Whole vs Term: The Case for Today’s Life Insurance Contracts

Whole vs Term: The Case for Today’s Life Insurance Contracts

For many years the conventional wisdom has been that life insurance contracts ought never be treated as investments.  Yet the conventional wisdom, to the extent that it was ever useful, is far from pertinent today. Indeed, it has always been the case that insurance products are only advisable given an individual’s unique circumstances.  

The widespread understanding, retailed by financial advisors and CPAs, was that the product of choice in almost every situation is term insurance.  Term insurance is like a rental car. It has a certain value for a delimited period of time, but the driver has no ownership rights. The purchaser of a 10-year term insurance policy is covered for some stipulated amount (let’s say $100,000), and if he or she doesn’t die during this ten years, the coverage lapses.  The premiums paid during this decade go to the insurance company and that, as “they” say, is that. If the insured passes away during this time, the $100,000 benefit goes to the designated recipient. The insured, generally speaking, receives nothing.  

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A permanent life insurance policy runs from the date of inception until the death of the insured.  It isn’t like a rental car. It is instead like owning a vehicle that actually appreciates in value over time. A fairly typical permanent life contract presently accumulates what is called a “cash value” at 8 % tax-free.  This return is roughly equivalent to that for the S & P 500 (7.95%) since its inception in 1957. The difference, of course, is that the life contract’s cash value is not subject to taxation. 

If one is going to carry life insurance at all, and it does seem like a good idea in most circumstances, a persuasive argument can be made for a permanent policy. The cash-value feature insures a return of premium that just isn’t available in a term product, lowering substantially the overall cost of the insurance protection. Moreover, in recent years life insurance contracts have been modified in a number of ways that clearly benefit consumers.  For instance, there is an “accelerated” feature that permits up to 100% of the death benefit to be made available in the event of chronic, critical or terminal illness. Let’s say that John Smith is diagnosed with a disabling medical condition. If. Mr. Smith has excellent health insurance, his medical bills may prove manageable. This is a significant concern in that two-thirds of bankruptcies in the United States are directly associated with medical expenses incurred.  But even with his top-tier health insurance coverage, Mr. Smith is by no means out of the woods. He is disabled and effectively out of the workforce. And it is at this point that his life insurance contract represents a remarkably good investment. Mr. Smith can apply some portion of his death benefit, typically from 25 to 100%, to medical care that he perhaps otherwise couldn’t afford. He can continue to make mortgage payments and buy groceries for his family. He buys himself time to recover from his disability without succumbing to financial ruin.       

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Two Types of Permanent Life

That’s not all you have to understand. As Permanent Life Policies: Whole Vs. Universal makes clear, there are two types of permanent life.

  • Whole life insurance gives you a consistent premiums and a guaranteed cash value accumulation. In return for this, the premiums are likely to be much higher than for term insurance, but the payout, if the company stays solvent, is assured. The only risk you have with whole life is that you paid more in fees than your return is worth – or that the company goes bankrupt.
  • Universal life offers more flexibility in premium payments, death benefits and the savings element of the policy because the policies allow policyholders to earn more when the stock market is strong.

Because whole life offers no flexibility and doesn’t allow policyholders to benefit from strong markets, some pundits started asking Is Whole Life an Obsolete Product?  What few noticed in those rosy early days was the fine print of what happens to universal life policyholders if the market does not do well.

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Universal Life: Investment Earnings Roulette

Early generations of policyholders ran into nightmare scenarios because their policies were written assuming 11% to 15% rates of return. Those policies didn’t take into account that, as the 20th century ended and we lived through the first 15 years of the 21st, interest rates would drop into the single digits – playing havoc with cash value’s growth and undermining the earnings needed to maintain the insurance. Policyholders found themselves forced to pay premiums entirely out of pocket; if they couldn’t, their policies became worthless. Once that happened, they faced a big tax bill on any sums they’d withdrawn over the years – undermining a key selling point for these policies when they were invented.

It helps to remember what made universal life look so appealing when it was invented as an alternative to traditional whole life. For starters, it’s a particularly flexible option, allowing the policy owner to shift funds between its insurance and savings components. Some policies also allow you to choose how the funds in the savings component will be allocated (similar to how you might choose among different mutual funds for your 401(k) plan). 

