The article below appeared in "Nation Review", vol. 3 no. 30 of May 11-17, 1973 (Cover story)
The dead truth about life insurance
By John Ray
'For those poor souls who already have been gulled into buying a whole of life policy the answer is painful -- but it may be good for you. Cancel it.'
The best advice one can give to anyone thinking of taking out life insurance is: Don't. That's not because insurance is not a good idea. It is a good idea. The trouble is that there are many forms of insurance and what your insurance man tries to sell you will probably not be in your own best interests. It will be in his best interest.
The trouble arises because most life insurance policies are a form of investment as well as a form of cover against death. In addition, as a form of investment they are comparatively poor - worst of all during inflation. Since our present government's policies are nothing if not inflationary, the worry is a real one.
The thing is, of course, that you do not need to accept the investment component in order to get insurance. You can, if you know what to ask for, get pure insurance - pure death cover -without needing to give them any funds for investment purposes. What you ask for is "term" insurance instead of the "whole of life" policy that your insurance man wants to sell you. With term insurance, because it contains no investment component, you get a many times higher cover for the same premium. You can see why whole of life policies must necessarily contain an investment component if you realise that in the end the company always pays out.
With ordinary insurance (such as car insurance or term insurance) the company only pays out in the event of some unforeseen calamity (such as an accident or your premature death). With whole of life insurance the company would appear always to lose the bet. Even if you live to 100 it will still have to pay out -- either to your widow or to your estate. Of course the company never does lose the bet if you die around the normally expected age. What it pays out is simply what it has earned by investing the investment portion of your policy. All your estate gets is what you have yourself invested - plus a very poor rate of interest.
At this stage you may well ask: "If the investment component of whole of life policies is so bad, how come insurance companies succeed in selling such a large volume of pure investment policies (endowment policies)?" It is true that many buyers of insurance who would not fall for the whole of life trick do fall for the endowment policy trick. That there is a trick (ie. an unmentioned disadvantage) in endowment policies is not widely realised. In fact it is a trick that I once fell for myself.
As mentioned, endowment policies consist of a series of payments (usually monthly) that you undertake to make to an insurance company. At the end of ten years, or some other period, you get all your payments back plus interest. It is best described as compulsory saving. Why then do people enter such contracts when the interest rate is so poor (usually around three percent - which is even less than bank interest and way below the inflation rate)? The answer lies in the fact that such payments are tax exempt.
Money spent on your monthly "insurance" premiums is not subject to income tax either at the time you earn it or at the time (ten or more years later) when you get it back. Since the tax rate for middle income earners is around 40 cents in the dollar the saving is a substantial one.
Quite correctly, insurance salesmen point out that this is equivalent to an interest rate of 40 percent on your investment. Every year you can make 40 percent return on the money you put into premiums. The catch, however, is that you give your money to the insurance company for, say, ten years but you only get your 40 percent interest (courtesy of the tax man) in the first year. For the remaining years they have your money, the only interest your money earns is a measly three percent or thereabouts. You think you are getting your 40 percent every year because every year you get your cheque from the taxation department. This, however, is only because every year you make a fresh investment.
Now the 40 percent in the first year seems unrivalled but a little calculation will tell you that this advantage is very rapidly diluted by the extremely poor interest rate in subsequent years. I once, in my callow youth, took out a ten year endowment policy with the Prudential into which I put $800 every year. I expect a 1.9 percent bonus rate every year on the $8000 "sum assured" ($800 x 10). I also collect $280 back from the taxation department. This means that I invest a net amount of $520 every year for ten years and collect a final amount of $9520 ($8000 plus $1520 bonuses). Overall, the result is equivalent to me investing $520 every year at about 11 percent compound interest.
"What is wrong with 11 percent?" you may ask. The answer is that you have no protection against inflation. Insurance company bonuses rise only very slowly in response to inflation and even in the best years do not equal it. It is only the generosity of the tax man that turns an abysmally poor investment into an apparently reasonable one. To get your true rate of return, you must subtract the inflation rate from the interest rate. At present our inflation rate is eight percent. Insurance, then, returns you in real terms only three percent.
