I’m a big fan of “Return of Premium” (ROP) term insurance. I’ve covered the topic in greater depth here, but the long story short is that the additional premium paid for ROP term (versus pure term) can come with an effective rate of return that is quite attractive for a contractually-guaranteed investment.

You wouldn’t buy ROP term just for the investment component, but if you are already buying term insurance for the death benefit, then it does make sense to then consider adding on the ROP component to get life insurance coverage along with an “investment” that can provide significantly above-market returns.

I’ve noted elsewhere that this product is not very popular in large part because the advisors who sell or recommend insurance tend to fall into one of two camps: (1) those who look for the cheapest coverage possible and don’t give any consideration to the accumulation potential of insurance, and (2) those who tend to recommend more expensive permanent insurance—often because they are selling the insurance and the greater cost will generate a larger commission.

ROP term falls in a middle ground of having both protection and accumulation benefits, but few financial advisors similarly occupy that middle ground of considering the dual benefits of owning life insurance.

After a recent discussion about ROP term, Shelby (name changed to protect confidentiality) reached out to me with the following question:

This all sounds good! Can I ask, what do “ROP rate of return” and “tax-equivalent ROP rates of return” mean?  Basically, explain it how you would explain it to a financially illiterate person. 

Now, Shelby is definitely not a financially illiterate person. She has taken it upon herself to learn about her finances and knows much more than your average person. But, obviously this can be a complex topic and it still wasn’t fully connecting with her, so here’s my attempt to provide some additional clarity.

What Is ROP Term?

First, it may be helpful to note that “term insurance” refers to a type of non-permanent life insurance. The coverage is in effect for a given term (e.g., 10 years, 20 years, 30 years, etc.) and then the coverage stops at the end of the term.

Standard term insurance is a lot like auto insurance. With auto insurance, if you don’t get into an accident or otherwise have any claims during a period of time, then you pay your premium and the policy pays nothing. (There’s nothing wrong with this, of course, because you did get the value of having protection throughout that period of time.)

With term life insurance, if you don’t die during the period of your term coverage, then you pay your premium the full term and the policy pays nothing.

However, ROP term insurance is a special form of term insurance that you can choose to buy that costs you a little bit more than pure term insurance, but it allows you to receive a tax-free lump sum payment if you happen to outlive your term coverage. Effectively, your premiums are returned if you outlive the policy.

So, if you buy 30 year ROP term and live more than 30 years (therefore never receiving any death benefit from your policy), at the end of the policy, you’ll receive a nice tax-free payment roughly equivalent to the amount of premium you paid (I say roughly because some companies vary in how they calculate exactly what is returned, but often it is equal to or close to the total premium paid).

One of the reasons I’m a fan of ROP term, is that it turns out that the additional premiums you pay for the ROP option can provide a nice rate of return (for reasons I expand on here), but to figure out what the rate of return from electing the ROP rider would be, you have to look at two different things:

1. The cost of pure term coverage without the ROP feature
2. The cost of the ROP term coverage with the feature

To illustrate, I will look some actual numbers from Shelby’s situation:

1. Shelby could elect pure term coverage that would cost her $1,330/year. This would give her $2 million of death benefit protection, but she would receive $0 back 30 years from now if she outlived the policy.
2. Shelby could also elect ROP term coverage from the same insurance company that would cost her $1,930/year. This would give her the same $2 million of death benefit protection, but she would also receive $55,200 as a tax-free lump sum if she outlived the policy.

ROP Rate of Return

Since the difference between these two policies is that with ROP term Shelby would pay an extra $580/year in order to receive $55,200 30 years from now, we can compute what rate of return someone would need to earn on annual savings of $580 in order to have that amount grow to $55,200 30 years from now.

If we do the math to compute that (see this post for more specifics on the math), it turns out Shelby would need to earn 6.7% per year to have $55,200 30 years from now making annual contributions of $580 per year. So that is where the 6.7% “ROP rate of return” Shelby asked about comes from. 

Tax-Equivalent ROP Rate of Return

Now, 6.7% is already a great return for an incredibly low-risk investment in the current environment, but it turns out that ROP term is actually an even better deal because it also comes to Shelby as a tax-free benefit.

Since the ROP benefit is tax-free, then the last step we want to do in evaluating the attractiveness of the ROP option from an investment perspective is to account for what Shelby would have to earn on a taxable basis to still end out with a 6.7% return after paying taxes.

If we do that math (assuming 24% federal and 8% state tax rates), Shelby would need to earn 9.8% on a taxable basis to end up with a 6.7% return after paying taxes. So that’s where the 9.8% “tax-equivalent ROP rate of return” that Shelby asked about comes from. Essentially, this is the amount that Shelby can think of as earning on the additional $580 paid each year to receive the $55,200 tax-free in 30 years.

Why The Return Can Be So Attractive On ROP Term

The reasons why the return on ROP term can be so attractive is a bit technical (I expand a bit on that more in this post), but the short answer is essentially that insurance companies expect a significant number of people who take out policies to stop paying for those policies and let them lapse. Since someone who lets their policy lapse would not be entitled to receive their full return of premium (it may be a lesser amount or even nothing at all; specifics depend on the policy), then essentially people who let their policies lapse are subsidizing people who don’t.

Or, to put it another way, savvy purchasers who purchasers of ROP who know in advance that they will keep their coverage in force are subsidized by less savvy purchasers who don’t keep their coverage in force.

So, ultimately, while it doesn’t make sense for someone to buy ROP term insurance if they don’t need the term insurance coverage, if they do need the coverage (and they are confident they will keep the policy long-term), ROP term insurance deserves a closer look for the dual accumulation and protection benefits that it provides.