Redesigning Microeconomics – Part 1

~700 words, ~4 min reading time

Because I, apparently, don’t actually believe in breaks, I’ve decided to do a major redesign of the main course I teach: Principles of Microeconomics. This has been inspired by a few things – some of it being the research which I’ve linked and summarized here.

Thus far, I have redesigned my syllabi for both my online and face to face courses – including the “Honors addendum” for my face-to-face honors students. I’ll summarize a bit of what I’m doing here:

Assessment

Both face-to-face and online sections are now basically 40% engagement and 60% mastery.

In my online course, I’m using a point system. Students accumulate points in 3 ways: Knewton Homework assignments (100 points, based on successful completion), Short Papers (300 points total), and Engagement Activities (100 points).

Knewton is an adaptive online homework system designed to help students achieve mastery of the course material. The system tries to teach through trial and error. So, if a student answers questions in a topic correct consistently, they won’t see as many questions on that topic. If a student answers them incorrectly, then Knewton tries to adjust the difficulty level to where students can start seeing what a correct answer should look like, and builds them up to the point of mastery. I’m counting this as “engagement” because their grade, in the end, comes from their willingness to keep participating until they “get it” rather than from a summative assessment.

The Short Papers are three papers, each of which is designed to evaluate one of the main course learning objectives in an “authentic” setting. For example: the first paper asks students to choose a good and to make a forecast for the price of that good 1 year from now, and explain that forecast in terms of supply and demand elasticities and supply and demand shifts. In the Spring, I am modifying this assignment a bit by requiring a rough draft and self and peer assessments before the final copy is submitted.

The Engagement Activities give students an ability to customize the course to their own interests. These are generally completion based assignments. Right now, I offer three different options: Excel projects (which teach some basic Excel skills), Economics in the News, and Book Reviews. Students are also free to make their own, if I approve them. These are all completion based, and really just have the goal of convincing students to think a little bit about economics as a field.

My face to face course uses a weighted system, which explicitly separates “Mastery” and “Engagement”. “Mastery” is evaluated based on their performance on the multiple-choice final exam, which can be modified by an optional Grade Proposal – in which they provide evidence that they should get a specific grade for their mastery of course material. This idea was taken from “Rethinking Exams and Letter Grades…” by Kitchen et al. So students aren’t in the dark about the final, I will also have them participate in a “Midterm Diagnostic” which will look a lot like the final, but won’t count toward the course grade.

The Engagement portion is evaluated based on 4 things: (1) Class attendance, (2) Class Preparation Questions, (3) Short Papers (like I use in my online course – but, here graded more on participating in the process than for mastery), and (4) Engagement Choice Activities (which mirror the Engagement Activities from the online course).

For my Honors students, half of their Engagement Choice Activities points come from their Honors Project.

Weekly Rhythm

I’ve established a “Weekly Rhythm”.

For the online courses, the Weekly Rhythm is: Reading, Lecture Videos, Knewton Assignments, Short Paper Step.

For the face-to-face courses, the Weekly Rhythm is: Reading, Lecture Videos, Class Preparation Questions, Short Paper Step, Class Activities.

Next Step

Now that I have my overarching design set up (sequence of course topics, etc), and an assessment plan in place, the next step is to set up my assessments – so I need to write the final and the rubrics/checklists for the papers for my online class – this should help me align everything during the semester with how students will ultimately be evaluated. (YAY for backward design!)

Medicare For All Update – Getting the Math Straight

~600 words, ~3 min reading time

Okay, so I’ve been looking at the Mercatus numbers.

First, Think Progress IS wrong in their representation. (Think Progress makes the very simple error of acting like an ADDITION to cost is the WHOLE cost.)

HOWEVER,  my initial impression was also wrong. My error was a bit more complicated – I assumed constancy in some things that weren’t constant in the Mercatus estimates, and ended up misrepresenting the results, TOO.

So, let’s try to get it right, and we’ll just focus on one year.

