For my friends out there who have seen my head and how it can cast a blinding reflection if the sun is at the right angle, you may wonder how it is possible that I even need haircuts, let alone a haircut that costs $86? It will make sense by the end of this month’s column.
I have been brainwashed by what I have learned in my college finance classes as well as my almost 20 years of experience in financial services. I have been brainwashed by the ocean of statistics that you and I have swum our professional lives in that emphasize the large amounts of money needed to pay for children’s education, our retirement, medical costs in retirement, long-term care expenses, etc. Thus, my wife accuses me of overanalyzing everything that is financial, and being one of the cheapest people around. I am frugal for a couple different reasons.
The first reason is because of the aforementioned statistics that have been burned into my brain and the need to avoid instant gratification so that I can otherwise save for those expenses decades down the road.
Another reason I am frugal is because of two very simple economic concepts that I live by and believe every high school and university should teach students before they venture out into the world of financial independence. The two concepts I am referring to are “time value of money” and “opportunity cost.” I believe that if the education system is not going to educate on these concepts, it is an opportunity for those of us in financial services to fill that gap which, in turn, will create client opportunities for us.
As you may know, the notion of time value of money is that a dollar today is more powerful than a dollar in the future. Why? Because a dollar today can be invested to be worth more than a dollar in the future. As Warren Buffett once said, “Someone is sitting in the shade today because someone planted a tree a long time ago.” Warren is referring to the fact that if you invest a dollar today and it gets a hypothetical five percent average return for 20 years, it will then be worth $2.65.
Opportunity cost, my second concept, is the notion that if you have a resource (such as time or money) that you allocate to “something,” there is a missed opportunity that you experience by not choosing the alternative to that “something.” This concept is the guiding hand of how we spend our lives! This is the very foundation of how we use the limited resource of time that is given to us over our lives. We all think, “If I do X today, then missing out on doing Y is less of a missed opportunity than if I did Y and missed out on X.” We all do this, whether it’s instinctively or not so instinctively. In other words, day after day, we allocate our time to the activities that we believe will result in the least amount of opportunity cost, whether you recognize you are following this economic principle or not.
An example of opportunity cost using money would be, if my seven year old pays $1 for a candy bar, he gets a candy bar, but the opportunity cost is the pack of gum he could have otherwise gotten. In essence, opportunity cost is the opportunity or opportunities you lose by choosing something.
Now let’s combine the two concepts of time value of money and opportunity cost using a real life example of a situation I went through several years ago. I had an eight year old vehicle that had over 150,000 miles on it, again, because I am cheap! Well, after the vehicle stranded us a couple of times, my wife implored me to trade this vehicle in for something else. As I went through the debate with my wife on whether or not to get another vehicle, here is the logic that went through my strange mind: If I were to trade in my eight year old vehicle that now is worth $10,000, for a brand new one that costs $40,000, the real cost to me will be somewhere around $130,000!
Right now you are thinking I am either crazy or I missed the subtraction part of my math classes in elementary school. Allow me to explain. Enter opportunity cost and time value of money.
By forking over $30,000 today, I am foregoing an opportunity to have that money invested elsewhere. Thus, there is an opportunity cost of what that investment could grow to be. This means that if I were to not give up that $30,000 today, but instead I would invest it where it can capture interest of, say five percent on average per year for 30 years, what would that value grow to? I would have $129,658 in this hypothetical account when I am 69 years old. That money could help with my retirement, pay for my grandchildren’s education, etc. That is the power of time value of money and opportunity cost. And that’s why I’m not ashamed to drive an old beater!
A couple of other examples would be:
- If I were to spend $20 on a haircut today, I would technically be paying out $86 in future value 30 years from now assuming a five percent rate.
- If I were to buy a $5 latte every day for 30 years, I would technically be paying out $127,000 in future value 30 years from now assuming a five percent rate.
Anyway, back to the vehicle. After explaining this logic to my wife, she exclaimed, “So do you suggest never getting a new car then?” I said, “Fair point,” and hesitantly agreed to it. (Note: I am embellishing a little as it is not like I get out a financial calculator every time I spend money.)
As we drove to the dealership, I asked my wife what her requirements were of the new vehicle, even though this new vehicle was going to be mine! She said she had two simple requirements. The first requirement would, of course, be cost! She knows I would not be on board with spending a fortune on something that depreciates the moment you fire it up. The second requirement she sought was capacity, i.e. the capability to comfortably transport our two sons and a million of their friends to and from sporting events along with all of their equipment. With this last requirement, my wish of buying a pickup truck immediately disappeared.
As we walked into the dealership, right there in front of us was a vehicle for which she immediately proclaimed, “I love it!” Again, this vehicle was supposed to be mine and the vehicle she was falling in love with was a minivan. Apparently this minivan satisfied her two criteria. This is when I enlightened my wife that I had a third requirement that the minivan did not fulfill. My third requirement was the horsepower and towing capabilities, should I decide to purchase something later on that needed to be towed—a boat for example. She agreed, and we went to the Sport Utility Vehicle (SUV) section.
