What follows is the third of seven to-the-point articles highlighting poor investments you should avoid.
3 of 7: Whole Life Insurance
Today’s loser is whole life insurance, universal life insurance, variable life insurance, variable universal life insurance and any other policy that fits in the cash value department of life insurance. Said another way, today’s loser is any type of life insurance that isn’t competitively priced term life insurance from a highly rated company.
Every life insurance shopper has to first stand at the fork in the road and choose, whole or term? There are a few Ford-Chevy debates in personal finance and this is one of them.
The fundamental difference is that term life insurance is pure insurance, insuring against the event of your untimely death. Whole life insurance bundles insurance with an investment component. Thus, we need only ask, does the investment side of whole life insurance offer strong returns or not? We can determine this by evaluating premium outlays and cash value growth over time to arrive at an internal rate of return.
Most reviews peg this rate of return at 1.5 to 3%. The policies I have personally reviewed have experienced rates of return between 1 and 2.5%. The typical whole life policy in force out there has a cash value that is a fraction of what the policyholder would have in their investment account if they had foregone the expensive insurance policy and invested in an equities-biased, diversified portfolio. However, this is comparing apples and oranges in one important respect. The whole life insurance policy has a death benefit meaning this comparison will require additional analysis. We must now calculate which is greater:
- the difference you arrive at subtracting the cash value of the insurance policy from the value of the hypothetical investment account (this difference results from suboptimal returns)
- the cost of term life insurance with said death benefit over the period in question
When you run this calculation, you consistently arrive at what amounts to an endorsement for term life insurance and a TKO of cash value life insurance. If you run these numbers a few times, you will likely count yourself an apologist for an argument commonly known as “buy term and invest the difference.”
But the insurance guy that sells these cash-value policies doesn’t talk about rate of return … can you blame him? He talks about all the bells and whistles these beauties have. Let’s look at three big ones:
- Policy Loans
Did they mention that you can take an income-tax free loan from your policy? The policies I’ve reviewed typically feature the insurer charging you something like 7 or 8%/year on the loan. While you may never pay these charges by coming out of pocket from another fund source, the interest charges are coming out of your estate in the form of a reduced death benefit. Anyone excited to pay 8% in this interest rate environment? The fact that you never have to pay it back simply means the insurance company is glad to eat into your equity at an 8% clip every year until you die.
- Income Tax Free Death Benefit
The death benefit is income-tax free. Admittedly, this is a significant tax feature that demands attention. The tax-free death benefit is good and, it better be, because you received no tax deduction on those premiums you paid through the years. If you failed to max out your tax-advantaged investments such as employer-based qualified plans or personal IRAs, you almost certainly took the wrong tax deal here. You would have been better off if you had reduced taxable income every year of your working life. You would have been far better off if you had invested in Roth options and created a piggy bank that could grow and grow and never be taxed (at least for you). Cash value life insurance pushes the tax benefit way down the road which forsakes compounding interest and, did I mention, you are dead.
- Advanced Strategies
The insurance industry sprinkles around a little razzle dazzle about advanced strategies that the sophisticated and wealthy use, creating a small halo effect. Heck, you might know some smart, wealthy character that got with his people, investment guys and trust attorney, to enter into just this kind of deal to thwart the taxman. For example, did you know, that those with large estates sometimes utilize an Irrevocable Life Insurance Trust to shield assets being passed down from estate taxation. This strategy actually works; the problem is that the strategy is relevant for almost no one. For a wealthy couple (or even a widow or widower possessing a deceased spouse’s unused exemption for estate taxes) this strategy shouldn’t even be on the table until an estate is north of $25 million. If this rare scenario fits your situation, congratulations, you might consider this advanced strategy to reduce intergenerational taxes, knowing that implementing it will be both expensive and limiting.
These are the normal bells and whistles we are sold, and they aren’t worth much.
I’ll close with one additional problem that should scare you off of most of these polices. The average cash value policy is very complicated. These are opaque instruments steeped in their own jargon. It is nearly impossible for the average person to reduce these policies to metrics that allow for comparison, such as what kind of return am I getting on my investment?
How complicated is a run-of-the-mill cash value policy? I’d place it right alongside the some-assembly-required items I’ve purchased for my children. What you should not lose in all this complication is that you are tying up way too much money, a significant part of your investable income, in a product guaranteed to delivery sorry returns. What’s more, you are going to be paying thousands of dollars in premiums each year, in perpetuity, for a policy in which you may be upside down for five to ten years due to commissions and sales expenses.
The bottom line is this: When it comes to investing, you want to own American business. You want to own great businesses, not a product. When you buy a policy product from an insurance company, they place the proceeds in their business and the broader market, make maybe 9% and give you back 2-3%.
Cash value insurance policies are product bundles that always come with two things, nearly worthless bells and whistles and poor returns.