Okay guys, it’s time to get all sexy and talk about life insurance. I know, I know. Keep your shirts on.
Until recently I had only written this brief primer life insurance because it doesn’t apply to a lot of people under 30. But as some of us reading (and writing) this blog get older, I’m getting asked more often about the topic. In particular, people want to understand what whole life insurance is and whether whole life insurance is a good investment.
These readers—mostly in their late 20s or early 30s and starting families—are beginning (rightly so) to think about life insurance. And at some point, an agent has mentioned whole life insurance and the concept—getting guaranteed cash value that you can access while you’re still alive—seems appealing.
But maybe they’ve also read something warning against whole life, and they’re confused.
Today I want to clearly explain whole life insurance as well as reiterate when you need (and don’t need) life insurance.
When You Need Life Insurance
If you’re like most, you won’t need life insurance until you have kids.
After all, the purpose of life insurance is, in the event of your death, to replace your income for the people who depend on it. In some cases, you may want to get life insurance for your spouse before you have kids. But there are few cases when young, single people need life insurance. Still, some insurance agents will try to sell it to you.
There’s one interesting possible exception: If you’ve graduated with big student loan debts that a parent cosigned, you or your parent may want to get a life insurance policy on you to cover the balance of the loans.
In this case, opt for just enough term life insurance to cover the outstanding debt. In your early 20s, this policy should be dirt cheap. Avoid insurance products designed only to pay off your loans, and remember that you only need this insurance if your loans have cosigners. If you are the only signer on your loans and you die, a parent cannot be held legally responsible for those debts.
What is Whole Life Insurance?
In the confusing world of insurance, there are two primary types of life insurance:
- Term life insurance
- Permanent life insurance (further divided into whole and universal)
With term life insurance, you pay premiums for a specified term (usually 20 or 30 years), and if you die within that term, the insurer pays your survivors a benefit. But term insurance is like car insurance: if you stop paying premiums, you lose the insurance.
With permanent life insurance, your insurance remains in force as long as you’re paying premiums. In addition, some of the money you pay in premiums accumulates as a cash value. You can use this cash value to save for retirement, or even take loans against it throughout life.
The big difference between whole life insurance and universal life insurance is that whole life insurance premiums are fixed for life while universal life insurance allows you to adjust the premiums and death benefit as you go. I’ll talk about whole life insurance here, but understand that where I say “whole”, this could apply to a universal policy as well.
With whole life insurance, after a number of years some of the money you’ve paid is yours to keep—even if you stop paying premiums. This is called the policy’s cash value. After several years, you’ll even see a guaranteed return on that cash value like you would in savings account.
For insurers, whole life insurance can be an easy sell. Nobody likes “throwing money away” on life insurance, so the prospect of combining life insurance policies with a way to save tax-deferred money for retirement is attractive.
But here’s the rub:
- Whole life premiums are expensive
- Because of fees, whole life is a mediocre investment
- Only an expert can tell if a whole life policy is a good deal
Whole Life Premiums Are Expensive
Take this example from SmartMoney.com:
To get a real sense of the value of term, let’s compare a term policy and a universal life policy. Say a 40-year-old nonsmoking male has a choice between a $250,000 Met Life universal policy with a $3,000 annual premium and a same amount of renewable term coverage with a 20-year fixed premium of $350. At the end of one year, the universal policy, assuming it paid 5.7% per year, tax-deferred, would have a cash value of exactly zero (cash value is the amount you would get back if you canceled the policy). But say he had instead invested $2,650 (the difference between $3,000 and $350) in a no-load mutual fund that averaged a total return of 10% annually. At the end of the first year, he’d have $2,841, accounting for taxes on the earnings at a 28% rate. At the end of 10 years, he would have accumulated more than $46,000 in after-tax savings in the mutual fund. Over the same period, the cash value of the policy would have climbed only to $31,819.
The biggest drawback to whole life insurance is that the premiums are way more expensive than term life insurance. Assuming equivalent investment returns, because of the way the polices are written, it takes a lot longer for a whole life policy to accumulate significant cash value (often 12-15 years) than if you invested on your own.
So for a young investor with limited free cash to buy insurance and invest for the future, this is why I only recommend term life insurance. It’s better to pay the cheaper premium and have savings left over to invest, use as an emergency fund, or spend as needed.
Whole Life Is a Mediocre Investment
With whole life cash accounts often paying around five to six percent interest before fees, conventional wisdom has been that you could do better investing on your own in a mutual fund for the long run. I still think so, but the market’s poor showing in recent years understandably has some investors doubtful.
But before deciding that whole life is a good investment, you have to consider the policy’s fees and commissions, which are not small. By these estimates, while an agent might make 30-40 percent of a term policy’s first-year premium, they might earn 80-100 percent of a whole life policy’s first year premium (which, remember, might have premiums that are 10 times as much as term). That’s a big incentive to push whole life.
Only An Expert Can Tell If a Policy Is a Good Deal
If you’re still on the fence about a whole life policy, consider the fact that even I couldn’t look at a whole life policy and tell you if it’s a good deal. That would take a seasoned insurance pro.
The key to understanding a whole life policy is the internal rate of return— that’s the return on the policy after taking all the fees out. But it’s not like that number is printed on your policy—deducing it would take someone with know-how and some serious spreadsheets.
Also, remember that the cash value of a whole life insurance policy only begins to earn meaningful returns after you’ve held it for 20 years or more. This can be a tool insurers use to sell policies to 20-year olds (look at the money you’ll have in the bank when you’re 40!) but for savvy savers, it should be a clue that you’re saying goodbye to a lot of money for a long time.
Because personal finance is personal, there are (almost) always exceptions to any rule. It’s no different with whole life insurance.
For wealthy families in their 30s or 40s, whole life insurance may be worthwhile as an estate planning tool because you can create an insurance trust that can pay estate taxes out of the policy’s proceeds and then pass the trust to heirs.
Lauren and I are going through the estate planning process now with an attorney she works with, so there will certainly be an upcoming post on it when we’re done. Until then, estate planning is something to consider once you have kids and/or you have assets or life insurance policies to pass one. When the time comes, consult an attorney who specializes in the estates and trusts.
How To Buy Life Insurance
The process of buying life insurance is a bit of a headache, but it’s at least easy to start shopping. You can get rate estimates online from many insurers after a few quick questions.
If you have a local independent insurance agent you work with on home or car insurance, he or she can also help you get started.
Once you’ve identified the policy you want and filled out an application, a nurse will come to your home to give you a brief physical exam and draw blood. Life insurance companies have to make sure you’re healthy enough to insure. That means recent medical diagnoses could work against you and a good reason to get life insurance as soon as you need it while you’re young.
Have you recently bought life insurance? What influenced your decision? Where’d you buy it? Have questions about term or whole life? Let me know in a comment.