If all the advisers are advising against it, why is so popular?
Is it possible that millions of Americans could be barking up the wrong tree?
I say yes.
As an agent of 10+ years who has seen hundreds of whole life insurance policies under-perform, lapse, or get surrendered (getting back only a fraction of what was paid in), I am no longer a fan of whole life insurance.
In this post, I’ll explain why life insurance agents want to sell you whole life insurance, the five key problems with whole life, and what you should buy instead.
Unraveling the Key Differences:
In this post, we’ll be discussing term and whole life insurance. A few distinguishing characteristics are:
Term Life Insurance
Term life insurance offers guaranteed level premiums and a guaranteed level death benefit for a fixed period of time such as 10, 20, or 30 years. Term is often purchased for short term needs.
- Low cost protection (often 3%-10% the cost of whole life)
- No cash value – It only pays out in the case of death
- Premiums are fixed for a set period of time – The premiums can’t increase during your level term even if you have a change in health
Whole Life Insurance
Whole life insurance offers lifetime coverage with the additional benefit of accumulating cash values. It is often purchased for supplemental retirement income.
- Offers Lifetime coverage
- Cash value – All premiums not going toward paying cost of insurance accrue in a cash value account, which typically earns interest and dividends and may be available to the policy owner via withdrawal or loan, provided that the cost of insurance is paid.
- Policy Loans – The owner may access his/her cash value via loan. The benefits here are potential access to tax-free money (as it is a loan) without needing to apply or qualify as other loans require. Interest is assessed on the outstanding balance and loans may or may not ever have to be paid back.
- Fixed premiums must be paid every year – Premiums can be paid out of pocket, or if that is not affordable, can be paid using policy dividends, or borrowed from the policy’s cash value, if available.
- Most expensive type of life insurance – Often 10-20x the cost of term life insurance and 2-3x the cost of guaranteed universal life
Life Insurance – A Safety Vest or Investment Opportunity?
We live in country where we are all to glad to pay into a home owner’s insurance policy for years, expecting nothing in return, unless our house burns down. We don’t expect anything from our auto insurance company either, unless we get in a wreck.
But that’s not the case with life insurance.
Millions of Americans buy life insurance expecting to take money out of it while they’re still living.
The sad thing is many of these people don’t even actually need life insurance. Instead, they are sold on how whole life insurance can supplement their retirement income.
The Right Reasons to Buy Life Insurance:
Life insurance ought to be viewed like a lifeboat, a life vest, or a seat-belt…
You don’t care about their bells and whistles, their color, make or model.
You just need them to save you from danger. In the case of life insurance, you need it to make your family or business “whole” in the event of your passing.
According to LIMRA’s 2015 Insurance Barometer, the top 3 reasons people buy life insurance are:
- To cover burial and other final expenses
- To help replace lost income
- To help pay off the mortgage
These are valid reasons to buy life insurance.
… and none of them require whole life insurance.
All of the above can be accomplished with term life insurance or guaranteed universal life (a no frills permanent type of life insurance).
5 Often Misunderstood Reasons to Steer Clear of Whole Life
Whole life insurance should almost always be avoided.
I say “almost” because whole life may have its place in some high earning individuals’ financial plans and in a few business scenarios, but for the majority of us, it is incredibly risky.
Here are the top five problems with whole life:
#1 – Whole Life Offers a Low Return
Whole life is not the best way to invest your money. Traditional investments are.
You must realize your premiums (or investment contributions) are immediately reduced by commissions, fees, and cost of insurance when paying into whole life.
The commissions are especially high. I know I personally make 80% to 100% of the first year’s premium on a policy, so if you pay $10,000 into a policy the first year, it almost all goes to your agent.
Then you also have to pay for the insurance itself.
What’s left over grows in a cash value account, which typically earns a guaranteed minimum interest rate and dividends, but overall, the return is poor since so little of your premiums actually makes it to the cash value account.
In fact, the typical policy doesn’t even break even for the first 7 to 10 years.
After that, most experts estimate returns at 2% to 5% over 30 to 50 years. Dave Ramsey says your return will average 2.6% for the life of your policy. Even with its tax benefits, whole life’s net return is unimpressive.
You might be thinking you’d gladly give up some return in exchange for a “safe” investment. Well, what if I told you whole life insurance is actually quite risky as an investment?