How can one do better than this? The traditional answer to the problem of inflation of course is: real estate. If you put your money into real estate, the rise in values will more than compensate you for inflation. In addition, you can get an income by renting it out. Most people, however, can very seldom afford an investment as big as buying another house or home unit. So for them this avenue of investment might appear to be closed. In fact it is not.
There are now on the market a great variety of "real estate trusts". These are an arrangement whereby many people club together in order to buy a piece of real estate. A share of the trust can be bought for as little as $500. Typical returns (rents) are nine to ten percent (about six percent after tax) - plus an automatic cover against inflation in the form of capital gains. As an investment, then, real estate trusts are roughly twice as good as insurance (three percent versus six percent after tax and inflation have been subtracted). If the inflation rate rises - as indeed it must given our Labor government's spending commitments - this advantage will become even more accentuated.
As a relatively new form of investment, real estate unit trusts do have some snags to watch out for. Give preference to those that are traded on the stock exchange. If you wish to sell them before the expiry of the trust (trust properties are sold and the proceeds distributed after periods ranging from 10 to 20 years) you may not get your full capital gains if only the vendor is in a position to buy them back. Also, trusts where the property to be bought with your money is known in advance are to be preferred. If you leave it up to the vendor to select the properties, he might unload anything on you.
Any stockbroker can advise on the range of trusts available. Also note that real estate trusts provide roughly the same type of security as do insurance policies. Both investments go into real estate - trusts wholly so, insurance policies largely so. As mentioned, with some trusts you have the additional advantage that you know what particular property your money is helping to buy.
You also have readier access to your money with trusts. With an insurance policy, you often get back less than you have paid in if you surrender it. With trusts you get back what you have paid, plus your interest, plus at least part of your capital gains. You can sell them either on the open market or in some cases the vendor company guarantees to buy them back. One company guarantees to buy back the trusts it has organised at one month's notice and with six percent capital gains. By contrast, some insurance policies cannot be cancelled at all until a period of several years has passed. All you can do is take out a loan on your policy - and be charged eight percent for the use of your own money!
Even worse, if you do have to borrow money (say to buy a car) insurance instalments are regarded as a liability. They reduce the amount lenders will give you - on the rationale that you are already committed by the amount of your instalments and so can not afford to pay back as much on a loan as you otherwise might. Trusts, by contrast, are a straight asset.
The compulsory savings aspect, then, is the sole remaining advantage of an endowment policy. Even this, however, can also be catered for with some trusts. One company will sell you trusts on "terms". You contract for a monthly payment to be made direct out of your bank account.
Strictly speaking, of course, the "bonuses" you get on an insurance policy are a form of capital gain rather than income. This is attested to by the fact that bonuses are tax free - unlike interest payments or rent. Insurance policies are then a form of investment which produces no income and a rate of capital gain that may not even cover the rate of inflation. By contrast, stocks and shares produce both an income and a rate of capital gain which, on the average, at least keeps up with inflation.
Real estate trusts are, of course, merely one sort of stocks and shares and although their performance seems almost magically good when compared with insurance, they are in fact, by reason of their safety, one of the dullest stock exchange performers. If one can expect a ten percent capital gain on trusts per year, only a tiny bit more adventurousness can yield far higher returns. Shares in BHP, for instance, are one of the safest stocks you could possibly hold and yet at the moment their price is way down around the eight dollar mark. On past performance, they could go up again to $16 within a year. If they do, you have made not ten percent capital gain but 100 percent.
Real estate trusts, however, are very good if you feel you may want "spot cash" at any hour of the day or night. Characteristically, real estate trusts show a steady rise in value, so when you sell them does not matter a great deal. With company shares, by contrast, you may easily lose if you cannot choose when you will sell. The reason people buy insurance of the non cover type (endowment or whole of life), however, is to build up an estate over a long time period. They certainly do not expect a need to cash it in over night. Obviously, long-term investors such as these are in an ideal position to take advantage of what share buying can offer as a means of building up an estate.