Before we hop in, we need to figure out what we’re talking about. We’re going to look at National Health Expenditures (page 5 is my reference here). What this is: Personal Health Care Expenses + Government Administrative Cost + Net Cost of Insurance (Basically, private administrative costs, I would guess) + Government Public Health Activities

Mercatus starts by looking at personal health care expenses in 2022. They suggest these are projected, under our current system, as being $3.859 trillion. (Note: this includes both public and private systems.) With Medicare 4 All, there would be a big jump in healthcare utilization – amounting to $435 billion. This comes from the currently uninsured being covered and from Medicare covering things that some private insurance doesn’t, and from people using more medical care because they are no longer responsible for copays or coinsurance (so, on the margin, they go to the doctor more often – though I suspect this effect is small). BUT, providers would receive less because of M4A’s pay structure. That would cut $384 billion from provider payments, and $61 billion from prescription drug costs. Net effect: personal health care spending FALLS by $10 billion in 2021.

The other change is that total administrative cost is expected to fall by about $83 billion. Basically, we’re eliminating private health insurance costs,  but Medicare’s administration would have to eat that up – but with some economies of scale, there would be a net savings on the administrative side.

So, total effect: $93 billion in National Health Expenditure savings. The other years in the estimate project savings of up to $300 billion in NHE by 2031.

Now, Mercatus’s point is that, EVEN WITH this savings, the government would be spending an additional $2.535 trillion that year – since it is absorbing the private insurance industry’s costs. They want to know where the money is coming from, since doubling income taxes on both individuals and corporations wouldn’t be enough to bring in that money.

On the one hand, progressives can reasonably point out that we’re already spending this money, it’s just a matter of redirecting it. And there’s a point in that. This $2.535 trillion is not new to the ECONOMY, it’s just new to the GOVERNMENT BUDGET. Okay.

But, would progressives then suggest that we should just have the government absorb the health insurance premiums currently paid by employees, employers, and individuals? I suspect not. That would mean that each person’s premium would vary not based on income, but on their current employer. This would be an administrative nightmare, I suspect. So, while the money is there, there is still the practical question of how best to collect it in a way that isn’t politically disastrous.

Another big point: Blahous is very clear that he’s being generous in his estimates of savings because he wants to estimate the MINIMUM amount of additional tax revenue that would be required.

Letter to Mises U Students (2017)

To Mises U students – especially those planning to enter economics as a vocation – an autobiographical note:

TL;DR – You’re amazing. Act like it.

After this week, you may feel inspired and overwhelmed. This is normal. It happens to me, too. Still. Every year. The level of interest, talent, and devotion to the study of good economics that I see among the students and my colleagues on the faculty is inspiring. And overwhelming. I know there are many of you – and I’m speaking of the students and young faculty here, not just David Gordon – who have out-read me. Easily. Many – possibly most – are cleverer and more insightful than I. Many of you will out-write me – if you haven’t already.

I write these not as mere empty words of encouragement – I don’t believe in such things. I write them because they are true – and that is something that I find encouraging, and believe you should, too.

I also write these things with very little regret, regardless what the tone may sound like. The reality is that I love my life and the balance that I have achieved between the various aspects of it.

So, here is my advice to you based on my own – admittedly limited, but rapidly becoming less-so – experience:

(1) I was asked today what the threshold of significance is to write a paper and send it to a journal. My answer: Do you think it is worth your time to write it down? If so, then share it. The reality is that, early in your career, you haven’t the slightest clue how significant your ideas are. You don’t have the experience to make that call. That’s what editors and referees are for. So, simply tell yourself that the odds of rejection are fairly high (which is true even for excellent papers, by the way), do your best, and send the thing out. Yes, rejections hurt. Especially the first few. But, you will learn more from being shot down in a rejection than you will learn from any acceptance. Maybe what you learn is that that editor is a jerk, but far more often, you will receive feedback that will help you refine your ideas or the presentation of your ideas.

(2) At first, follow Carmen’s advice I mentioned in another post – that is, add to what the Masters are doing. Expand, explain, defend, and apply (in no particular order). I especially advise doing this with people who are currently alive. One paper I’m still working on connects Mark Thornton’s Skyscraper research with some basic, fairly mainstream, urban economics and Rothbard’s theory of wages. I presented a draft of this paper at the Austrian Economic Research Conference. What happened? Mark Thornton asked me to coauthor a response to a critic of the theory. It should be obvious but, DON’T SAY NO TO THAT. Coauthoring with an established economist is amazing. It’s far less work than working alone. You get the benefit of their name attached to what you’re doing. You get to observe their research process. And you get to build a relationship with them that can lead to further projects.

