The "Investment" That's Sold, Not Bought
I could have spent last Thursday doing something - anything - else. But I was committed to a conference call where I was supposed to challenge an insurance agent about the investment benefits of whole life insurance.
Before you stifle that yawn and click off, listen up.
True, life insurance is not as exciting as the latest Miley Cyrus tour photo. But you may need life insurance - or might already own a whole life policy - and what you decide to do about it is enormously important to you and your family. So you might find our dispute instructive.
Let me begin by defining the two primary types of life insurance. A term policy is life insurance only. It has no cash value, but upon the death of the insured, it pays the face amount of the policy to the beneficiary. You can buy term for almost any period of time up to 30 years.
Whole life insurance combines a term policy with an investment component. And since there is tax-exempt compounding, a lot of insurance salesmen call these policies "retirement plans" and emphasize the "forced savings."
When it comes to discussing whole life, the advantage is always with the agent. That's because there are thousands of variations on these policies and each one has its own particular features and benefits. Unfortunately, they generally have the same drawbacks.
Here is what you are likely to hear from someone selling whole life. "Buy this policy and it is like owning an IRA with tax-free compounding but no contribution limits. Your principal is guaranteed. If you need cash, you can borrow against the policy tax-free. And it also offers asset protection from potential creditors."
That's a lot of benefits. What's not to like? As it turns out, a lot.
Here's what you don't hear from someone selling whole life insurance:
- The policy is enormously complicated and those complications are designed to benefit the insurance company and its agents, not the policyholder. Even those selling them usually can't explain all the particulars of how these policies work. And you aren't likely to understand the legalese in the inch-thick prospectus either.
- Whole life insurance is terribly expensive. There are commissions, fees, mortality expenses, surrender penalties and tax consequences. Typically, your entire first-year premium will go to the agent. And don't fall for the line that the insurance company pays the commission, not the customer. Where do you think the insurance company gets the money? (Hint: The agent doesn't get a commission if you don't buy the policy.)
- Future returns are generally low... and uncertain. You will often hear that a particular policy pays, for instance, "up to 5%." If you look closer, you will often find that there is a "projected return" and a "guaranteed minimum return." Expect to get the guaranteed minimum. The insurance company has little incentive to pay you more. James Hunt, actuary for the Consumer Federation of America, who has analyzed thousands of policies, notes that whole life insurance policies hardly ever yield a reasonable return unless held for 20 years or more.
- Your money is highly illiquid. Once you buy whole life, you're stuck. If you lose your job, become disabled or decide you'd rather put the premium money into something else, the insurance company doesn't care. It takes an average eight years for a policyholder to break even, 12 if you consider inflation. Changing your mind - or waking up to what you've done - is expensive.
- Yes, you have a principal guarantee, but that's only if you hold the policy a long, long time. There are other investments that offer principal guarantees too, of course. U.S. Treasury bonds are one of them. And they generally pay nearly as much as the guaranteed minimum of a whole life insurance policy... but without the illiquidity and penalties.
- No guarantee is better than the guarantor. Insurance agents like to brag that their company gets a top (or near-top) rating by Moody's, Standard & Poor's or A.M. Best. But here's something to think about: AIG, the biggest insurance company in the world, went bust in the financial crisis and had to be bailed out by Uncle Sam.
- There are estate-planning benefits, yes. But these generally benefit only the very rich. Under the new tax law, estate taxes don't even kick in unless your estate is worth more than $10 million.
- You can get asset protection with a whole life policy, but do you need it? After all, you also get that protection through your primary residence, your retirement accounts and titling assets as tenancy-by-the-entirety.
- Also, while it's true you can borrow against the policy, you will pay interest (currently around 5%) and it's no big deal that the loan is tax-free. After all, money borrowed from a bank or other private source is also tax-free. Why should you pay taxes when you borrow against your own policy paid for with your own after-tax money?
- Cash in your policy decades down the road and you still face another hurdle. Your profits will be taxed at your income tax rate (currently as high as 39.6%) not the lower capital gains tax rate (which currently tops out at 20%). You may owe state income taxes too.
It's not that whole life insurance is a rip-off, although policyholders who don't have these negatives explained to them in advance - and few of them do, in my experience - are likely to feel pretty hot about it once they discover them all down the road.
The real problem is that the benefits are limited and can generally be obtained elsewhere at far lower cost. "Investing" in a whole life policy is like buying your everyday flatware at Tiffany.
What if you truly do need life insurance to protect your loved ones? In that case, the old A.L. Williams slogan still holds true. Instead of buying expensive whole life, "Buy Term and Invest the Difference."