Why Dave Ramsey is wrong about permanent life insurance | ThinkAdvisor (2024)

Now some of you may argue the GUL premiums don’t cease at age 80, whereas if we see a 10 percent gross CAGR then the saved insurance premiums plus interest have matched the desired security blanket somewhere past age 80. You’re right; you pay the GUL premiums until you pass. This may be prior to reaching 80, or it may be later. But I think this was a fair comparison. If you want to squibble about it, then let’s squibble over the rate of return, as well. Anyway, to prevent future squibbling I ran a 10 pay GUL policy starting at age 40 and paid up at 50. (And don’t yell at me about “squibble” not being a word. It’s not. I made it up. I took a page out of Mr. Ramsey’s book: see investing advisor.)

We accounted for the cost of term insurance during the different age bands based on the rates assumed earlier. The first table below shows term insurance ending at age 60; the second shows it ending at age 80.

Term ending at age 60

Term ending at age 80

Again, the glaring point here is that being half wrong on the rate of return doesn’t equate to the outcome being half as much! This is why we use calculators and not blank statements or simplistic math that isn’t valid. (Thanks, HP calculator.) Furthermore, if you argue the first chart is more accurate since if you save the money you’ll no longer “need” the insurance, remember the mathematical need is not the same as the behavioral reality to maintain the additional security. Lastly, the ending amounts do not account for estate taxes, which certainly do change from time to time and would make the tax-free benefit of life insurance more attractive.

Building an estate with life insurance

I noted earlier that life insurance can be used to create an estate. It doesn’t sound like a radical assertion, I know, but it goes against what Dave says.

On July 14^th, 2014 a reader asked Dave if his 71-year-old mother should continue a universal life insurance policy she purchased to leave an estate, or if there was a better investment alternative. Dave answered this: “…You don’t use life insurance to leave an estate. It’s a bad idea. You leave an estate by saving and investing. The only people who will tell you to use a life insurance policy to leave an estate are life insurance salesmen.”

Wrong! Just plain wrong. Many individuals benefit from using life insurance in an estate. Let’s call our 71-year-old woman Betty. Like many of her generation, Betty has plenty of income from Social Security and pensions, but has relatively lower invested assets. At this point she’d like to make sure she leaves an estate. How would this be a bad thing? Earlier I mentioned the show where a caller asked why he should pay off his mortgage, since earning 12 percent growth is much better than 4 percent paid in interest. Dave replied that if your house was paid off and you were told to take out a mortgage and invest the proceeds, you’d think that was nuts. What he meant was that the security of having one’s house paid is greater than the potential additional interest made through leveraging. As our examples illustrated, the security of a known amount is better than the potential interest made through leveraging one’s need or desire for death benefit proceeds with volatile 100 percent stock investments made over the course of many years.

Here’s a shortened version of Dave’s response to Betty’s investment dilemma: “It would probably take about 13 years for the money to turn into $250,000. Assuming she’s healthy, I’d rather do that and bet on her living. That way, she can leave an estate and avoid the expense and rip-off part of the universal life policy.”

Interestingly enough, my HP calculator found that Dave’s right: It would only take 13.75 years to accumulate $250,000 if I input a 12 percent CAGR. But Dave has stated he understands the difference between compounded and average. He has also stated that he uses the 12 percent “average” rate to inspire and illustrate the power of compounding interest (once again see Stofell vs Ramsey). Yet when we do the math here, he’s using his standard go-to number of 12 percent, but in CAGR function not averaging. (There are plenty of examples online which will show how the math differs. Just use Google.)

Here’s the problem. First, when you use different growth methods at different times and don’t differentiate, it becomes very hard for people to know what you mean. Second, the average life expectancy for a 71-year-old female is 15 years (15.6 years, to be precise). So, what if Dave is half wrong? What if she earns only 6 percent before fees? Then it takes a bit over 20 years. If we account for the same tax and rebalancing as earlier, then it’s nearly 24 years. Furthermore, this assumption puts a portfolio which exceeds the average risk tolerance for most 71-year-old individuals. Therefore, even if the math is correct, it’s improbable that our Betty will maintain this course during adverse periods.

Think of it this way: When Betty first starts putting money away, she can be riskier with these funds. As the balance accumulates and her life expectancy decreases, it’s reasonable to conclude she’d want to scale back on risk. It is one thing to experience a downturn after year three or four, when there’s only twenty to thirty thousand dollars at stake, but when the number is bigger — say a hundred thousand or so — then a sizable downturn has a greater impact, especially when you consider her life expectancy has decreased. Will she live long enough for the benefit to come back? Will she continue to save and invest during this period?

