I recently wrote about the mistakes I initially made when purchasing life insurance policies for me and my wife. One of the things I mentioned was that at the very least I was relieved we had avoided being sold whole life insurance. A fellow blogger, my friend Edward Antrobus, responded with the following comment:
“General consensus is that you shouldn’t view insurance as an investment. But nobody has ever been able to make a case for WHY.”
It’s a great question. There are a lot of personal finance topics out there where you hear many people repeat the same mantra over and over again without any explanation as to why. Whole life insurance is one of those topics that often gets a bad rap without much detail. So today I’d like to detail the reasons why whole life insurance is a bad investment.
Some background on whole life insurance
I’ve written before about the importance of life insurance, how to determine your life insurance needs, and what type of life insurance to buy. I think life insurance is a crucial part of any family’s financial security.
When you buy life insurance, there are essentially two types: term and permanent. Term life insurance is very simple. You pay a (typically) small premium for financial protection that lasts a specific amount of time, typically 10-30 years. It is pure insurance. The only potential benefit is the payout upon death. In my opinion, this is the only type of life insurance that most young parents should consider, as the financial protection provided by the death benefit is the whole purpose of life insurance.
Permanent insurance comes in many different flavors, but the primary one is whole life. That is what we’ll be discussing here today, though the principles below apply to almost any form of permanent insurance. Whole life insurance does not have a term. It has a death benefit that lasts until you die, whenever that occurs. It also has a cash value component that grows over time, similar to a savings or investment account.
From a pure insurance standpoint, whole life is not useful for the vast majority of young people. It is MUCH more expensive than term (we’re talking like 10 times more expensive). Most people don’t need coverage for their entire life, as the primary purpose is to ensure that your children have the financial resources to get to independence. So as a pure insurance product, except for in a minority of cases that are the subject of another discussion, it doesn’t make a lot of sense.
But how it’s often sold to young people is as an investment. The benefits of the cash value component are made to sound very attractive, particularly as a retirement planning tool. It is this purpose of whole life insurance that I would like to deconstruct today.
So without further ado, here are 8 reasons why whole life insurance is a bad investment.
Reason #1: Whole life insurance is undiversified
Diversification is the practice of spreading your money out over many different types of types of investments and different types of companies. It’s the single tool you have that allows you to decrease your investment risk without decreasing your expected return. Unless you’re Warren Buffet, this isn’t something you should part with lightly.
Whole life insurance is by definition undiversified. You are investing a large amount of money with a single company and relying entirely on their goodwill to give you good returns. The insurance company will make their own investments and then decide what portion of their returns they would like to pass on to their policyholders. You are completely at their whim. If that one company goes bankrupt, has some bad years, or simply changes their outlook on paying out to customers, your return will suffer.
Putting a large amount of your eggs in this single basket exposes you to a large amount of risk from a single company and sacrifices the basic principle of diversification. This isn’t something that should be done without compensation in the form of large expected returns, and even then the risk would have to be very carefully evaluated.
Reason #2: Whole life returns are not guaranteed
Life insurance salesmen like to talk about the returns on their policies as if they are guaranteed. They are not. Neither are the returns from stocks or bonds, but don’t be misled into thinking that whole life insurance returns are somehow on a different level. The illustrations they present showing beautiful long-term growth are simply projections, and rosy ones at that since the company is trying to sell you. There is plenty of risk that the actual performance will be worse than what is shown during the sales process.
With that said, there is actually a small guaranteed return on these policies, but even this is incredibly misleading. In the policy that was attempted to be sold to me, the “guaranteed return” was stated as 4%. But when I actually ran the numbers, using their own growth chart for the guaranteed portion of my cash value, after 40 years the annual return only amounted to 0.74%. There are a number of explanations for this difference, including fees and the way in which the interest rate is applied. In any case, do not take that guaranteed return at face value. It is incredibly deceptive. Run the numbers for yourself and see if you’re happy with the result. The reality is that you can get better guaranteed returns from a CD that locks up your money for a shorter period of time and is FDIC insured.
Reason #3: Positive returns take a long time to appear
In the rosy illustrations, beyond the guaranteed portion mentioned above, a policy that’s held for 40 years or so will show a return of around 4%. That’s not bad, although 10-year Treasury Bonds have historically returned 5.4%. The problem is that it takes a long time for the returns to reach that level. There will be many years at the start of the policy where your return will be negative, and many more years where the return will be only slightly positive. If you stick with it for a long time, you eventually get into a reasonable range of returns, but if at any point before that you decide you want to do something different, you will have spent many years and a lot of money getting very poor returns.
Keep in mind that this is very different from the possibility of poor returns from stocks and bonds. While stocks and bonds guarantee nothing and certainly might show poor performance over certain periods, whole life is almost guaranteed to have very poor performance for at least a decade and often upwards of two decades.
This is not the possibility of bad returns. It is the promise of it.
Reason #4: Whole life insurance is illiquid
“The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold are known as liquid assets.”
Liquidity is important because it gives you options. While you hope to never have to touch your long-term savings, the reality is that life happens and the more options you have the more financially secure you can be. Having access to your money gives you options.
Whole life insurance is illiquid for several reasons:
- For the first decade or so, you are almost guaranteed to have negative returns. This means you can’t even expect to get back the amount of money you put in.
- Many policies have a surrender charge, which is essentially a fee you have to pay if you decide to cancel the policy and withdraw the cash value. If you surrender, there will also be income tax consequences on any earnings.
