve the economy?  Well that is a subject for Part Two in this series.

To summarize, balancing the budget is a hard problem.  Cutting spending enough to balance it is going to be difficult.  It would require hard choices with respect to some of the most sacred areas of Government:  Social Security, Medicare/Medicaid, and Defense.  It is doubtful that our elected officials will have the guts to make any cuts to these three programs.  Likewise raising taxes is equally unpalatable.  The only politically feasible way to increase revenues would be to improve the economy so that there is a bigger pool of money subject to tax.

Balancing the budget sounds good in a campaign sound byte, or when you don't have to be accountable like those windbags on the cable new channels.  With all of these hard choices, it makes me glad that I am not a politician!

Monday, November 1, 2010

Life Insurance Primer. Part Three: Whole Life Insurance

This is part three in my series of articles on life insurance.  In Part One, I gave a general overview of the different types of life insurance.  In Part Two, I discussed term insurance, the most common form of life insurance.  In this article, I will give an in-depth description of whole life insurance.  Before I begin, I want to repeat the statement that I made in the first article in this series:

Most people should buy term life insurance and forget the rest.

That being said, it never hurts to understand the other forms of life insurance, if only to see why they are too confusing for most consumers.

How Whole Life Works:

Whole life insurance gets its name from the fact that it lasts for your whole life.  In its most common form, you pay the same premium for your entire life.  This is in contrast to term life insurance where the policy renews at a higher premium after some number of years.  The other characteristic of whole life insurance is that it accumulates cash value.  You can think of a policy's cash value as an investment account that the insurance company sets aside in your name.  Every year, this account grows and accumulates more money.  If you cancel the insurance policy, any money in the account is yours to keep.  However, if you die, your heirs get the face value of the insurance policy.

Here is a simple example.  Let's say you buy a whole life insurance policy that pays $500,000 if you die.  After 20 years, you might decide that you don't need the insurance anymore so you cancel the policy.  Let's say that over 20 years, $50,000 has accumulated in your cash value account.  When you cancel your policy, the insurance company sends you a check for $50,000.  On the other hand, let's say that the unthinkable happens and you die after 20 years.  The insurance company sends your heirs a check for $500,000, which is the amount of insurance that you bought.

Contrast that to a term life policy that doesn't accumulate any cash value.  Let's say that in the above example you purchased a term life policy for $500,000.  If you cancel your policy after 20 years, the insurance company sends you a check for $0.  In other words, you get nothing!  However, if you die after 20 years, your heirs get a check for $500,000.

It sounds like whole life insurance is a better deal.  After all, you get a check from the insurance company when you cancel your policy.  Who doesn't like to get checks in the mail from insurance companies (or any company for that matter)?  The downside is that the monthly premium that you pay to the insurance company is higher in the early years of the policy than what you would pay for term insurance.  In some cases, it is a lot higher.  It is possible that you could come out ahead if you buy term insurance, take the money that you saved by not buying term, and invest it yourself.  This is commonly known as "buy(ing) term and invest the difference".

Setting the Premium:

The mechanics of how a whole life policy works is quite complicated.  I will try to break is down with a hypothetical example.  This example is in no way representative of any specific policy.  In other words, I just made these numbers up.

As mentioned above, in the early years of the policy, you are paying more for whole life than you would for term life.  That means that the insurance company only needs a portion of your premium to cover the risk of providing you with insurance.  Let's say that your $500,000 whole life premium is $6000 for the year, but it only costs the insurance company $1000 to provide you with term insurance.  That means that there is a $5000 surplus.  That surplus gets put into the policy's cash value account, minus the usual fees and expenses that the insurance company will deduct.  Normally in the early years of the policy, the insurance company's fees are quite high because they have to pay a commission to the salesperson who sold you the policy.  You might end up with only $1000 being deposited into your cash value account.

Here is what your policy looks like after one year:

$6000 premiums paid
- $1000 to cover the cost of $500,000 of insurance
- $4000 to cover fees and expenses
= $1000 deposited into your cash value account

Total cash value after year 1 = $1000

In the second year, you continue to pay $6000 in premiums since the premiums always stay constant.  Since you are a year older, the cost to provide you with $500,000 of insurance might rise to $1100.  However, since you have $1000 in your cash value account, the insurance company only has to provide you with $499,000 of insurance.  Why is that?  Remember if you die, your heirs get $500,000.  The insurance company uses $1000 from your cash value plus $499,000 from its own bank account to pay your heirs.  Therefore, the insurance company only needs to provide you with $499,000 of insurance.  This might only cost the insurance company $1050.  Also, in the second year, the fees and expenses might drop to only $2000 because most of the salesperson's commission is paid in the first year.  Finally, the insurance company will credit you with some amount of interest on the cash value you have already earned.

