It seems that a number of readers and especially whole life insurance salesmen don't seem to get how the concept of buying term and investing the rest actually works. I thought I would make a chart, using some of my own data, as well as some projections into the future, that would demonstrate the concept.
In the chart above, there are four lines. The purple line, labeled Financial Independence, is the amount of money I would need to never work again. It is the equivalent of $2 Million in 2003 dollars. Notice that by 2020, that's something like $3.3 Million due to the effects of 3% per year inflation (although from 2003-2014, inflation, measured by the CPI-U, has been well below that.)
The blue line is the amount of term life insurance I have carried and anticipate carrying over the next couple of decades. Note that in the first few years, that line overlaps the green line, NOT the purple line.
The red line is the size of my retirement portfolio (actually net worth, since the vast majority of my calculated net worth is my retirement portfolio.) It uses actual numbers up until 2014, then I apply an 8% nominal growth rate to it and add $100K to it each year for new contributions.
The green line is the sum of the portfolio and the insurance.
Some Observations
There are a few things worth noting here. Notice that there was a period of a few years at the very beginning of the chart where the green line was much less than the purple line. This was when I was underinsured as a resident. That was due to two factors- first, my own ignorance of how much insurance I ought to be carrying, and second, the fact that I couldn't afford to buy as much as I needed (somewhat related to the fact that I was doing a lot of climbing at the time.)
If I decide to keep working hard and saving hard until I'm 65, well, I'm going to retire pretty darn comfortably on that $17M.Now, notice the step-offs in the blue insurance line. I'm gradually decreasing the amount of life insurance I'm carrying. When I was in the military, I had three policies, including the 20 year $750K level term with USAA and the 30 year $1M level term with Metlife that I still have. In addition, I had a $400K SGLI policy. When I left the military, I opted not to continue that, since I had a portfolio that was essentially making up for that. I no longer needed that insurance. So I dropped it. In 2026 or so, my 20 year level term will expire. Big deal? Nope. I'll probably drop it before then since the red line will cross the purple line all by itself several years before that. Finally, the 30 year level term policy will expire in 2037. That's the back-up plan. I anticipate dropping that long before 2037.
Portfolio + Insurance = Financial Independence
The most important concept here is that when added to your portfolio, your term insurance needs to be enough money that you/your family would be financially independent. Money is fungible and it all spends the same. If your portfolio by itself equals financial independence, you don't need any insurance. Thus the reason that retirees shouldn't need any life insurance and thus the reason that buying a permanent insurance policy means you're buying life insurance for periods of time in your life when you don't need it. It also just so happens that those periods are also the time when the insurance is most expensive!
The most important point on this graph occurs when the red line crosses the purple line in 2022, when I'm 47 years old. That's when I reach financial independence and can retire if I so desire. That doesn't mean I will. Everyone likes a cushion, and perhaps when I'm 47 I'll be thinking I want a cushier retirement than I thought I might need when I was 30. But basically, at that point I can cancel my life and disability insurance and quit work. I don't need to pay for those insurances for the rest of my life, freeing up about $4K in after-tax income each year.
Now, these numbers may not work for you. You might want more or less in retirement. You might have a smaller or a larger portfolio. You might not be able to save as much each year as I do. But it is probably a worthwhile exercise for you to plot out something similar for your situation, using some reasonable assumptions. You may find that not only do you not need permanent life insurance, you might not even need a 20 year term.
What do you think? When do you expect your portfolio to hit your “number?” At what point will you cancel your term life and disability insurance? Comment below!
I agree completely with this, except perhaps the estimate of what number constitutes financial independence. I did calculations in 2006, and I came up with the number $11M then- what I estimated could provide a comfortable, passive cashflow assuming a 3% annual return on a relatively conservatively invested, diversified portfolio, in perpetuity. Your 8% nominal growth rate may be correct, especially if your portfolio is mostly stocks, however I think this does not include enough reasonable pessimism, if the question is when can you choose to give up active income.
Another way to look at the “number” for FI (financial independence) is to base this on spending. The rule of thumb is 25X your spending per year (30X if you retire prior to 65). 11 million is a high number for most docs. This implies a spending level of $360000-400000. In retirement you will not be saving for retirement, children are off the payroll, and payroll taxes go away so most of us have lesser spending needs than when working. I reached FI several years ago so I dropped my disability insurance and recently started working 3 days a week. Figuring out your number allows you to relax and kick back after years of burning the midnight oil.