The importance of income replacement

Lastly, let’s look at income replacement. Let’s talk Social Security for a moment. A few years ago we started to notice a trend. I noticed that married spouses rarely pass away in the same year. Mind-blowing information there, I know! When the first spouse passes, the surviving spouse (assuming they don’t remarry) is taxed as a single individual the following calendar year. The surviving spouse also loses the smaller of the two Social Security benefits and possibly some pension income, but let’s ignore that.

Here’s an example: Let’s say that Bob and Mary get $3,000 per month from Social Security combined. Bob gets $1,800 and Mary gets $1,200.They take out $1500 per month from their IRAs to supplement their income. They have no debts. They just like to live life, travel some, and help out the kids or grandkids where they can. In short, they’re a normal couple. Approximately $500 of their Social Security benefits are taxed. No big deal. Their adjusted gross income is $18,500 and standard deductions should wipe out all of their federal income tax liability.

Bob dies. And here’s the trend we’ve noticed. Spending doesn’t drastically change. Mary still wants to do the things she did while they were together. She still wants to give or help out the kids, do a little traveling, and live life. There are a few bills that are eliminated from Bob’s death, say a Medicare Part B premium, a car insurance, a supplemental insurance, and a cell phone bill. But overall, two do not spend much more than one. After Bob’s death, bottom line expenses change by less than $500 per month. Mary’s new Social Security benefit is only $1,800, and her monthly income need has gone from $4,500 down to $4,000.

What to do? We’ve noticed many who were taking $2,200 from the IRAs continue to do what they were doing before. The $2,200 per month distribution was $700 per month more than before, or $9,400 more annually. At the end of the year, Mary would owe a little more than $4,500 of tax she didn’t owe before. This wasn’t to increase her lifestyle; it was just to maintain it. If we deducted this as a monthly amount, she’d be short about $400 per month. If she wanted to make that up, she’d have to increase her withdrawals by another $5,500 per year. So, while as a married couple Mary and Bob were fine, as a surviving spouse, Mary must increase her distributions by about $14,000 per year. Not to mention, without any life insurance, their estate saw a negative cash flow of about $30k for burial and income for the 12 months +/- depending on funeral costs and depending on the month Bob passed. In this example, $20k-50k of permanent insurance would be beneficial to some and unnecessary for others depending on the other details regarding their personal situation.

How life insurance can increase spending capacity

I noted earlier that permanent life insurance can increase the spending capacity for retirees. I’ll give you a simple scenario. I met a woman whose husband had passed. He left her with $400,000. Together they had a goal of leaving $50,000 to each of their five children. To accomplish this goal without life insurance, she would need to purchase standalone LTCI insurance to protect against future healthcare costs, and could only base spending on the $150,000 of net assets. She would need to continue to work to make sure this would happen. The solution offered by life insurance is much more attractive: All she needed to do was purchase permanent life insurance. Make it a single pay and then make an irrevocable life insurance trust the owner. This eliminates the need for LTCI insurance, frees up more cash flow and leaves her with over $300,000 to spend as she sees fit, while still accomplishing their goal of leaving $50,000 to each child. The freed-up premiums would have increased her cash flow and therefore freed income to spend by nearly $400 per month, and now she had two times the amount of assets to draw an income from. Permanent insurance can increase one’s spending capacity if used in the correct form for the correct situation.

Dave Ramsey is an intelligent person. He understands the difference between compounded annualized growth rates and annual averages, but chooses to ignore the mathematical impact since the wonder of compounding interest will “inspire” people to invest. He asserts that we math nerds fight over a few percentage points which are irrelevant as long as he gets people to invest. He says there’s no need for permanent insurance, that it’s garbage and a rip-off. He uses the example of a 32-year-old buying a 20-year term policy who follows the Ramsey system to illustrate why permanent life insurance is not needed. Yet poor unknowing Dave proves his very own point wrong by sharing with us that, at 47 years old, with no personal or corporate debt, no mortgage, ample savings, and ample income, he still maintains coverage past the point where his plan says it’s needed.

I’m not making this up. I’m just stating the facts. The fact is term insurance exists for a reason. It’s good and appropriate for people given particular objectives, needs and desires. The fact is permanent insurance exists for a reason. It’s good and appropriate for people given particular objectives, needs and desires.

See the earlier articles in this series:

Two great Dave Ramsey myths, debunked

These are the 7 steps Dave Ramsey followers really need

As always thanks for walking down this path with me. If you see something you’d like us to address from American’s “Favorite” finance coach, please email my editor at [emailprotected].