(3) Get started early. You’re lucky. Austrian economics is still a small field. As a result, we, frankly, can’t afford to be as credentialist as most other fields. You don’t have a PhD. So what? Look at the Quarterly Journal of Austrian Economics. It’s pretty common for there to be articles in there that are not written by PhDs – they might be grad students, or even undergrads. But, they all go through the same double-blind review process. Yes, if you have a PhD, your odds of acceptance are higher – but that’s because people with PhDs probably have more experience with academic writing and publishing than you do. So, get that experience. Read academic articles – I mean QJAE, not Mises Wire, for this purpose – and try to write them, too. You’ll learn.

(4) Go ahead and write popular pieces – like for Mises Wire and others. This is good practice for writing clearly – something that is far too often missing in academic writing. Confession: when I was a Fellow at the Mises Institute in 2004, I spent a great deal of time commenting on the Mises Blog. This caught the attention of Lew Rockwell, who asked to see me in his office. Yes, I thought I was in trouble for not taking the Fellowship seriously, and spending too much time arguing with people in comment threads instead of doing real economic research. Instead, he said he was going to set me up with a password so that I could post on the Mises Blog on a regular basis. This writing was important for my development, as I had to think far more about being sure that I was clear. Now, it’s true, I haven’t written a popular piece – self-published or published by anyone else – in a LONG time. But, that’s not my focus right now, and it doesn’t take away from the fact that you may learn a lot from doing it.

(5) Keep your life in balance. What that means is purely up to you. But don’t wear yourself out, beat yourself up, or put yourself down just because you don’t write 80 pages a day like Murray Rothbard did. You aren’t Murray Rothbard. Now, that doesn’t mean you aren’t as brilliant as he. But, it does mean that you very well may have different preferences. If you do, don’t pretend otherwise. Austrian economics may be a small field – but there are far more of us than there were just 20 years ago (before I even knew of Austrian economics). We each have a part to play in the division of intellectual labor. Take a break when you need to, and let others take on their roles.

It has been 14 years since I was in your shoes. From this side, it’s a very short time. Make the most of your time – whatever that happens to mean to you. I can only hope that, in 14 years, when you have filled my shoes again (and likely have outgrown them!), you will also find yourself inspired and overwhelmed – but, most of all, encouraged by the days ahead and the bright minds that will lead us there.

Hayek’s The Meaning of Competition

~300 words, ~2 min reading time

Summary of the full article. Article available from the Mises Institute.

In modern economic theory “competition” is used to describe a state of affairs that is probably best thought of as being the CONCLUSION of a competitive process adjusting to fixed underlying conditions. Something as simple as charging the same price is unlikely outside of the most organized markets. Yet, this is a key feature of the perfect competition model.

The common speech sense of competition understands competition to be a dynamic process – one that is typified by people finding and exploiting differences between themselves and their competitors. This is directly opposed to the perfect competition model which assumes a similarity between firms (and certainly between products!).

Making a fetish of the perfect competition model can lead to odd results – in particular, the suppression of an actual competitive process by the use of regulation to impose standardization.

A more productive path than comparing the real world to a hypothetical world of perfect competition is to compare the real world with competition as commonly understood with the real world with competition (as a process) suppressed by legislation. If we allow the competitive process to occur, entrepreneurs will continually adjust their products and processes to try to produce goods that best serve consumers at the best possible prices. Failure to serve consumers’ demands for quality and price will result in losing business to competitors. On the other hand, suppressing competition – perhaps by using price regulation to enforce a common price – will tend to suppress the desire to serve consumers well and efficiently.

Mises’s Economic Calculation

~300 words, ~2 min reading time

This summarizes a section of Ludwig von Mises’s Socialism titled “Economic Calculation”, available from the Mises Institute and Amazon.

Value is fundamentally subjective. For a single consumer, comparing the values of different consumer goods is fairly straightforward. Similarly, comparing the values of factors of production in fairly simple production processes is also fairly straightforward, as the connection between the factors of production and the resulting consumer goods are clear. However, once the production processes achieve any significant degree of complexity, a direct value comparison becomes impossible – especially since there are typically a multitude of possible methods of producing any particular good. In order to deal with this situation, we need economic calculation – the calculation of profits, losses, and equity.

Economic calculation requires two conditions: first, there must be exchange of the factors of production. (This is why socialism – which Mises uses in the strict sense of government control of the means of production – can’t calculate. With government controlling all the means of production, there can be no exchange of them.) Second, it must be a monetary economy. With these two conditions, factors will have money prices, which can be used to calculate costs, profit, and equity.