$11M may not be that high a number for young doctors, when you account for inflation. The “magic of compounding” works for that beast too. I “did the math” last year on Excel figuring for retirement in about 30 years, inflation near it’s historic long-term rate of 3%, and a desired spending level of $200,000 in today’s dollars. I found out that using the 4% rule I will need about $12.5 million to generate the nominal $500,000/yr I will need in the 2040’s for the purchasing power I want. Of course, you need to adjust your target for actual yearly inflation as time passes, since it can deviate significantly for extended periods of time causing you to over- or under-save if you’re not tracking it.
Also, my calculation does not account for Social Security. This is not because I don’t think it will be there, but because I think the structure of benefits may change significantly by then. I will incorporate it into my plan when I’m five to ten years out from claiming and have a better idea of what the benefit will look like. A near-term retiree can lop about a million bucks off their number if they qualify for the maximum benefit.
I agree that 5-10 years out is a great time to really start factoring in Social Security. But I wouldn’t ever assume you will get nothing from it. That seems highly unlikely to me.
Everyone is going to have a different number, of course, and just because you hit yours doesn’t mean you necessarily have to stop working, or cancel your term life and disability insurance.
How would you suggest one best calculate their financial independence level?
That’s like pregnancy. You either are, or you aren’t, no? 🙂 But if you want a percentage, I suppose you could calculate how much you need to be financially independent, and divide it by your assets.
I don’t question your results at all. If you have discipline and can live within your means, what you describe is as good as it gets. Done appropriately, mindful that when you retire, the game plan shifts from accumulation to distribution, what you describe is a great goal for anyone. I would add that you should not simply give up your policies. One alternative is to convert them and sell them on the open market. What you are effectively selling is your insurability which you’ve decided is no longer relevant. Add the proceeds to your investment accounts.
If you don’t have the discipline then you will be like the greater than 80% of people who purchase permanent insurance and surrender/lapse the policy.
I’m not aware of a large demand for converted polices until AFTER you have paid the early years where all the major costs are sunk. Care to show where one sells a policy immediately after conversion.
If you don’t have the discipline, I suggest you read up and get on with the program. This material is is not difficult to understand for medical professionals. Otherwise, you’re fodder for WH salesmen. Get a partner/spouse involved and as a team you’ll get there.
Interesting. Hadn’t considered that approach. I suppose it would depend on what the offer would be. Any idea where to shop out a converted policy, preferably before it is ever converted?
You are not going to want to once you look into it likely. What they do is offer you a little more than the CSV from what I’ve seen.
I suspect you’re right that there is unlikely to be a free lunch there. I’d have to check again, but I don’t think either of my policies is convertible anyway.
You need to look into this and write a post on it. Like you, my plan was to just drop my term gradually, but if I can convert and sell at a profit, that would be even better. I had never thought of that.
WCI, you might be surprised on whether you can convert your policy. I had no intention to ever convert mine, so I asked if there was a cheaper, non-convertible option I could apply. The cheapest ones available (I’ve got Banner and Ohio national) were convertible.
Good post. I think it is especially important to bring to light and note that Insurance is to make up for what the portfolio is not (at least not yet). Once you have savings/net worth then insurance is more and more likely to be a poor choice.
I’ve always wondered–do you include your primary residence in your portfolio calculation? While this is definitely a part of your net worth (if needed to liquidate), it is realistically just an income sink (e.g. property taxes) and will not be appreciating at 8%/yr. I’ve tended to make two calculations–one with and one without illiquid investments. I am working hard to be mortgage-free, but this definitely makes that first curve less impressive.
Kiyosaki would suggest that you don’t for the reasons you stated. Your home could very well be appreciating at 8%/year, but as you said it throws off no income and you can’t really dip into principal without selling the home or incurring debt.
By most definitions a home, car, etc. is not a “portfolio” asset, which typically refers to financial products including stocks, bonds, funds, etc. Some would not even include a closely-held business as a “portfolio” asset.