#2 – Whole Life is NOT a Safe Place to “Invest”
Agents love to point out how you’ll earn a guaranteed interest rate on your policy cash value and how its backed by insurance companies, who are the pillars of financial strength in our country, most of whom have been around over 100 years, have survived the great depression and multiple wars… and so on.
What they don’t explain to you is that, as far as investments go, you’re taking a huge risk when you buy a whole life insurance policy. And that’s because premiums are fixed and must be paid every year.
Imagine you contribute to a 401K or Roth IRA and tough times hit. Perhaps you’re laid off or there’s a family financial emergency. In a 401k or Roth IRA, you can skip contributions for a year or two (or as long as you’d like) without penalty.
But in whole life, you can’t stop paying.
If the premiums don’t come out of your pocket, they must be borrowed from your cash value or paid for by policy dividends. The problem is, in early years, cash values are very low and so are dividends, so if they can’t cover your cost of insurance, your policy lapses. That means your initial investment could be wiped out.
In other words, whole life premiums don’t allow for hiccups in life. And in my experience, very few people possess the financial prudency to keep these policies long term. Usually at some point, they can no longer afford them, or simply don’t see the value anymore and surrender them. Maybe that’s why 80% of people who buy a whole life product get rid of it before they die.
#3 – The Tax Benefits of Whole Life are Grossly Overstated
Agents boast of 3 key tax benefits you’ll enjoy as a whole life owner.
- Life insurance death benefits are typically not taxed (for federal or state income tax – death benefits may be included in an estate valuation for federal and state estate/death taxes)
- Cash value accumulation is tax deferred
- Income tax free access to your cash value via policy loans
While these are important tax benefits, I think their value is oversold by agents.
First, all life insurance tax benefits are income tax free, not just whole life benefits. So if you were to buy a less expensive term or guaranteed universal life policy, you’d enjoy the same benefit.
Tax deferral of your cash value is helpful, but certainly does not make up for the low returns found in whole life. You can find the same tax deferred status in multiple qualified investment accounts. Even taxable accounts are likely to provide a higher net return since the returns would likely be so much greater. (i.e. A 10% ROR in a taxable account would beat a 3% whole life return)
The last of the alleged tax benefits of whole life insurance is the ability to borrow funds from the policy’s cash value. Since it’s a loan, you can obtain this money income tax free.
But let me ask you this?
What good is a tax-free loan on money that has not appreciated? Even in a taxable account, you can typically withdraw your principal (or cost basis) without getting taxed.
So for the first 10 years, while your cash value is less than or equal to your basis, tax-free access to your money is worthless.
If you take out a loan once you’ve finally seen some appreciation, say 15 years into the policy, you can do so and yes, it’s going to be tax-free.
But be careful!
If your policy ever lapses, all the gains you ever made will be assessed on your following tax return.
If you borrow a modest amount, like 20% to 30% of the cash value, the remaining cash value should still generate enough interest and dividends to help you pay the interest on the loan. In fact, you may not ever have to pay the loan back.
But a lot of people don’t stop at 20% or 30%. They use their cash value the way their agent told them they could. They use it to supplement their retirement, but overextend the policy, can’t afford the premiums to keep up the loan interest and cost of insurance, and the policy ends up lapsing.
It’s a very slippery slope borrowing from life insurance. I personally don’t find this alleged benefit to be worth the risk. If there’s a kink in your financial plan, as there so often is, and you let the policy lapse, this benefit is worthless, and worse, could impose a steep and unexpected tax bill on you.
#4 – The “Liquidity” of Whole Life Cash Value is More Like a Thick Sludge
We’ve talked about a few of the traps agents use to get you to buy whole life insurance. Quick and easy access to your liquid cash values is another trap.
I just have to laugh when I see a life insurance illustration projecting future cash values 20 or 30 years down the road.
You don’t really have access to all your money!
Most companies only allow access of up to about 90% of your money. Remember if you exceed that, you’ll be subject to extremely high premium calls or your policy will lapse.
So don’t plan on funding your retirement with life insurance loans unless you’re prepared to continue paying premiums plus interest on your loans.
Agents will point out the convenience of having access to your funds for a personal loan, business loan, or to help fund your children’s college, without needing to apply for a loan or qualify. That’s a valid point, but how great of a benefit is this really?
First of all, you have to pay for this benefit. That’s right. The company charges you interest on any loans levied against your policy, typically to the tune of 6% to 8%.