Economic calculation is not perfect. It cannot account for certain “non-economic” considerations. (Mises cites the example of a productive process that destroys the beauty of the natural landscape.) However, without economic calculation, there is no clear guide for how to produce what we would like to produce.

Socialism can stumble along for a bit, if it holds to the old pattern of production. Since preferences and resources usually don’t change very quickly, the old pattern of production won’t be far from the right one at first. However, in the real world, change happens – which means that holding to the old production patterns would cease to be rational as time passes.

Rothbard’s Fundamentals of Value and Price

~700 words, ~4 min reading time

Chapter 8 in the Rothbard Reader, available from the Mises Institute or Amazon.

One of the primary contributions of the Austrian school was moving from thinking of goods and people in terms of “classes” to think of them in individual units and as individual people. This emphasis on the individual provided three main insights.

(1) The Law of Diminishing Marginal Utility – while classical economics was stuck on the paradox of value (best seen in the diamond-water paradox, which points out that water is essential for life but cheap while diamonds are mere decoration but are expensive) and had to propose that there was a disconnect between use value and exchange value, Carl Menger pointed out that this paradox is resolved if we think about the usefulness of an additional (that is to say, marginal) unit of the good. While water, as a class, may be very important, the reality is that we have so much of it available in most places that humans live that ADDITIONAL water isn’t really very useful. As a result, water is cheap – we’re not willing to pay much to get more than we already have. Diamonds, however, are very rare. So, we are willing to pay a lot to get an additional one. By thinking in terms of exchanging individual units of the good, Austrians could discover this law of diminishing marginal utility – which connects exchange value with (marginal) use value.

(2) Time Preference – where does interest come from? With their faulty value theory, classical economists were stuck going one of two directions. One group – which led to the Marxian view – suggested that interest was a kind of “surplus value”. The labor embodied in the good was what gave it value, so if the exchange value was greater than that intrinsic value, then the difference was a “surplus” of value. Another group suggested that capital is productive. So, the reason that capitalists earn interest or profit is because they own productive resources. However, both of these views are incorrect. Austrian economist Eugen von Bohm-Bawerk builds on Menger’s individualist view of value to show that what distinguishes capital is not its exploitative nature (which competition between employers would diminish) nor its productivity (which should be fully embodied in the price of the capital good when it is purchased). Rather, it is time. When an individual acts, they demonstrate a preference for sooner want-fulfillment to later want-fulfillment. What a capitalist does, then, is pay for the production of a good up front – knowing that they won’t get the revenue until later. They would only do this if they expect the revenue to be enough greater than the cost that it is worthwhile to delay gratification. That is: if they receive interest. Meanwhile, workers are willing to work at a “discount” below the value of the product precisely because they do not have to wait for the final product to be sold before they receive their pay. They are willing to sacrifice some money in order to get their pay sooner rather than later.

(3) The law of diminishing marginal productivity – finally, thinking in terms of individual units allows for the Austrians to explain, for example, wages (and other factor prices). Factors are paid according to their marginal productivity – that is what an additional unit of the factor would add to production. We can’t arbitrarily divide production of goods from distribution of income. Rather the two are intimately connected. Distribution of income is not arbitrary – rather it comes about as a result of marginal productivity. This thinking also changes the question of class dynamics. Laborers and capitalists should not fight over how to distribute goods between them – the two are partners, as labor and capital are typically complements. (That is, most of the time, having more capital makes labor more productive – raising wages, while having more laborers makes capital more productive as well!) Rather, the conflict should be between members of the SAME class. Rothbard’s example: a new discovery of copper doesn’t hurt workers (who will now have additional jobs available) or consumers (who will find that copper goods are cheaper). It hurts those who ALREADY PRODUCE copper, as they see the price of their product decline. So, then, the Marxian approach suggesting there is some fundamental conflict between labor and capital is incorrect. Rather, conflict exists WITHIN each of these classes – labor v labor and capital v capital.

Mises’s Planning for Freedom (Selections)

~ 400 words, ~2 min reading time

Available from the Mises Institute or Amazon.

Planning for Freedom – interventionists claim that their version of economic planning is radically different from the socialists’ as well as the capitalists’. They claim to be able to achieve a best of both worlds. However, interventionism tends to create results that are counter to the stated intent. For example, minimum wage, rather than lifting all workers (and especially the least fortunate) tend to lift some workers’ wages while disemploying others entirely. Similarly, high union wages tend to end up suppressing nonunion wages. If we want to help everyone, we should allow for a maximum of freedom, which will encourage entrepreneurs to produce what consumers want and to do so as productively as possible (raising wages).

