Like most financial planners who don’t sell whole life insurance, I’ve always seen whole life insurance policies as great big rip-offs sold by sleazy life insurance agents. But my opinion changed a bit after a recent conversation I had with a helpline caller. While I still think most people are better off buying term insurance, I’ve come to the conclusion that whole life insurance can be a better deal for some people.
For those that aren’t familiar with the intricacies of life insurance, there are basically two kinds of policies: term and permanent. With a term policy, your premium is fixed for a period of time and then increases afterwards based on your age. People generally buy these policies to cover a limited period of time when they need life insurance, like when you have dependent children. They then drop the policy once they no longer need the insurance and before the rate adjusts upward
With permanent insurance, part of your premium goes into a cash account that can later be used to pay the cost of the insurance when you’re older and more expensive to insure. Depending on the type of policy, this cash account can be invested in mutual fund-like sub-accounts as in a variable universal life policy (or VUL) or can earn interest or dividends as in a whole life policy. The main benefit is that you can borrow from this cash value tax-free regardless of your income or credit and there’s no required repayment structure. Anything you don’t pay back is just subtracted from the death benefit when you pass away.
The first problem is that these policies tend to come with high fees. For example, most of your entire first year’s premiums may go to pay a commission to the agent who sold it to you. Insurance and administrative fees also eat into the returns, making most people better off buying a much lower cost term policy and investing the different. That’s because studies have generally shown the cash accounts in whole life policies to have a net return after fees of 4-6% over the last 20-30 years compared to stock market returns of 8-10% over that same time period.
In addition, the premiums are much higher than with a term policy so you might not be able to afford as much coverage as you need. If you fail to pay the premiums or if the investments in the cash account plummet in value, the policy can lapse, leaving you without coverage. (39% of whole life policies are terminated in the first 10 years.) Adding insult to injury, the gain in your cash account would also become taxable if that were to happen.
For these reasons, I haven’t thought too highly of permanent life insurance policies. But that changed after I received a helpline call from a young, high income earner who was maxing out all of her retirement accounts and looking for more tax-advantaged ways to save. Her friend’s husband, who was a former life insurance agent, suggested that she consider a whole life policy.
As we reviewed the pros and cons, it actually looked like a whole life policy made a lot of sense for her. She wanted to purchase life insurance while she was still young and healthy to lock in favorable rates. Her high income made her feel comfortable that she could afford to make the higher premium payments and gave her a bigger benefit from having the cash account shielded from her high tax bracket.
What about the low returns? Well, the flip side of low returns, at least with whole life, is low risk. Many of these policies guarantee a minimum 2-4% return, which is a whole (no pun intended) lot more than you can earn in almost any other guaranteed investment, especially after you factor in the fact that she could use the money tax-free. So while she invests aggressively in her retirement accounts, the whole life policy could be used as a safer resource for more short term needs like emergency savings and a down payment on a home. Eventually, it could also supplement her retirement income and help pay for the costs of long term care and education for her children. In the latter case, the cash account would have the additional benefit of not reducing her children’s eligibility for financial aid. It would also be protected from creditors.
So should you buy a whole life insurance policy? Probably not. I still think they’re only appropriate for a small percentage of the population. To see if you fit in that category, here are some questions to consider:
1) Do you actually need life insurance?
2) Are you maxing out your retirement plan contributions?
3) Are you in a high tax bracket?
If you answered “yes” to those questions, look for a policy from a high-rated insurer with relatively low fees and a long track record of paying generous dividends. Rather than talking to a commissioned agent for help, you might want to consult a fee-only life insurance adviser or use the life insurance policy evaluation service offered through the non-profit Consumer Federation of America. Finally, after reviewing the benefits, make sure you can afford the premiums. If so, you might be in that small percentage that whole life insurance makes sense for.