As we looked at the SUV we liked, we realized this decision was going to be a bit more complicated than what we thought. That is, the SUV required a premium of $5,000 over the minivan. At this point we essentially had a value triangle for each of these vehicles that we needed to analyze, since this decision was not just about “cost” in isolation or “capacity” in isolation. It was more complicated than that.
As you can see above, the value triangles lay out our three requirements and the corresponding data. The bottom left side of the triangle was equivalent on both vehicles. They both had the capacity to transport several kids, as my wife was seeking. The differences came in the top corner (price) and the bottom right corner (horsepower and towing). Effectively, if we went with the minivan to save $5,000, there would be an opportunity cost of not having the horsepower and towing I was looking for. After debating for an hour, she let me buy the SUV.
To me, the opportunity cost of paying the $5,000 extra and getting the towing capabilities was much less than saving $5,000 and not having that capability. There is a reason why one of the fastest growing segments of the U.S. automobile market has been SUVs in recent years. They have the versatility of being able to haul a million people around like a minivan, with the horsepower and towing capabilities of a pickup truck. The SUV has the best of both worlds where opportunity cost may often be minimized.
With that being a primer, let’s discuss opportunity cost as it relates to guaranteed universal life insurance (GUL) and guaranteed index universal life Insurance (GIUL). I believe this is a conversation that is not discussed enough because of our (the entire industry) comfort level around GUL. However, if we start analyzing and discussing the concept of opportunity cost, I am confident that the industry will start selling a lot more GIUL.
Let’s use an example of a 50-year-old male (preferred non-smoker) that has a death benefit need of $1 million. Because this individual has an absolute need for the life insurance to be in force for his lifetime, I illustrated the death benefit to be guaranteed until age 120, as long as he pays the premiums until age 100.
At this point, a picture is worth a thousand words. Below you will see the value triangles of these two products.
As was the case with the minivan/SUV example, the bottom left corner is equivalent in both examples. Regardless of how interest rates or any index perform, the death benefit is guaranteed to age 120 as long as the client pays the premiums as illustrated. Where do these products differ? If you look at the top corner, the cheapest product is the GUL, with an annual premium (to age 100) of $10,380 per year. Thus, by looking at just these two specs/corners in isolation, one would believe that the GUL would be the way to go. However, we need to consider all three corners of the value triangle and the tradeoffs/opportunity costs that exist. Even though the GUL is $508 cheaper than the GIUL, choosing the GUL comes at an opportunity cost in the form of cash value. As you can see the cash value on the GIUL in year 20 grows to $215,675 (assuming a six percent illustrated rate), which is almost a return of the total premiums paid up to that point.
I would estimate that if I were to ask a room of 10 prospects which one they would choose, a good majority of them would choose to pay the roughly five percent more premium in exchange for the cash value potential. GIUL is flexible and versatile so that if the consumer’s needs change later in life and cash value is needed to subsidize retirement, it’s there. Just as the SUV had both the capacity of a minivan and horsepower of a pickup, the GIUL has the death benefit guarantee of a GUL while also providing cash value potential that indexed universal life (IUL) insurance is known for.
If there was an overarching message I would like to communicate in this month’s column, it would be two things:
- The first is, my desired features of a couple of life insurance policies I own today are different than what I thought they would be 15 years ago when I bought them. Why? Because as much as we believe we can determine what we will need in the future, time changes a person and their financial goals. Products that have the flexibility and versatility to change along with life are important. I bet when Walt Disney applied for his life insurance policy he never thought that he would ultimately use that policy’s cash value to finance and create what would be Disneyland.
- As mentioned, life is about tradeoffs and opportunity costs, and many times the cheapest product is not the cheapest when you factor in opportunity costs. This is especially true with life insurance pricing. So let the client decide if saving $508 is worth the opportunity cost of not having cash value. Even though it may be an easier sale to just give the client what they want when they ask for the cheapest permanent coverage, discussing the tradeoffs/value triangle should be our responsibility as we cannot assume our clients know about the opportunity cost of buying the cheapest product.
For the reader that has a keen understanding of the two concepts I have been discussing, time value of money and opportunity cost, you may be thinking, “What if my client were to buy the GUL and invest the premium difference of $508? Could they achieve the same level of cash value in that investment?” My financial calculator tells me it is possible only if the investment performs to the tune of 24.9 percent compound average return over the 20 years in order to get the same $215,675. Furthermore, this is not taking into consideration the potential tax benefits of cash value life insurance.
In closing, GUL is a great product and there are, of course, many scenarios where GUL would be the more appropriate product for that respective client. I am merely advocating that financial professionals and consumers heed the tradeoffs that may exist from product to product.
“As I hurtled through space, one thought kept crossing my mind—every part of this rocket was supplied by the lowest bidder.” —John Glenn
Neither North American nor its agents give tax advice. Please advise your customers to consult with and rely on a qualified legal or tax advisor before entering into or paying additional premiums with respect to such arrangements.
Indexed universal life insurance products are not an investment in the “market” or in the applicable index and are subject to all policy fees and charges normally associated with most universal life insurance.
The opinions and ideas expressed by Charles Gipple are his own and not necessarily those of North American or its affiliates. North American does not endorse or promote these opinions and ideas nor does the company or agents give tax advice. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed as to accuracy. All presentations are for agent representative use only and cannot be used, in whole or part, with consumers.