Middle of the Road Policy Leads to Socialism – Following from the previous chapter, the middle of the road policy tends to be a road to socialism (that is, full government control of the economy). Consider a price control on milk – which is intended to make milk more affordable and available to the lower classes. However, the price ceiling will lead some farmers to produce less milk – instead they’ll produce things like butter or cheese which are not price controlled. So, milk may be cheaper, but it is less available than before. To offset this, the government would have to place price controls on the inputs (and perhaps the other goods that milk producers would be tempted to switch to), so that it is profitable to produce milk even at the lower price. This would simply lead to fewer of those inputs being made available – leading to yet more price controls being needed. In the end, the government would have to take over control of all production in order to meet its goal of providing more, affordable milk – just as in full socialism. This path is not mere conjecture – it was largely along this path that the British economy became socialist through World War 2, and that the German economy became socialist (of the Nazi variety) in the lead up to World War 2. The march toward socialism is, however, reversible, if the people adopt an ideology that is not simply anti-communist and anti-socialist, but is a positive endorsement of the market system that has led to the prosperity we have.

Taylor’s An Introduction to Austrian Economics (Selections)

~200 words, ~1 min reading time

The full text is available from the Mises Institute or from Amazon.

Introduction – What distinguishes the Austrian school: (1) devotion to a deductive method aimed at conceptual understanding, (2) methodological individualism – seeing economic phenomena as the result of individual actions.

The Subjective Theory of Value – Value is fundamentally subjective. Even prices are the result of subjective valuations of amounts of money (and their expected eventual use) and the goods that are being traded for that money. Producing for exchange means that we need to consider not only our own preferences, but also the preferences of our buyers. The fact of subjective preference suggests that there is no “economic man” who is bound purely by monetary calculations. Rather, monetary concerns are balanced against other concerns as well. For example, anticipating modern behavioral economics and the idea of “bounded rationality”, Bohm-Bawerk points out that the process of economic calculation is, in itself, costly in terms of time and effort. So, for trivial matters, it is probably best to follow general heuristics, saving the effort of monetary calculation for larger matters where precision is more important.

Mises’s Economic Freedom and Interventionism (Selections)

~200 words, ~1 min reading time

Full text available from the Mises Institute or Amazon.

The Individual in Society – This chapter is about the meaning of “freedom”. Mises suggests that there is no such thing as “freedom” from nature. All people are bound by scientific laws. To be meaningful, “freedom” then is freedom from the arbitrarily imposed will of others. At the same time, complete freedom from the influence of others would come at the price of abandoning all social relations. A market economy based on private property allows for interactions that enhance our productivity, while still allowing people to be free from compulsion and coercion. Historically, those who want to subvert freedom have tended to shift the definitions of terms – suggesting that employees are “wage slaves” rather than being really free, for example.

The Elite Under Capitalism – People are born unequal in certain respects – leading to “superior” and “inferior” people. In precapitalist societies, the superior used violence to take advantage of the inferior. In the market economy, the superior can only benefit by serving the inferior – producing products that the inferior are willing to pay enough for. So, in a market economy, the consumers – most of whom belong to the “inferior” group – end up “ruling” the superior – in that it is the masses of consumers that determine how profitable a business will be.

An Analysis of Infinite Banking / Bank on Yourself

~2800 words, ~15 min reading time

In my previous post, I explained a bit about how whole life insurance works – in particular trying to explain the idea of “cash value” and where it actually comes from. (Something that both the industry and critics get wrong, with just one exception that I’ve found.) This explanation was sought out and brought on by interest in the Infinite Banking Concept (IBC) or Bank on Yourself (BOY).

The basic idea: when structured carefully, a whole life insurance policy can be used as a savings instrument that can replace your need to take loans from banks. It’s really that simple. Now, let’s get into the “how” and “should I”?

How Does It Work?

As I previously explained, whole life insurance policies build up a cash value – which is basically a buyout offer from the insurance company to get you to cancel your policy so they can avoid paying the large death benefit. In order to maximize that buyout offer, you need to carefully structure your life insurance policy so that it’s worthwhile to buy you out quickly. How you do that: structure things so that you pay the premiums early in the policy.