- Most policies will allow you to borrow against the cash value, but you have to pay interest. This is true even if you are borrowing only the amount of money you have put in, not what it has earned above that.
All of these factors make it difficult to get to your money if you need it. In theory, you should be compensated for this difficulty in the form of higher returns, but as we saw above this is not the case.
I have seen it argued that retirement accounts are also illiquid because of the penalties associated with early withdrawals, and this is certainly true to some extent. But I have several counters to this argument:
- A traditional 401(k) or IRA, with the penalties for early withdrawal, is indeed illiquid. But they have many other advantages over whole life, namely the ability to choose your investments, true tax deferral, higher transparency in fees, and cash flow flexibility, which I will talk about below.
- With a Roth IRA, you can withdraw your contibutions at any time without penalty. You should never do this except in true emergency situations, but it’s an available option.
- Regular old taxable accounts have no inherent liquidity issues, give you the full range of investment options, and can be used in a tax-efficient manner.
Reason #5: Less cash flow flexibility
A corollary to the liquidity issue is the concept of flexibility of your contributions. Even with a traditional 401(k) or IRA, where you can’t access your money without penalty, you can always choose to stop contributing for a period of time if you need that money for other purposes. In the meantime, your account stays intact, steadily earning tax-deferred returns on the money you’ve already put in.
With whole life insurance, you can’t just decide to stop paying premiums. Well, you can, but if you do then the policy lapses and you’re forced to withdraw the cash value, which will subject you to taxes and possibly a surrender charge. And if you haven’t had the policy in place for multiple decades, you will also be left with meager, if not negative, returns. Are you ready to commit to paying that huge premium year after year, no matter what happens in your life? Of course we all want to keep our retirement contributions steady, and even see them increase, but life happens and there are many instances in which having options is incredibly helpful. Those options are much more limited once whole life is introduced.
Reason #6: The claim of “tax-free” withdrawals is misleading
One of the big selling points of whole life is the “tax-free” retirement income. What they’re describing is your ability to take out loans against your policy, which are not taxed. This can indeed be an attractive feature of the policy, but it comes with several warnings.
Although there are no taxes, there is interest. When you borrow from your policy, interest starts accruing from day 1 and keeps accruing until you pay back the loan. If you’re using it for retirement purposes, are you going to pay back the loan? No, of course not. So the interest keeps accruing. And the interest applies to all money withdrawn, including your contributions, which were already taxed. These loans also reduce the death benefit of the policy, which may or may not be important to you. So no, there aren’t “taxes” applied those to loans, but there is a similar cost.
Furthermore, you can run into complications when you withdraw too much from the policy and there’s no longer a big enough cash value to support the premium payments. When this happens, you either need to put more money into the policy (likely not part of your retirement budget) or the policy will lapse and then you will face tax consequences. These policies are fraught with complications like this that the salesmen never tell you about.
Reason #7: Lack of transparency in fees. Complicated terms and conditions.
Whole life policies include many fees that are never laid out for you. There is the commission to the salesman. There are administrative costs. There is the cost of the insurance. I challenge you to find an example of a whole life illustration that lays out these costs for you, similar to the way a mutual fund has to tell you the expense ratio, sales commissions, and other fees. They just aren’t transparent, which makes it impossible to understand what you’re truly paying for. And these costs can change over time, again without you knowing, and those changes can affect the return you receive.
There are many other terms and conditions that make these policies very complicated. One such example is the issue described above where borrowing too much from your policy can cause it to lapse. Another is the “guaranteed” interest rate that’s actually much lower than what they state. Even the salesmen selling them often don’t understand how it all works. One salesman, after I asked a number of questions he didn’t know the answer to, compared it to buying a watch. He showed me his watch and said that he didn’t know how it worked, he just knew that it worked. Whole life, he said, was the same way. Needless to say, I did not give him any business.
Reason #8: There are plenty of other options available
Whole life insurance might be more attractive as an investment if there weren’t so many other good options available.
Many people have a 401(k) or other retirement plan with their employer. Everyone has the option of an IRA. Then there are regular taxable accounts. All of these options allow you to choose your investments, control your costs (though employer plans will be more limited here), diversify, and avoid the downsides of whole life insurance we’ve just gone over.
And if you’re worried about some day wanting the permanent life insurance coverage, know that any good term insurance policy will allow you to convert some or all of it to whole life at any point during the life of the policy. This means that you can save money now by buying term, but still have the option open to get some permanent coverage later. There is no need to lock yourself in now.
There are certain instances where whole life can be useful. If you have a genuine need for a permanent death benefit, such as having a disabled child, it can serve a valuable purpose. If you have a large amount of money, have already maxed out all of your tax-deferred savings, and you can afford to front-load your policy with large payments in the first several years, it can provide better returns than was discussed above. It is a useful product in a limited number of cases.
But the majority of people to whom whole life is sold do not fit these criteria. The majority of us do not need a permanent death benefit and do not have the large amounts of money on hand to make these policies a reasonable investment. For us, there are many reasons why whole life should be avoided. There are too many other good investment options out there to let yourself get stuck with this expensive and poorly performing product.
Update 3/16/2016: For those of you who are interested in “banking on yourself” or “infinite banking”, financial planner Michael Kitces wrote a smart article explaining the major flaws behind these strategies. You can read it here: How Life Insurance Loans Really Work And Why It’s Problematic To “Bank On Yourself”.