Here is what your policy looks like after two years:

$6000 premiums paid
+ $10 in interest on your cash value
- $1050 to cover the cost of $499,000 of insurance
- $2000 to cover fees and expenses
= $2960 deposited into your cash value account

Total cash value after year 2 = $3960

This table gives a quick synopsis of how this hypothetical whole life policy might work:

Year Beginning Cash Value Premiums Paid Interest on Cash Value Insurance Required to Buy Cost of Insurance Expenses Ending Cash Value
1$- $6,000.00 $- $500,000.00 $1,000.00 $4,000.00 $1,000.00
2$1,000.00 $6,000.00 $10.00 $499,000.00 $1,050.00 $2,000.00 $3,960.00
3$3,960.00 $6,000.00 $39.60 $496,040.00 $1,075.00 $1,000.00 $7,924.60
4$7,924.60 $6,000.00 $79.25 $492,075.40 $1,100.00 $1,000.00 $11,903.85
5$11,903.85 $6,000.00 $119.04 $488,096.15 $1,125.00 $1,000.00 $15,897.88

The main thing to take away from this example is that the cash value that accumulates in your account reduces the amount of insurance that the insurance company must cover.  Even though your risk of dying goes up with age, your cash value offsets this rising cost.
In the early years of the policy, whole life insurance is more expensive than an equivalent term policy.  This is because some of your whole life premium is syphoned off into your cash value account.  However, in the later years of the policy, your whole life premium will be cheaper than an equivalent term policy because your cash value reduces the amount of insurance that the insurance company needs to buy on your behalf.  Of course, you can do what is known as "buy term and invest the difference", meaning that you can buy term insurance and invest the money that you save yourself, and then use that money in your later years to pay for more expensive term insurance in your later years.  Or you can just drop your term insurance and use the money that you've accumulated for your retirement.

So which is a better deal:  investing the difference yourself, or letting the insurance company invest your money for you in the whole life cash value account?

That is a hard question to answer because in most cases, insurance companies do not make it easy to figure out which is a better deal.  When you buy whole life, your insurance agent will give you an impenetrable document known as a policy illustration.  This document will contain your yearly premium and your guaranteed cash value.  However, this doesn't tell you how much is being deducted for expenses and for the cost of insurance, so you have no way of knowing what interest rate you are getting from the insurance company.  Whole life policies have very high expenses in the early years (mostly to pay the commission of your salesperson), but it generally is hard to find out what they are.  The only thing you might notice is that your cash value will not accumulate very much money in the early years.  Likewise, you won't see an interest rate on the illustration.  Yes, your cash value will grow, but you won't know how much is being taken out to pay for the insurance, so you won't be able to compare it to, say, a Certificate of Deposit.

Varieties of Whole Life Insurance:

There are two main varieties of whole life.  The simplest is non-participating whole life (or non-par).  With this type, you are guaranteed a certain amount of money in your cash value account every year.  It is up to the insurance company to meet this obligation.  If the insurance company's investments do better than expected, then the insurance company keeps the profits.  If not, then the insurance company must make up the difference.

The second variety is called participating whole life.  With this type of insurance, the insurance company still guarantees you a certain cash value.  However, if the insurance company's investments do better than expected, they will share some of the profits with you.  This additional profit is called a dividend, and it is given to you as an additional payment into your cash value.  While extra money is always welcome, it is hard to predict what this dividend will be since the insurance companies generally don't share with you how they invest their money or what their past returns are.  Thus, you are making a leap of faith that the insurance company is going to invest its money better than you would.

You Should Consider Whole Life Insurance If:

As you can see, whole life insurance is both complicated and opaque - two qualities that you don't like to see in an investment.  Most people dont' fully grasp the mechanics of how the policy works, and insurance company's don't provide enough information to compare buying a whole life policy versus investing on your own.  Therefore, it is hard to recommend a whole life policy to most people.  However, there are a couple of positives:

- The premiums for whole life insurance are constant for your entire life.  They are guaranteed never to go up.  Therefore, if you think you might need life insurance for most of your life, you may benefit from a constant premium.  However, a level term life insurance policy might work better for most people.

- Money accumulates in your cash value account tax-free.  You do not pay taxes on the amount of interest that accumulates in your cash value until you withdraw the cash from your account.  In this way, it is similar to an IRA or 401(k).  If you have maxed out your contributions into these investment accounts, and you are looking for a way to put away more tax-deferred savings, then you might want to look into a whole life policy.  However, since you have no good way to judge the quality of the insurance company's investments, you might come out ahead by investing in a taxable investment.

- The cash value feature provides you with a forced savings account.  One check gives you both insurance protection and savings.  If you think you would have trouble saving and investing on your own, you may want to consider a whole life policy.  However, you should consider automatic deductions into a savings account or other "set-it-and-forget-it" options.

Overall, there isn't enough upside to recommend a whole life insurance policy to most people.  Most people are better off buying term insurance and investing in something that has fewer fees and better disclosures.