At the extreme end, you would buy a “paid up” policy where you only pay once. And, this policy DOES build up cash value fastest. If you wanted to invest, say, $1000 per year, buying a paid up policy each year would build up cash value MUCH faster than getting a basic whole life insurance policy with a $1000/yr annual premium. But, there’s a catch: taxes.

For whatever reason, the government has decided that earnings in life insurance policies shouldn’t be taxed as long as you don’t access them until late in life (or after death…). This is a handy benefit. HOWEVER, the government has also decided that paid-up insurance isn’t REALLY insurance. It’s just an investment – called a “modified endowment contract” or MEC.  So, using the “buy a paid-up policy each year” plan would result in negative tax consequences.

So,  Infinite Banking/Bank on Yourself set out to maximize your cash value while, at the same time, avoiding the negative tax consequences. So, here’s what they do (this is from Bank on Yourself):

(1) Start with a standard whole life insurance policy with a smallish death benefit.

(2) Tack on a Paid-up Additions Rider – in effect, this rider lets you ADD paid-up insurance to your standard policy. As long as the proportions are right, since the tax man analyzes the policy AS A WHOLE (basic policy PLUS the riders), this can allow you to build up cash value more quickly than the basic policy would while still avoiding the negative tax consequences of an MEC.

(3) Tack on a Term Insurance Rider – this increases your death benefit for fairly cheap. Since the MEC determination is based on a comparison of your premiums vs. the death benefit, this rider allows you to put MORE into paid-up additions. Eventually, you can let this rider expire if you follow the Bank on Yourself method. The dividends you get from the whole life insurance policy will build up your death benefit to the point where you don’t need the term rider to allow the larger paid-up additions.

Sound complicated? That’s okay. This is why Infinite Banking and Bank on Yourself recommend that you NOT try to cobble this thing together on your own. Instead, both are assembling teams of agents who are trained in their techniques – which are pretty similar to each other, as far as that goes. And, unfortunately, life insurance is so highly individualized that you kind of HAVE to talk to an agent about your case. (Or is it just me that hates to talk to people trying to sell me things?) I’m just laying out the basics so you have some clue what’s going on.

Once you’ve built up a cash value, you can then access it in one of two ways:

(1) you can withdraw as much as you have put in – this involves a partial buyout, so you sacrifice some death benefit. (Withdrawing more than this sparks tax problems.)

(2) you can borrow from the insurance company, using the cash value as collateral – this allows the cash value to continue accumulating and does not sacrifice death benefit. If you happen to die before you pay the loan off, then the insurance company will subtract the amount of the loan from the death benefit. This option allows you to use the FULL cash value now (at least as I understand it…) – not just the premiums that you put in. Of course you have to pay it back, or the interest (interest rate 8% from what I’ve seen) may accumulate to the point where the insurance company cashes in your policy for you to make sure the loan gets paid. Basically, like with a bank, you can withdraw money from your account without putting it back in – it just means it’s not there in the future. And, like with a bank, if you don’t pay the loan you might lose the collateral. Policy loans are just a LOT more flexible than bank loans.

The Problem with Analyzing IBC/BOY

The problem I ran into: I like to analyze things myself without a sales person looking over my shoulder. So, I didn’t want to contact a trained agent to ask about the details for one of these policies. I would probably end up feeling guilty enough to buy one if I did that, just because they invested their time in talking to me. But, life insurance companies seem to keep information about their policies under lock and key. It’s VERY hard to get the detail I wanted without giving them my phone number so an agent could call me. (Something, by the way, that is RIGHT THERE in the fine print on the website – that I’m agreeing to have agents call me when I ask for information.) Since the structure of these policies is a bit complex, I couldn’t analyze them exactly.

But, I found something that could get me close. State Farm has decided that it might actually be worthwhile to provide some detailed information to people WITHOUT forcing them to give their contact information. So, I could run some scenarios through them. Awesome.

EXCEPT that they don’t let me tailor things in the IBC/BOY way. To be fair: IBC is less restrictive than BOY in terms of the policy structure, based on my limited understanding. It’s more a philosophy of how to structure these things. Some IBC advocates point out that a 10 pay policy (in which you pay premiums for just 10 years to get the death benefit for life) does a reasonably good job for IBC purposes. It satisfies the tax man’s definition of insurance, AND it builds cash value reasonably quickly. Best of all – I could actually get information about it from State Farm.

