Monday, May 17, 2010

Does Your Family Have an Effective Risk Management Plan?

To create an effective risk management plan for your family you must consider mitigating two risks:

1.) The Risk of Dying Too Soon – You need to think to yourself that if you were to die unexpectedly and your family members are still relying on your income, how will they replace that income? Basically you will need some form of Life Insurance to mitigate this risk.

2.) The Risk of Living Too Long – You need to think to yourself that if you were to no longer have anyone depending on your income and you made it into your retirement years, how much money will you need to live on? To mitigate this risk you need to consider some type of Investment vehicle for your future needs.

Below is a story of twin brothers named Slim and Tim who are 30 years old and who use two different approaches to manage the risks of Dying Too Soon and Living Too Long. The two brothers have the same financial resources and make the same amount of money so they can afford to pay the same amount of money.

After much discussion and pressure from a salesman, Slim finally bought a “Cash Value” Life Insurance policy to protect the $50,000.00 of annual income that he and his family relied on. He decided he needed a policy for $500,000.00, because if he were to die, the surviving family members could invest this money and if it was working at 10% they could withdrawal $50,000.00 annually.

Total Coverage (Face Amount)$500,000.00
Monthly Premium$350.00
Cash Value at Age 65$300,000.00
Total Premiums Paid In (over 35 years)$147,000.00
Difference at Age 65$153,000.00(Gain)

So, by paying $350.00 a month in premiums, Slim had both of his risks covered. If he Died Too Soon the $500,000.00 death benefit would help his family to continue living the lifestyle that they were currently used to living. If he Lived Too Long he would have accumulated $300,000.00 of cash value from his life insurance policy to use in his retirement years which will be $153,000.00 over what he actually paid into the policy! In this case, Slim has mitigated both of his risks in one pretty little package!

Tim’s family also relied on his $50,000.00 income. So, Tim decided to get the same amount of coverage as Slim, but he decided to go with Term Insurance instead.

Total Coverage (Face Amount)$500,000.00
Monthly Premium$62.00
Cash Value at Age 65$0.00
Total Premiums Paid In (over 35 years)$26,000.00
Difference at Age 65$26,000.00(Loss)

Because Term Insurance is so cheap, Tim has a significantly lower monthly premium payment of $62.00 per month that is $288.00 lower than that of Slims. It looks like Tim has the risk of Dying Too Soon taken care of with his $500,000.00 death benefit. But what about Tim’s risk of Living Too Long? It looks like when Tim is at retirement age he will have nothing to show for himself after paying $26,000.00 into the Term policy.

So, at this point who has made the better choice? Slim, who bought a Cash Value Life Insurance policy or Tim, who bought a Term Life Insurance policy?

Now, let’s just look and see what would happen if Tim were to save the $288.00 difference in monthly premiums over the 35 year period of time and invest that difference in a Mutual Fund with a Roth IRA tag.

Here’s what would happen if Tim were to invest $288.00 per month for 35 years
  • @ 6% = $412,000.00
  • @ 8% = $665,000.00
  • @ 10% = $1,100,000.00
  • @ 12% = $1,800,000.00

This is how Tim could mitigate his risk of Living Too Long! With a Roth IRA, Tim will be able to start pulling out money Tax Free when he is over 59 ½! If Tim only got 6% on his investment, it would still be better than the amount of cash value Slim had accumulated in his Cash Value Life Insurance policy over the same amount of time!

Another interesting point is that for most* Cash Value Life Insurance policies you can only get one or the other. If you Die Too Soon, your family still gets the death benefit, however, the cash value is used to help pay for the death benefit. Also, if you Live Too Long the cash value is paid out to you and the policy terminated – so, no more chance at the death benefit money! (*Some Cash Value Life Insurance policies will pay you both the death benefit as well as the cash value, however, you will pay for this with a much higher premium payment)

When you buy Term Life Insurance and invest the difference, the two accounts are separate. So, if you were to Die Too Soon your beneficiaries would be able to receive the death benefit as well as the amount of the investment. If you Live Too Long, chances are you no longer need life insurance. You can decide at any time to cancel your Term Life Insurance and live off of your investment.

Moral of the Story: If your family doesn’t have an effective risk management plan in place then you should consider getting one. But always remember – when mitigating the risks of Living Too Long with Dying Too Soon never mix your Investments with your Insurance!

I'm so excited to share this information with you. If you have enjoyed the information or feel that it would benefit someone else, please share it. If you have any questions or comments, please feel free to contact me.
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