Are return-of-premium riders worth it?

Life insurance carriers began offering return-of-premium riders on their term policies in the early 1990s as a solution to the "live-and-lose" dilemma presented by traditional term policies. As the name implies, this rider will allow term life insurance policyholders to recover all or part of their premiums paid over the life of the policy if they do not die during the stated term. This effectively reduces their net cost to zero if a death benefit is not paid.

Of course, adding this protection will raise the overall cost of the policy accordingly. In this article, we'll take a look at this form of policy rider that may be very attractive to investment-minded individuals who are seeking the sensibility of term coverage.

Let's take a look at an example of how to weight the decision of whether to sign up for a return-of-premium rider.

Example 1 - Cost of Premium Vs. Benefit A 37-year-old nonsmoking male can get $250,000 of term coverage through AIG for $562 per year with a standard rating. If a return-of-premium rider is added on, the cost jumps to $880 per year, an increase of more than $300 annually. Without the rider, the policy owner will pay a total of $16,860 over the life of the policy. The additional rider will thus bring the total cost of the term policy to $26,400. Note: Quote given is for a 30-year, level-term policy for a 37-year-old male, 6'3", 220 lbs, 6 points on driving record, nonsmoker, no medications, no diseases.

For the analytically-minded, the inevitable next question is: Will the recovery of this amount of money make it worth paying an additional $9,540 in the meantime? (To learn more about this, see Let Life Insurance Riders Drive Your Coverage and Understand Your Insurance Contract.)

To find out whether the additional cost is worthwhile, you need to do the same type of analysis as used for deciding whether to purchase permanent insurance coverage or buy term insurance and invest the difference. To this end, the opportunity cost of adding the rider to the policy must be calculated using a reasonable set of assumptions.

Example 2 - Opportunity Cost of Adding a Rider Using the numbers shown in Example 1, if the additional $318 of annual premium that is required to purchase the rider is invested in a stock mutual fund inside a Roth IRA, in 30 years the fund will be worth a little over $50,000, assuming an annual growth rate of 10%. In this case the policy owner would be better off investing the difference than adding the rider on to his policy. But this answer is deceptively simple because this calculation doesn't consider such factors as investor risk tolerance or the policy owner's tax bracket.

What if the policy owner has a low risk tolerance, or his income is too high to allow him to contribute to a Roth IRA? If so, then he could invest the money in a taxable certificate of deposit (CD) paying 5%. If he is in the 30% tax bracket, then this would grow to a little over $16,000 at the end of 30 years, after taxes.

Therefore, if the policy owner outlives the coverage term, he will be left with the $16,000 CD balance after investing a total of $26,400 ($16,860 for the policy and another $318 per year, or $9,540 total over 30 years into the CD.) This means that the return-of-premium rider itself would yield a higher overall return. (To learn more about risk tolerance, read Personalizing Risk Tolerance and Determining Risk And The Risk Pyramid.)

Now, let's put this into perspective. In Example 2, $318 is spent every year for 30 years to recover a total of $26,400; this translates into an annual tax-free rate of return of approximately 6.25%. This money is tax free because it is a return of principal.

It is important to keep in mind that if the policy owner dies at any time during the term period, simply buying just the traditional term coverage and investing the difference will always provide the greatest return on capital, because in this case the policy owner's estate would not only receive the death benefit but can distribute the invested cash as well. Therefore, if the policy owner feels that there is a substantial chance that he or she will not outlive the term, then the return-of-premium rider would likely be inappropriate.

Whether it is better to purchase the return-of-premium rider or invest the difference ultimately will depend upon the policy owner's investment risk tolerance, and his or her individual tax situation. For policy owners that can invest in tax-deferred or tax-free accounts and are comfortable investing in the markets, a basic term policy without the rider probably makes more sense. Higher income, risk averse policy owners will probably find the return-of-income rider with its guaranteed rate of return more appealing.