As cash value accumulates, policyholders can borrow against it. In fact, borrowing is the most tax-advantaged way to use these funds. “Life insurance cash values can be accessed during the policy owner’s lifetime through two ways, loans and withdrawals,” says Jason Silverberg, vice-president of financial planning at Financial Advantage Associates (Rockville, Maryland). “You can access your basis (what you contributed to the policy), without any tax implications.”  That is, the funds you withdraw from the account usually aren’t subject to income tax – unlike Traditional IRA and 401(k) plan distributions

“The gains, however, are taxed at ordinary income rates, unless you take them out as a loan,” Silverberg cautions. In other words, you technically don’t withdraw funds from the insurance policy; you borrow against it – not unlike taking out a home-equity loan against the accrued value of your house. These loans are not subject to income tax. You do pay interest on them (though you can use the cash value account funds to cover the interest payments too).

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What Happens When You Retire

Another key benefit, in addition to the life insurance component, is that you can tap into your universal life policy for income after you’ve retired. There are some compelling reasons to do so: The cash value account within an insurance policy accumulates tax-free, for one thing. “Some people use the cash value in their life insurance policy to bridge the gap from [the year of their] retirement to age 70, when they can receive the highest Social Security benefit,” David Wilken, president of Individual Life for Voya Financial’s Insurance Solutions division says. “Others allow their policy to mature and cash out later to receive the maximum benefit [of the policy].

“In general, the more time you allow your cash value life insurance policy to grow, the better. A good rule of thumb is to plan to wait at least 15 years [after you purchase a policy] before you begin taking distributions.”

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The Risk of Lapsing

In order to take distributions, of course, your insurance policy has to have cash value. That’s never a problem with whole life, but universal life policies are differently designed. Earnings on the cash value are an important component in maintaining the policy – it’s not just the premiums you pay. Often, with universal life policies, the size of the premium varies based on how the investment portion of the policy is performing. In other words, the cash value of the policy isn’t just your cash cow; it’s there to help pay for the insurance, supplementing or even covering your premiums. 

Earnings on cash value are designed to help keep a policy from lapsing – especially during periods when the policyholder takes out a loan against the policy’s cash value. “If you take out too much money and the cost of the policy exceeds the cash value,” Wilken says, it’s “similar to being underwater on your home.” Your insurance policy could lapse. Not only would you lose your death benefit; all the funds you borrowed or withdrew from the policy would now be considered taxable income.     

Deciding What’s Safe to Withdraw

How do you know how much you can safely withdraw – before retirement or after it? When you buy one of these policies, the terms will be laid out in what the insurance industry calls an illustration. This is a document that lays out the assumptions made to compute your expected cash value, monthly interest rate and other key components of your policy.

It is key to making sure that once you reach a point where you might draw on the policy’s cash value, you have enough in money in place to meet your financial needs – and to keep the policy in force. Unrealistically optimistic illustrations were what left so many early holders of universal life policies underwater, often just when they were counting on their holdings to help them into retirement.

If your policy was written years ago and you haven’t had a comprehensive review of it lately, it might be time to pay a visit to your insurance agent.

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The Bottom Line

If you’re thinking of buying a universal life policy, you (and your financial advisor, if you have one) should cast a critical eye on the illustration, making sure it errs on the side of conservative. One help: The National Association of Insurance Commissioners recently adopted a new actuarial guideline to regulate and standardize illustrations. Going into effect in March 2016, “the new law AG 49 makes sure the illustrated rate of return and its growth is realistic,” according to Brad Cummins, founder of Local Life Agents, a Columbus, Ohio-based firm of independent insurance agents.

Breaking it down, you have to properly watch and manage your universal life policy to keep pace with the rising cost of insurance, the rate of return on the cash value, and how much of a death benefit you need, in order consider this a viable income source. It’s complicated, and some financial professionals argue that there are better, easier ways to save for retirement that don’t involve life insurance policies – mutual funds, ETFs, annuities, to name just a few.

Still, the cash value policy – old-style whole life included – might be a good fit for some individuals. “If properly planned for, life insurance policies can produce a pretty hefty income stream in retirement,” as Silverberg puts it. “Just make sure that the policy doesn’t lapse.”

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This Post Has One Comment

  1. Diana M.

    Like!! Thank you for publishing this awesome article.

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