Reader Question: Since whole life insurance has a cash value, wouldn’t that be better than a term policy?
Posted on
Wed, 22nd August, 2007 by
Jeremy
Occasionally I receive questions from readers that bring up good topics that should be addressed for everyone, and recently I had one in regards to life insurance. The question was:
Since whole life insurance has a cash value, wouldn’t that be better than a term policy?
On the surface, this would make sense. A whole life policy does in fact build up cash value over time, whereas a term policy is “use it or lose it”, meaning if you don’t die before the term is up, you get nothing out of it. Even though building up cash may sound better than not, it is important to understand how a whole life policy actually works.
Whole Life Insurance
Whole life insurance is designed to pay out a predetermined benefit upon death, while also building cash value via an investment component. There are various types of whole life policies, from universal, variable, and traditional, but they are all the same aside from how the cash value portion is invested. The problem with whole life is that not only are you paying for the coverage premium, but you’re also paying into the cash value portion. This makes the premiums much higher than term insurance.
Rate of Return and Fees
A typical whole life policy will have an internal rate of return, which is how much interest your cash value will earn after fees and expenses are deducted. Unfortunately, most whole life policies are like mutual funds with high expense ratios; after you factor in the annual fees, the actual return is minimal. In some cases you may only earn a couple percentage points. You’ll also want to be aware of penalties or fees incurred when canceling a policy, as these can be quite steep.
Why Term is Better
Even though you may never receive a payout from your term policy, remember, you are just buying protection for your loved ones. Insurance always seems like a waste when you never see the rewards, but if you don’t have any coverage and the unfortunate does happen, the results can be devastating. So, what seems like a better deal; paying a lower premium that builds no cash value, or paying a much higher premium to earn 3% on only a fraction of the amount?
For working adults, term is almost always the way to go. Typically you purchase insurance once you get married and/or have children. Once the kids are out of the house and you’re beginning to approach retirement, your need for life insurance drops rapidly. This is why a 30 year old would be perfectly fine with a 30 year term policy.
Does Whole Life Have Any Use?
Whole life policies do have their place, just typically not for working adults. These policies can provide significant wealth transfer and estate planning benefits, but are more than likely far too costly for someone in their 30s or 40s. You really need to be careful when dealing with an insurance salesman as they can do a pretty good job at making whole life sound like an investment. Granted, there is an investment component, but you can save money by buying a term policy and earn far more by investing the difference elsewhere.
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Very informative post, thanks. One point I’d like to make though about Term Life Insurance is that if it looks like you are going to have health problems later on then this may not be the way to go because if your term policy runs out when your health is really bad then you may be uninsurable. You may ask: how can we know if our health will be bad in 20 or 30 years? Well, if you have risk factors for heart disese or cancer in your family or if you have a history of health problems yourself then by the time your 60 you might have some serious problems. For an alternate opinion on the Life Insurance issue Randi over at Boulevard R wrote a good post about this: http://blog.boulevardr.com/2007/08/24/life-insurance-the-basics/
While I generally like your website and similar sites, I have to disagree with you on this one (Just to note - I am Director of Financial Planning at a Wealth management firm associated with MassMutual….also hold a J.D. - only mention this because of the estate tax impliciations)
I’ll go with the easiest rebuttle to the argument and if there are further comments I’ll chime in…
1) If your estate is worth over the $2million mark what assets are going to be liquidated to pay the HUGE (45%) Tax bill???? Is it your family home? Is it the business you strived to build? Is it the IRA which could be stretched to give your grand kids enough money where they don’t have to work? etc etc? By its very nature life insurance IS LIQUID. As such, you can pay that bill (due within 9 months of death) without liquidating anything.
As far as an argument of buy term and invest the rest - Term (in NY) ends at 80 - by statute! So you die at 81 that lovely and cheap term policy is GONE and now your family owes $X amount in taxes. Further, who is better than an insurance company to invest your money? MassMutual has a triple A rating and has been around for 150+ years - Guardian has a AA rating and has been around the same. BETTER THAN MOST STATES IN THE UNION LOL
Just a few thoughts on the subject - if there is interest by the blogger or others I will comment further!
