Is Whole Life Coverage All Bad?

Like most financial planners who don’t depend on selling whole life insurance, I’ve often seen whole life insurance policies in a dim light. This is because for much of my career as a financial planner, I have had more clients count on me to help them unravel their whole life policies rather than purchase one. There have been cases where I felt like the whole life decision was a reasonable choice among other choices. While I still think the majority of people are better off buying term insurance, I’ve come to the conclusion that whole life insurance can be a decent solution in some cases.

Term vs. permanent

For those that aren’t familiar with the intricacies of life insurance, there are basically two kinds of policies: term and permanent. With a term policy, your premium is fixed for a period and then increases afterward based on your age. People generally buy these policies to cover a limited period when they need life insurance, like when they have dependent children. They then drop the policy once they no longer need the insurance and before the rate adjusts upward.

With permanent insurance, part of your premium goes into a cash account that can later be used to pay the cost of the insurance when you’re older and more expensive to insure. Depending on the type of policy, this cash account can be invested in mutual fund-like subaccounts as in a variable universal life policy (or VUL) or can earn interest or dividends as in a whole life policy. The main benefit is that you can borrow from this cash value tax-free regardless of your income or credit and there’s no required repayment structure. Anything you don’t pay back is just subtracted from the death benefit when you pass away.

The downsides of permanent

The borrowing of the cash value is often highlighted by those that sell permanent coverage, but this is nothing like sticking money in a stock or ETF. For example, most of your entire first year’s premiums may go to pay a commission to the agent who sold it to you. Insurance and administrative fees may also eat into the returns, making most people better off buying a much lower cost term policy and investing in the difference. Over the last 20-30 years, based on data published by various insurance providers, the net returns after fees on the cash value in whole life insurance policies have earned between 4-6%, in comparison, stock markets returns have been at ~8-10% over that same time. Note that the net returns of these policies can vary due to a difference in fees, underwriting, management and other nuances that are particular to the specific insurance provider. So, if you’re shopping around – make sure you ask the providers for their numbers.

In addition, the premiums are much higher than with a term policy so you might not want to look to whole life to cover all of your life insurance needs. If you fail to pay the premiums or if the investments in the cash account plummet in value, the policy can lapse, leaving you without coverage unless you add more cash. Adding insult to injury, the gain in your cash account would also become taxable if that were to happen.

It’s not all bad

For these reasons, I haven’t recommended permanent life insurance policies that often. But there have been cases where I did not object to it. For instance, I worked with a young, high-income earner who was maxing out all of her retirement accounts and looking for more tax-advantaged ways to save. Her life insurance agent suggested that she consider a whole life policy.

As we reviewed the pros and cons, it appeared that a whole life policy made a lot of sense for her. She wanted to purchase life insurance while she was still young and healthy to lock in favorable rates. Her income made her feel comfortable that she could afford to make the greater premium payments and gave her a bigger benefit from having the cash account shielded from her high tax bracket.

What about the low returns? Well, the flip side of low returns, at least with whole life, is low risk. Many of these policies guarantee a minimum 2-4% return, which was more than she could earn in almost any other guaranteed investment at that time, especially after you factor in the fact that she could use the money tax-free. While she invests aggressively in her retirement accounts, the whole life policy could be used as a less volatile portion of her portfolio.

Eventually, it could also supplement her retirement income and help pay for the costs of long-term care and education for her children. In the latter case, the cash account would have the additional benefit of not reducing her children’s eligibility for financial aid. It would also be protected from creditors.

Should you buy a whole life insurance policy? I still think they’re only appropriate for a small percentage of the population. To see if you fit in that category, here are some questions to consider:

1) Do you need life insurance?

2) Are you maxing out your retirement plan contributions?

3) Are you in a high tax bracket?

4) If you used term for your insurance needs, would you be disciplined enough to invest the difference?

If you answered “yes” to the first 3 questions and no to the 4th, then you might consider it. Look for a policy from a highly rated insurer with relatively low fees and a long track record of paying generous dividends. Rather than talking to a commissioned agent for help, you might want to consult an unbiased financial coach or fee-only life insurance adviser. Finally, after reviewing the benefits, make sure you can afford the premiums. If so, you might be in that small percentage that whole life insurance makes sense for.