What about the Labor government's proposed tax on capital gains? Would such a tax nullify the advantages so far described? A moment's thought should show that it would not. One can only speculate on what form the tax might take but even if it was a draconian 50 percent across the board, you would still be better off with 50 percent of 10 percent than 50 percent of three percent.
Even if for some reason insurance policy bonuses were exempted from the tax, you would still end up with five percent on trusts versus three percent on insurance. This is assuming of course that bonus rates would be unaffected by the tax - which is hard to imagine. Since insurance companies would have to pay the tax on any of their investments which they sold, the bonuses they gave to policyholders would presumably be reduced to even lower levels than they are at now.
At any event, a high tax rate on capital gains is not at all likely. This is because capital gains are largely a reaction to inflation. They are the investor's hedge against the govern-ment-created erosion of money values. To deprive investors of this hedge would be to penalise people for investing rather than consuming their income straight away. This is something that no society can afford. Without investment, the workers have no machines to work with and we would all soon be back in the caveman era.
Since Whitlam is probably the only man in Australia who thinks that Labor's spending spree will not lead to higher inflation, this question of capital gains has become more important than ever before. All that has been said above concerning the comparison of insurance policies with alterna-tive forms of investment would be true no matter what government were in power.
We always have inflation so we will always need capital gains to protect the real value of our savings. This need, however, is proportional to the rate of inflation. Under the Liberals, people did gain something on their investment in insurance. Under Labor, they could actually lose (ie. suffer negative capital gains).
By now, some readers will be asking, "How can insurance companies be so bad? Where does all the money go?" This is a good question. If people who buy trusts get ten percent interest (share of rents) plus capital gains, what does the insurance company do with its money that it can afford to return so little to the policyholder?
Insurance companies use your money to buy property. What do they do with the profits? The answer is not far to seek for anyone who knows how insurance companies operate. Basically the answer is: a huge and inefficient bureaucracy and fat commissions to salesmen.
We all know the huge office blocks that insurance com-panies occupy. All those people have to be paid - out of the profits on your investments. By contrast, when you buy trusts, all the profits go straight to you. Also, when can you last recollect some salesman from BHP coming around trying to sell you BHP shares? No one, of course, ever does. Result? When you buy BHP shares there is no salesman's commission to pay. The size of an insurance salesman's commission is not easy to find out but it is known that you can be paying these gentry hundreds of dollars when you sign up for a policy.
Insurance salesmen who have read up to this point will by now be well and truly ready with their standard retort: "But you're treating insurance as if it were only an investment. The comparison is unfair. Insurance is much more than an investment." There is some truth in this. Some insurance policies are so in name only. They are really just straight investments.
An inordinate amount of space has been given to such policies so far not because they are the most common but rather because their faults are less well known. The most common policy, however (whole of life), does contain some straight cover as well as investment. What I will now proceed to show is that even the straight cover aspect of such policies is not in most peoples best interests. The investment component is not alone in being ja poor proposition. The investment component of whole of life policies I have shown to be a poor proposition by comparing it with alternative investments. The cover component I will show to be a poor proposition by com-paring it with alternative forms of cover.
The alternative is term insurance - as was mentioned briefly earlier. Most insurance companies do sell it but some salesmen seem to never have heard of it. The reason, of course, is that it yields negligible commissions. It derives its name from the fact that it is for a fixed term - unlike whole of life insurance. If you take out at age 25 a 30 year term policy and die aged 56, you get nothing from the company. More precisely, your estate gets nothing. "What's so good about that?," honest Joe might ask.
Certainly, accustomed as we are to whole of life insurance, it does in fact look rather a bad deal on the face of it. The point, however, is that with whole of life insurance you wouldnt get anything from the company either. All your estate gets is your own depreciated money plus a poor rate of interest. It simply gets whatever the investment portion of your whole of life policy yielded. Whether it is term insurance or whole of life, you only get something from the company if you die prematurely, By adding in an investment portion to the basic term policy - and calling it whole of life - the company simply makes it look as if you always get something from them.
