Bill is 20 years old and is thinking about buying a term life insurance policy w
ID: 1093495 • Letter: B
Question
Bill is 20 years old and is thinking about buying a term life insurance policy with his wife as the beneficiary. The quoted annual premium for Bill is $8.48 per thousand dollars of insurance coverage. Because Bill wants a $100,000 policy (which is 2.5 times his annual salary),the annual premium would be $848, with the fist payment due immediatly (i.e, at age 21). A friend of Bills suggests that the $848 annual premium should be deposited in a good mutual fund rather than in the insurance policy. "If the mutal fund earns 10% per year, you can become a millionaire by the time you retire at age 65" the friend advised
A.) is the friends statement really true?
B.) Discuss the trade-off that liam is making if he decides to invest his money in a mutual fund
5 stars to whoever includes a "cash flow diagram"
Explanation / Answer
a.) Future value of an annuity = R * ((1+i)^n - 1)/i) where R is the monthly payment, i is the interest rate and n is the no of years
R = 848, i = 10% and n = 65-20 = 45 years
FV of the annuity = 848 *(1.1^45 - 1)/0.10 = 609631.30
Thus the friends statement is not true. Besides, 609K 45 years from now is not the same as 609k today. Considering an inflation of 3%, its value is only 609k/(1.03^45) = $161k today.
PS: Cashflow diagram for mutual fund would show cash outflow of $848 for 45 years and an inflow of $609K at the end of 45 years
Cashflow diagram for insurance policy would show cash outflow of $848 per year. If Bill dies before 65 years of age, it would have inflow of$100K that year with outflows stopping subsequently. If Bill lives beyond 65 years of age, there will be no inflows.
B.) If Bill buys the insurance policy, consider the 2 scenarios:
1. Bill dies before the age of 65 years - Bill's dependant gets $100K
2. Bill lives beyond the age of 65 years - In this case Bill gets nothing from the insurance firm.
If Bill doesnt buy the insurance policy, consider the 2 scenarios:
1. Bill dies before the age of 65 years - Bill's dependant are worse off by $100K. They only get whatever amount is accumulated in the mutual fund. A rough calculation shows that only after 27 years, mutual fund corpus becomes greater than 100K and that too is not certain if the mutual fund doesn't give good returns or if there is a market crash
2. Bill lives beyond the age of 65 years - In this case Bill is better off with the returns from the mutual fund corpus, provided it gives good returns.
Personally i feel Bill should go for the insurance to secure the future of his dependants.
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