Sounds like Dahle is including his full net worth: “The red line is the size of my retirement portfolio (actually net worth, since the vast majority of my calculated net worth is my retirement portfolio.)” I do not get the impression that he lives in some palatial mansion which accounts for 1/2 of his net worth 🙂
While a home is in many ways a consumption item, it is also in at least two ways an investment. First, as you mention, it might appreciate at a rapid rate during certain time periods. Second, and more importantly, it kicks off “dividends” i.e. free rent each month. That isn’t insignificant.
My home equity is less than 20% of my net worth, so while not zero, it’s close to a rounding error at this point.
Obviously pluses and minuses to doing it either way. The important thing is to realize that it does make a difference.
Great post. The visual really drives the point home. How did you design the chart – with Microsoft Excel? I’d like to make a similar one for my own situation if you can point us in the right direction for the software to use.
Yes, just excel.
The contribution is appropriately conservative – it seems to assume 100K contributions nominally – this creates some “breathing room” in the budget since at inflation of 3%, the burden of putting in that nominal 100K declines every year. Probably wise with SGR and other reimbursement threats always over our heads.
Especially when I’m actually contributing almost 50% more than that. 🙂 But the point of the graph isn’t making it perfect or even perfectly describing my plan. It’s to demonstrate that insurance + portfolio should = financial independence.
Wonderful timing for us as we are, embarrassingly, just now finalizing our first big life insurance underwriting. The graph makes perfect sense to my wife. We owe so much to you. Thanks again!
Agree. The graph is a brilliant visual.
To be completely objective you need to subtract the lost opportunity cost of owning the insurance + the tax liability of your investment account from the investment account total future value.
Not necessarily. If your “financial independence” number assumes you’ll be paying taxes with that income, you don’t have to subtract it out. You just need to be consistent. Not sure why you’d subtract the lost opportunity cost of the insurance. Insurance has a cost, and that’s one of them. Can you expand your thought because I’m not sure I’m getting what you’re referring to.
I think what he means is that you would be “dropping” relatively cheap term insurance when no longer needed. You drop a lot of potential value for a small gain. i.e. dropping a 1 million dollar 20 year policy at the end of 20 years vs. having 30 year policy to begin with. The excess cost (probably $15 a month for 20 years and say $75 a month for the other 10 years = $12,600) is minimal compared to potential 1 million payment if you were to expire.
I’ve noticed personally that your financial plan is to provide well for yourself while setting your children off on the right financial footing. Some people have financial goals of making their children “wealthy” when the die. For those individuals they would see it as an opportunity cost when dropping term insurance early.
Personally I have 1 million dollar 30 year and 500K 20 year. I really wish I would have just done 1.5 for the whole 30 years for that reason. The cost difference was only about $10 a month.
I think you overestimate the value, as you are just looking at the face value. You also have to consider the likelihood of you actually dying during that extra 10 years. If the extra cost is $15 a month, that likelihood is probably very small. Plus, you get that $15 a month over 20 years. At 8% that’s $9000. Add in $75 for another 10 years and you get up to $33,500. If your chance of dying in those 10 years is only 2%, well, maybe that’s not such a good bet. Those insurance companies and they’re actuaries aren’t dumb. They have the data and they’ve run the numbers. Insurance isn’t a good deal ON AVERAGE. There has to be enough money there to run the company and unless mutual, provide a profit. That comes from people paying a little more for the insurance than it is truly worth, ON AVERAGE. Of course, you buy insurance because of the possibility of being less than average.
Good, simplified example. Couple comments – I would argue that if you’re cashing your life insurance policy you’re not likely to be around anymore 🙂 That would mean that you really only need to fund retirement for one person, not two. That means that you could insure at a lesser level.
Second, I’m not sure you should drop your disability policy when you reach your “financial independence” level. If your disability is severe (paralysis, etc…), your expenses could very well go up considerably.
Good point
Yes, that ought to be factored in to the decision as to when to drop. As should a bear market + total disability shortly after the cancellation.
Possibly but remember they only pay if you are still working and only until typically age 65. Might be better to use the premiums for ltci although that also has issues.
I agree that while this information is highly useful and a good benchmark, the “financial independence” level varies depending on your standard of living, perception of poverty, and other accumulated costs. That could really affect the functionality of the chart.
Yes, everyone needs their own personal chart. And there is no guarantee your standard of living/perception of poverty etc won’t change as you get older.