Whole life insurance is basically term life insurance that has an investment component that builds cash value but does not have a “term”, which means an end date on the policy. That sounds appealing when compared to buying term life insurance, which does not build cash value and has an end date after which the premiums are often thought of as wasted if you do not die while the policy is still in effect. On the other hand, whole life insurance policies are very expensive. If you have a whole life insurance policy or are considering buying a policy, here are three things you need to know:
Whole life insurance is the most popular type of “permanent” life insurance, but it has cousins such as universal life and variable life insurance. Universal life insurance has a death benefit and an investment component much like whole life insurance. The death benefit can be increased or decreased almost like a one-year term insurance policy, and both the premium and the investment component can be increased throughout the term, rather than fixed. Additionally, while the premium with universal life insurance is often lower than a whole life policy with the same death benefit, the return on the investment component can vary year-to-year subject to a certain minimum return. With variable life insurance, the premiums are set aside into a separate account and invested in one or more funds like stocks, bonds, or money market accounts. The cash value built up by the investments can raise and fall, which is different than whole life and universal life. There is a minimum death benefit, but the death benefit can be higher if the investments perform well. Of course, all three of these types of life insurance have many variations, and they can be very confusing. It is important that you review any type of life insurance policy with someone other than the person selling it to you, to make sure it is the right product for you.
Whole life insurance is often oversold, much in the same way as annuities. The confusion between whether someone is acting in your best interest in selling you a life insurance product is one of the reasons that the fiduciary duty standard changed recently. While many salesmen are great people, they are salesmen first and not necessarily acting in your best interest. If you go to a car dealership to buy a $25,000 Volkswagen Passat and the salesman tries to get you to buy a $90,000 Porsche 911, you are likely going to be able to resist the urge even though the Porsche does a whole lot more. If you want to buy a term life policy at $700 per year and the salesman tries to get you to buy an whole life policy with the same death benefit at $8,000 per year, many more people opt for the Porsche equivalent, even though it only takes about 9 years for those additional premiums to add up to the difference in cost between a Passat and a 911. There have been multiple studies on why whole life insurance is not a great investment, since the difference in premiums between a whole life policy and a regular term policy can be invested and earn a higher rate of return than what will accumulate in your whole life policy, if for no reason other than the fees charged by the insurance company.
So who should consider a whole life policy? Here is my checklist:
- The client must be maxing out all of their tax-deferred investment options, such as 401k, HSA, IRAs, etc.
- The client must have a very healthy emergency fund, including an adequate reserve for any upcoming large expenses or possible investments such as rental property.
- The client has very little debt or no debt with a high interest rate. None of the debt should be coming due in any large amounts (no adjustable rate mortgages or balloon payments, for example).
- The client will not need access to the cash value of the whole life policy for at least 5-10 years.
- With all those being met, the client still has too much excess cash flow each month, and that cash flow is very consistent, so not someone who is about to change jobs, or whose income fluctuates.
- The client desires a conservative, bond-like investment.
If all of those are met, then whole life insurance might make sense, since its returns will provide some diversification to the stock market, and even the bond market, and the returns are tax-deferred. As you can see, there is a very high bar to climb before a whole life insurance policy, or any of its variations, start to make sense.