And second, if you were in a taxable account, could you not borrow from yourself without “applying or qualifying” for a loan? Sure, and you wouldn’t even charge yourself interest!
# 5 – Punt and Deflect – The 2 Key Ingredients for Whole Life Sales
The key reason I dislike whole life insurance is because its cost and benefits confuse consumers.
I find consumers are unable to separate the life insurance benefits from the cash accumulation and income benefits of whole life.
If you walked into an AT&T store at the mall and they offered you two services – high speed internet and unlimited calls & text on your cell phone for the low price of $750 per month… you’d know it was a ripoff.
Because you have an idea of what those two services should cost. You’d know you’re being scammed so you’d pass.
But when consumers are considering a $750 per month whole life insurance premium, I find few of them are able to separate out the input/output for both benefits.
They might ask their agent, “Isn’t this expensive for life insurance?” at which point their agent will remind their client of the supplemental retirement benefits it offers. Or if they ask about the low returns, their agent will say, “Yes, but remember, you’re also getting the life insurance benefit.”
So, if it’s so confusing, why do consumers buy it?
Because agents LOVE to sell whole life.
“Commission Breath” – A Chronic Illness Among Insurance Agents
Say a 40 year old man walks into my office. He makes $90,000 per year, has a non-working spouse, and two lovely children.
His wife and kids depend on his income, so there’s clearly a need for life insurance. He assures me his family is paying down their debt and investing for the future, so he’ll have no need for life insurance in 20 years. We calculate his insurance need at $750,000.
At this point, I could sell him a 20 year term policy for $499 per year (from which I’ll make about $450) or a whole life insurance policy for $12,009 per year (from which I’ll make about $11,500).
See the conflict?
If I’m a new or struggling agent, the only question I have is “how will I get him to buy that whole life insurance policy instead of term?”
So always remember when buying life insurance that commissioned sales people rarely make for good financial advisers. They have families to feed and when financial incentives are so high, it leaves room for humans to act unethically.
The Term & Guaranteed Universal Life Alternatives
Here’s what I’d recommend you buy instead.
If you have a short term need such as insurance to:
- Replace lost income
- Pay off the mortgage or other debts
- Fund a buy-sell agreement, key person insurance, or business loan
- Per divorce decree for alimony or child support
- Or other short term needs
Consider term life insurance. You can get a quote here.
The benefit of term life insurance is you’ll pay the least amount of money for the most amount of coverage, without the frills of the cash value accumulation, loans, and dividends.
Then speak to a financial adviser (I recommend a fee-based Certified Financial Adviser) about your financial goals and where you should put your money instead of whole life for the perfect blend of liquidity, safety, and rate of return.
My Term vs. Whole Life Insurance Calculator helps you compare buying whole life to buying term and investing the difference. It’s a nice tool and I highly recommend it.
Some people need lifetime coverage however, and for those people, term won’t work. Some people need coverage whenever they pass on.
So if you have a need for permanent coverage for things like:
- Estate planning (estate taxes or estate liquidity)
- Charitable giving
- Or Asset maximization
I recommend guaranteed universal life insurance (GUL) for these situations. GUL offers lifetime coverage with guaranteed fixed premiums and death benefit at a fraction of the cost of whole life. And that’s because the cash value of GUL’s is little to nothing. So if you cancel a GUL 10-20 years after purchasing it, you’ll typically get little to no money back.
But what you do get is affordable lifetime coverage. It’s really more like a “term to age 100” policy than a cash value policy. You can get a quote here.
Not all insurance agents are greedy or unethical and intentionally trying to use the traps above to swindle you.
A lot of these agents are indoctrinated by the companies they represent to believe that whole life is some holy grail of investing – a place where you can earn a good return in a safe environment, with excellent tax and liquidity benefits to boot. And they might really believe their product is a great option for you.
Hopefully, this post will give you some ammunition for the next insurance salesman you meet pitching overpriced whole life, and you’ll stick to term or GUL instead.
In the comment section below, please tell me if you’ve been pitched a whole life insurance policy. Did you buy it? Why or why not, and what did you buy instead?
And agents, let me save you the time. Your comments are welcome if constructive and informational. All other comments will be deleted.
About the Author
Chris Huntley is the owner of Huntley Wealth Insurance, a life insurance agency in San Diego, California.