Evan, you are correct, and if you read the last paragraph of the post I say this: “These policies can provide significant wealth transfer and estate planning benefits.”
Whole life policies certainly DO have significant benefits, which you highlighted perfectly. But this site is tailored towards those who are still relatively young, generally speaking, early 30s. So, for the average reader, they may not have any, or have just started a family, and their estate is probably nowhere near the estate tax threshold.
During this phase in life, most people only need short-term coverage to protect their spouse or dependent children in the even of a loss of income, and whole life is not the best way to accomplish this.
But like you said, as you age, have created wealth, substantial investment assets or possibly a business, there are many more important tax and estate planning issues to consider that could warrant a different type of policy.
Jeremy,
I am 25 - I do not have whole life, simply because I can’t afford it, but if cash flow is not an issue its better than term. I have term mainly to protect my fiance.
Ask any insurance agent/financial planner - term pays out less than 5% depending on the company, there is a reason it is cheap.
Remember, you are never as insurable as yesterday, so your whole life premium would be considerably less at 25 (ignoring cash flow implications) then at 45 when you think you need it. This also ignored 20 years of compounding!
Again, just a few comments against preconcived notions of insurance
Evan,
Right, if you or I can’t afford whole life insurance, how many in this demographic can? If someone could scrape up enough money to pay the premiums, hey that’s fine, but it is a lot of money to pay for a minimal benefit.
And I was a financial planner and also an insurance salesman in the past. We used that same 5% payout statistic to scare people all the time. I sold insurance for three years and during that time I had 3 clients actually have to file a claim. Each of these were term policies and were paid out in full.
That statistic is thrown around just like I was taught about the FDIC claim. Maybe you’ve heard it, where FDIC has 99 years to repay you so it is worthless, etc just to get people into non-bank investments. It is just a scare tactic that uses a tiny piece of truth that is exaggerated as a sales technique.
But you are right, it is always easier to insure yourself when you are younger and have less health issues, but if you can’t even afford whole life anyway that 20 years of compounding is moot. Plus, what good is a vehicle that barely compounds at the rate of inflation?
Do any of you have any comments on the pros and cons of cashing in a life insurance policy vs. borrowning against it to pay of high interest debts? Thanks.
Jeremy,
Great post and I agree with your assessment entirely, well almost. While for younger working families I too believe that term life insurance is definitely the best choice to keep premiums low and affordable.
Now the case for a permanent policy while younger, in our experience the key to making life insurance work as a cash accumulation vehicle is to over fund the policy. We like variable universal or index products that you have the opportunity to get a higher rate of return in the policy, this also helps offset the cost’s and fees in the policy.
Typically we use this concept with someone who is high income earner with discretionary income and they are fully funding their 401k, IRA etc. Now we can look at over funding a VUL contract for a number of years the longer the better (compound interest) and look to use the cash build up as a supplemental retirement income.
The most powerful aspect of life insurance is the awesome tax leverage you obtain which is tax deferred growth inside of the policy and tax free withdrawals of your cash value via withdrawals and loans from the policy.
If someone can commit to this type of plan it works very very well as a tool for retirement planning. Plus no penalties for early withdrawals of your cash value unlike a qualified plan. The key is to commit to the plan!
I can purchase 1.1 million 20yr level term for my wife and myself for $44/mn. This amount is equal to our annual salaries with a return of 10%. For example: I make 65,000/yr and my wife makes 45,000/yr. If I were to die with a $650,000 policy and my wife invested that into Mutual Funds with a 10% rate of return, she could live off of the 65,000 (my annual salary). The cost for both of us to get $250,000 in whole life was $350/mn. If I were to invest the difference of the 2 policies ($306/mn) into Mutual funds at a rate of return of 10% for 30yrs, I would have $554,556. Hope this makes sense. One more thing, ask the person who sells you whole life what happens to the cash value you buildup in a whole life policy if you die! You don’t get it. They’ll try to tell you something like it takes care of their fees.