Analytical Method

From State Farm, I could use 2 values: the “Guaranteed Cash Value” (which assumed zero dividends) and an “Illustrated Cash Value” (which assumes reasonable, but certainly not extravagant, dividends).

The next choice I had to make: what should I compare this TO? I mean, it’s fairly obvious that, as long as the cash value eventually exceeds the total premiums I paid, it’s going to beat my savings account at my bank – which literally pays 0.1% right now – over the long run. That’s hardly a necessary comparison.

So, I took a page from Pamela Yellen of BOY. She seems to advocate (I’ve not finished the book, so I might be wrong here) replacing a 401(k) with a BOY policy. So, the obvious point of comparison would be stocks – or, more properly, a stock/bond mix like you might use in a 401(k).

Personally, I think a Roth IRA is a reasonable comparison. It has a lot in common with these policies. Earnings are tax-free, as long as they’re invested until you’re old enough (59 1/2). AND you can withdraw anything you put in without sparking tax consequences. The Roth has 2 restrictions these policies don’t: (1) You can only put in a set amount each year (for me, $5,500 for me and $5,500 for my wife). (2) You can’t borrow against the earnings. So, keep that in mind.

Here’s my method to do the Roth comparison:

(1) I looked up a 10 pay policy from State Farm for $100,000 (the smallest they offer of that policy type). Premium for me: $2784/yr.

(2) I looked up how much a 3o year $100,000 term life policy would cost. (answer: $216 per year)

(3) I subtracted $2784-$216 (the premium for the term policy) – $20 (likely annual commissions in a Roth account that is rebalanced once a year using TDAmeritrade).

Putting together 1-3, I’m assuming “buy term and invest the difference”. So, $2784 is going into the 10 pay policy in the one case, and $2784 is going into buying a term life policy ($216) + commissions ($20) + Roth contributions ($2548) in the other. This is for the first 10 years. After that, I’m assuming that the Roth IRA cashes out $216 per year to pay the term life premium.

I assume that the investments in the Roth will be a bit aggressive. 80% small-cap stocks (using the IJR ETF), and 20% in a boring bond fund that just pays 3% per year with no price volatility. (3% is the dividend yield on BND right now. BND isn’t old enough to fit my whole time frame, so I just assumed that bonds were held until maturity and earned 3% per year.) The Roth is rebalanced each year to ensure an 80/20 allocation. Also, because I assumed ETFs were used I don’t have to worry about any hidden expenses.

For time frame, I went back as far as I could. Turns out IJR has existed since 2001. This is GREAT – because it means we’ll capture BOTH the tail end of the dot-com burst (which was not good for small caps) AND the subprime crisis. So, we’ll see both a fairly “standard” stock market crash associated with a mild recession, AND a major “worst since 1929” crash followed by a prolonged, deeper recession.

80/20 Roth v. 10 Pay Life Insurance

So… what happens? Well, here you go:

Roth ends much higher than either insurance policy

In the early years the Roth outpaces the insurance policies – even through the tail end of the dot-com burst. The Roth keeps going up because of the contributions being made in this time, which are large enough relative to the existing balance to offset the losses.

At the end, the high average returns of stocks (especially small cap stocks) lead the Roth to outpace the insurance policies by quite a bit – so you end up with about 2x as much money at the end of this time as in either of the life insurance scenarios.

The only time frame where you should say “Oh, I’m so glad that I followed the insurance plan rather than the Roth plan.” is in 2009 – which reflects that the market collapsed amidst the financial crisis in 2008. But, the recovery was so fast that by as early as 2010, the Roth was ahead again.

[Note: one might think that the end result is affected by the fact that the Roth was still in the contributions phase during the crash. And that is true. However, I performed another analysis using SPY – which is an older ETF – over a longer time frame – so that contributions had stopped before 2009. The end result was still similar to above.]

In terms of total value, it’s pretty clear that the Roth wins in the long run. However, in terms of ACCESSIBLE value, it loses (as long as you’re not 59 1/2 yet!). The Roth had $25,480 go into it that can be withdrawn without tax consequences. Of that, $1,888 HAS been withdrawn to pay for the term life insurance – so only about $23,500 can be accessed without sparking tax consequences.

Meanwhile, of the $39,130 in the Guaranteed Cash Value in the life insurance, fully $27,840 can be withdrawn without having to repay AND without sparking tax consequences. OR the entire amount can be borrowed.

