What is the cash accumulation method?
The cash accumulation method is one of several methods used to compare the cost of life insurance. It may be used to compare both similar and dissimilar policies (e.g., term with term or term with permanent) where premiums are different.
Using the cash accumulation method to compare life insurance costs
Here is a simplified explanation of how the cash accumulation method works. The policies used in the examples are an ordinary life policy and a one-year renewable term policy.
Step 1: The premiums paid for the policies (outlays) are equated, meaning that if one policy’s premium is more than another, the difference between the two is placed in a side fund.
For example, the premium for Policy A (an ordinary life policy) is $1,000. The premium for Policy B (a one-year renewable term policy) is $200. So, the amount placed in the side fund is $800.
Step 2: Accumulate the amount in the side fund at an assumed rate of interest (6 percent is common).
For example, the difference in premiums (the side fund) is accumulated at 6 percent interest, so the amount in the side fund in Year 1 is $848.
Step 3: Change the face amount of the policy with the lower premium so that the sum of the side fund and the face amount of that policy equals the face amount of the policy.
For example, the original face amount of Policies A and B is $100,000. The face amount of Policy B is changed, however, so that the sum of the side fund ($848) and the face amount (now $99,152) equals the face amount of Policy A.
Step 4: Compare the cash value of Policy A with the side fund balance of Policy B over a period of years to see which is the better value.
For example, the side fund value of Policy B is more than the cash value of Policy A until Year 10, when the cash value of Policy A exceeds the side fund value of Policy B. This means that Policy A may be a better value if you plan to keep the policy for more than 10 years.
Strengths
Good way to compare term insurance with permanent insurance
The cash accumulation method is a good way to compare term insurance with permanent insurance because it allows you to equate two policies that are dissimilar and usually difficult to compare. The result is usually clear-cut as long as the appropriate interest rate is used and the appropriate term for the policy is considered. See Tradeoffs.
Tradeoffs
Cash accumulation method may inaccurately portray policy costs unless data is carefully chosen
One problem with the cash accumulation method (which is a problem with other methods as well) is that the results may be misleading if the interest rate chosen to apply to the side fund is unrealistic. If the interest rate chosen is too high, then the policy with the lower premium and the side fund will usually seem like a better buy than the policy with the higher premium. So, when you perform the calculation, you must choose the interest rate with care. Select an interest rate that closely matches the rate you could expect to earn on the cash value of the other policy so that the comparison will be fair. In addition, the calculation must be completed for a sufficient period of time (10-20 years, perhaps) because one policy may perform better when a shorter time frame is used, the other when a longer time frame is used.
Conclusion
The cash accumulation method can be an effective tool for comparing life insurance options, particularly when evaluating term policies against permanent policies. By equating premiums, investing the difference, and factoring in an appropriate interest rate, it allows for a more direct cost comparison between products that typically differ in structure and benefits. However, the accuracy of the results depends heavily on selecting realistic assumptions—especially the interest rate—and using a time frame long enough to reflect the true performance of each policy. When applied carefully, the cash accumulation method can help clarify which policy delivers better value for your long-term needs.
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Source:
Broadridge Investor Communication Solutions, Inc. prepared this material for use by Scarlet Oak Financial Services.
Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on individual circumstances. Scarlet Oak Financial Services provide these materials for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