The trouble with a whole of life policy, then, is that it forces you to make an investment in order to get the privilege of buying insurance and hence forces up the cost of insurance. Poor old Joe the worker wants to provide as big a sum as possible for his wife and children if he should die unexpected-ly. So he buys whole of life - the only form of insurance he is ever told about. Result? A large part of his premium is siphoned off as investment funds and he ends up with only a fifth of the cover he might otherwise have given his family. If he does die young, they only get $10,000 instead of the $50,000 they might have got if he had bought term insurance. This is of course a monstrous social injustice that must be eliminated.
What Joe should have done, then, was to take out a term policy as soon as he got married (some companies offer cover for as long as 40 years ahead) and put any money he could spare into investments of his own. Then no matter what happened he would have come out better than with a whole of life policy. If he died young, his family would get more money from the insurance company and if he died at maturity even mediocre investments would leave his estate richer than any policy would.
The most important thing of all, however, is that with a whole of life policy one never gets to enjoy the fruits of one's investment. The company pays up only after one's death. By making one's own investments, one can choose to cash them in at any time. Often, then, whole of life policies provide too much cover. After one has reached 60 it is extremely unlikely that one will want as much cover as was needed when one had a young and growing family. Insurance companies do offer schemes to make some allowance for contingencies such as these (eg. by converting whole of life policies to endowment policies) but all such compromises are needlessly costly.
If one was fully informed at the start, what might be done is to say: "I want maximum cover when my family is growing up. Therefore I will take out a $50,000 cover on my life to expire at age 60. I will also try to invest what I save by taking out term insurance instead of whole of life. Then when we get to 60, my wife and I can set out to enjoy the fruit of our investment - world trip and all the rest of it. If I die at that point, my wife alone will have the fruit of my lifetime of investment and she won't at least go without. She will certainly have much more than if I had invested in a whole of life policy.
"If I do die young, she won't have the fruits of a lifetime of investment but she will have the $50,000 that the term policy yields in the event of my not reaching the normally expected age. Either way she will have more money in her hand. Additionally, I might get a chance of helping her spend it."
What then is to be done for those poor souls who already have been gulled into buying a whole of life policy? The answer is painful but, like surgery, it may be good for you. Cancel it. Before you do, however, make sure you have sufficient cover from other sources.
If you are in a superannuation scheme, that is probably all you need. Just make sure your wife knows to take the lump sum option that such schemes normally offer. If she accepts a weekly payments scheme, she will find the weekly payments, courtesy of our inflation rate, worth very little a few years after your death. A lump sum she can invest and thus more than keep up with inflation. If you dont have superannuation or want more cover than your scheme provides, take out term insurance. You will be surprised how much you can get for a small annual premium.
You may find that when you go to cancel your whole of life policy the company will give you nothing back. Most will give you back at least less than you have paid in. This is, of course, a scandalous and inexcusable situation but you will probably still be far better off to suffer the loss. Only if you are in your 50s might you have something to gain by not cancelling.
This, however, is only a rule of thumb. Each person will have to make an exact calculation of costs and gains for himself. Whatever you do, make sure you have a letter of complaint to the prime minister in the mail. It is long overdue that some government action was taken to protect the uninformed from insurance salesmen.
The simplest measure that one can recommend - and one that might have some chance of getting through parliament - would be a law requiring that all insurance policies be cancelled on demand without loss of funds not used to pay for cover. At present one may have to be a contributor for as much as two or more years before the company in its kindness allows you the privilege of surrendering your policy and even then you will have to accept a huge percentage loss.
What one ought to expect is of course the opposite. The company has had your funds for several years so it ought to pay you interest as well as your original funds. You should get back more than you paid in.
I have heard it said that with all the new initiatives the Labor government has so far taken, it has done nothing for the working man. Insurance industry reform legislation would be a good place to start. Big investors are of course awake up to insurance. It is the little man who suffers and who needs protection.
John Ray is a lecturer in sociology at the University of New South Wales.
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