In addition, the Roth plan’s $100,000 insurance policy is going to run out in about 12 years (and will need about $2500 more in premiums). The $100,000 whole life insurance policy won’t, doesn’t need any more premiums, and the death benefit might grow. (In the illustrated version, the death benefit has grown to $103,602 by the last year analyzed, thanks to dividends.)

100% Bonds v 10 Pay Insurance

“BUT WAIT!” an IBC/BOY advocate may say. “Look at the roller coaster that is the Roth! If things had ended in early 2009, then IBC/BOY would have won.” I absolutely do not deny that. The issue is that, over the long term, 2008-2009 happens, but doesn’t stay around forever. Stocks do recover. So, their average return is what matters. And that beats what State Farm is telling me about their policy.

However, there are some really risk averse people out there. They just can’t stomach the idea that 2009 happens. Okay. Let’s compare a Roth portfolio (keeping the tax benefits) 100% in perfectly stable bonds paying 3% per year to the 10 Pay Insurance plan. Here, I’ll decrease commissions to $10 per year (since I’m just buying the bonds once a year, instead of having to rebalance between two investments), but continue the $216 term life insurance premium.

The results:

In the first few years the bonds win, since it takes time for significant cash value to build up in the insurance policies, but you have 100% access to all your contributions immediately with the bonds – but that reverses by year 8 (for the illustrated case) or 9 (for the guaranteed case).

Add to that, again, that in terms of immediately ACCESSIBLE value, the insurance policies obviously win around year 7 or so, as their cash value has grown past what has been contributed to the bonds in the Roth IRA at that point. AND that the term policy paired with the Roth is going to run out in 12 years (and require continuing premium payments in that time) while the whole life policies’ death benefit will never go away and might grow.

Conclusions

Weirdly, writing this blog entry led me in a direction I didn’t expect. I expected to conclude with something like “An 80% stock/20% bond Roth provides a better long run return and better short-run (less than 6 yr) access to contributions. Whole life policies really shine if you’re very risk averse – otherwise, go with a stock-heavy Roth.” Since I’m not particularly risk-averse, I figured I’d conclude that IBC/BOY was good for some people, but not for me.

But, I think that conclusion isn’t *quite* right. Now, don’t get me wrong. The 80/20 Roth DOES provide a better long-run return. And it DOES provide better short-run access to contributions for the first 6 years.

But, there’s another possibility I hadn’t considered.

The analysis shows that, over the long run (8-9+ years), a 10 pay policy IS an attractive alternative to super-safe investments in things like bonds, Certificates of Deposit, or savings accounts.

The fact is that EVERYONE should have SOME safe investments. Why not (gradually) REPLACE your bonds and savings accounts with whole life policies’ cash value?

I mean, bonds in a 401(k) or Roth IRA are long-term investments ANYWAY. And you can keep your cash emergency funds while you build up your cash value.

In the grand scheme: what about combining a smaller IBC/BOY policy with a Roth that gradually turns to 100% in stocks as the policy’s cash value grows? Basically, do the 80/2o thing, but, instead of it all being in the Roth, have the 20% in “bonds” be replaced with an IBC/BOY policy.

Some thoughts on this:

(1) Using this as a replacement for a larger life insurance policy probably wouldn’t be a great idea – so you’d still need to carry a term policy, at least until the stock portion of the Roth IRA grew enough to self-insure.

(2) Early on (years 1-7 or so), you’d still want to have some bonds in the Roth, as the cash value hasn’t caught up yet.

(3) You might be able to eliminate your need for a cash emergency fund. Since the purpose of a cash emergency fund is to have liquid savings available that will not lose value, the fact is that whole life insurance cash value FITS that. It just takes some time to build up. So, keep the cash emergency fund until the life insurance cash value catches up, then you can use the cash emergency fund to either buy more life insurance or to go into a Roth, 401(k), or some other riskier investment.

(4) This would be most effectively done with a flexible paid-up additions rider. This allows you to buy extra paid-up life insurance on your own schedule. The insurance company will be careful to make sure that you don’t accidentally convert your life insurance into an MEC by buying too much paid-up insurance.

In Brief

Based on my analysis, 10 pay life insurance is best seen as a replacement for long-term (7+ year) SAFE investments.

Now, I’m seriously considering taking part of my raise from next year and talking with someone about how I can get started in a whole life insurance policy…