Whole/Universal (Variable) Life Insurance -- Ever a good idea?

In My Humble Opinion
1

I know this is a standard financial planning question, but bear with me…

For those that might be unfamiliar, the gist of these products is that you’re sold a very expensive life insurance policy that accumulates cash value over time that is equal to the sum of your premiums less commissions, fees, expenses, and the cost of insurance. This value accumulates non-guaranteed but historically-regular dividends hovering somewhere just above the returns on AAA bonds (right now it’s around 4.2%, I believe). The selling point is basically threefold: first, the accrual of cash value through the dividends is untaxed as are the ultimate death benefits, and you can essentially take out distributions of the cash value as loans which can ultimately be paid by the death benefit; second, you can use the cash value as collateral to take out relatively low-interest rate loans from the bank (without actually lowering the value of the collateral, so it continues to collect dividends), resulting in what has historically been the ability to essentially borrow money for free (since the rate of return is higher than the interest rate); and third, your cash value never decreases, so it represents a very low-risk investment comparable to a bond index but with historically slightly-better returns.

The conventional wisdom on these products is that the sales pitch above is pretty much bullshit; they are not worth it for 99% of people, and that it is better to buy term life and invest the difference. Among the many downsides are that if you become unable to afford the premiums in the early years of the policy, you’ll have to take the cash value which will be less than what you’ve paid in (you’re not really in the black until a decade or more into the policy). Moreover, they’re extremely complicated and non-transparent–you have no way of knowing in advance how much of your premium will make its way to the cash value each year (and not end up in fees or changing costs of insurance), and no way of knowing what kind of dividend will get paid.

So are there people for whom these products are rational purchases?

Consider the following scenario:

[ul]
[li]Johnny Earner is maxing his 401k and is ineligible for Roth (so his other retirement investments will all be taxed at whatever rates prevail decades from now).[/li]
[li]Johnny Earner anticipates that capital gains and income taxes will be higher in the future, maybe even higher than they are for current income even accounting for lower income brackets at retirement–at a minimum, Johnny Earner wants to hedge slightly against this possibility.[/li]
[li]Johnny Earner’s investment portfolio will include at least some lower-risk, lower-return investments anyway, so the risk/return comparator here is probably bond funds.[/li]
[li]Johnny Earner is safe in the assumption that he will be able to pay the premiums at least until the cash value exceeds the premiums paid.[/li]
[/ul]

So would the conventional wisdom apply to such a fellow? Are the premises in the sales pitch misleading or wrong? Are there downsides not listed above?

[In case it matters, I am not in the position of our hypothetical fellow for one or more of the premises. Just asking academically.]

2

You can wait until income/capital taxes are higher in the future to put your money in variable products.

It typically takes 15-20 years before your cash value equals the money you put in. So if you put in $1000/year, so much of it is consumed to pay for your death benefit and other charges that on average, you can expect to have 15K in cash value in year 15. If you are going with bond funds, the cash value tipping point may be closer to 20 years.

Furthermore, there is a borrowing cost when you borrow your own money from the cash value on your policy.

On the other hand the “forced savings” aspect of whole life insurance has made a difference for a couple of people I know during this recession. Some of them had special bells and whistles that provided a buffer against a collapse in market returns or the interest rate environment. I know one guy that had what he thought was a throw away rider that gave him the right to annuitize at a particular rate and now that interst rates are so low that he has annuitized his life insurance policy and is drawing an annuity based on something like a 5% rate of return.

3

How so? If Johnny Earner has savings beyond the 401k cap, where does he put that money now if he wants to hedge against future increase rates? Is the notion just to pull it out of an ordinary investment before the rates go into effect? If so, that seems risky.

What I have heard, and this may or may not be true, is that one can post the cash value as collateral for an ordinary bank loan at an interest rate that is equal to or less than the typical return on the cash value. So, effectively, there is no borrowing cost. Is this a myth?

4

I had this same discussion with my son a couple of months ago when one of his college friends suddenly reappeared in his life as an insurance salesman. There are only a couple of situations where I think a whole life policy makes any kind of sense at all.

  1. You got the policy when you were young (more likely, your parents took it out when you were a child) and the monthly premiums are so low you don’t even feel them.

  2. The idea of “level premium, level coverage” works for you; i.e., you’re going to need as much insurance at age 75 as you do at age 25, and term life policies typically either increase premiums or reduce coverage at some point.

  3. You read the income projection tables and you like the point where dividends and interest mean you can take the paid-up insurance option and never pay a premium again.

But note that each of those options speaks to the main goal of life insurance as being - you know - life insurance. Not as some half-assed multipurpose investment/tax break plan.

5

Short answer - no, Hell No!

Read the fine print, look at the fees involved, be aware that the commission paid to the agent may run as high as 150% of the first year annual premium and then look at other more rational alternatives.

6

But why, specifically, is it a bad investment? Isn’t it just a matter of running the numbers on whether the typical return on premiums outpaces the alternatives?

It’s true that a lot of the premiums goes to fees and such. But, as above, isn’t the bottom line just whether the return on the premiums is expected to outpace alternatives?

So, for example, if for the last century the company has paid at least 4% annually, and nearly always above the AAA bond rates on the premium amount (i.e., the rate is actually higher if you account for the fees and such), then why are bonds a more rational choice?

7

Because the insurance company doesn’t have magical access to better performing investments than you do. If they can consistently give you greater than AAA bond rates (after paying themselves handsomely to manage your money) then they’re investing in something riskier than AAA bonds.

If the insurance company can manage to give you 4% every year then you can do at least as well by directly investing in whatever the insurance company was through cheaper and more transparent vehicles.

Unless you’re in a situation where you can use the policy to ‘cheat’ the taxman I see no reason to pay the large fees insurance companies charge.

8

Do not forget that nobody is “ineligible” for a Roth. All you have to do is to open a standard nondeductible IRA, fund it to the maximum, and convert it to a Roth every year. Since you only pay taxes on interest accrued (since the money you put in is already post-tax), if you absolutely want to not pay taxes then put in the entire amount as a lump sum and convert it the next day. Since my income varies, I keep 2 IRAs open at Schwab, a regular one (which has $1.65 just to keep it open) and a Roth IRA that has the rest of my investments. Currently, I can fund the Roth, but if my income goes up I just fund the regular IRA and convert the funds and my retirement money grows tax free with no penalties, no fee, and no future income tax.

9

Is that true? It doesn’t seem like it must be true as a matter of logic. For one, there are lots of investments in the world that are proprietary. And for another, the investment profile of a mutual insurance company may indeed be unique, for all I know (i.e., not accountable to any short-term needs or interests and been investing for 100 years).

Is there a similar investment that has returned at least 4% every year since 1929? (Or, alternatively, are these companies lying when the claim that fact?)

Isn’t pretty much everyone who doesn’t have a Roth (or wants to save more than the Roth allows) in that position?

Fascinating. Why the heck is there no income cap on conversions from IRAs? That doesn’t make any sense to me.

So you’re saying someone could put $5,500 in an IRA and the next day convert it to a Roth IRA? Isn’t this just a loophole waiting to be closed?

10

I’m not saying that you, as an individual, can buy every investment that an insurance company can. But other large investors (like mutual funds, etfs, hedge funds, large banks, or companies like Berkshire Hathaway) can buy absolutely anything an insurance company can. And lots of these other large investors will let you invest with them, for much lower fees than the insurance company.

If the insurance company is really saying that you can never lose principle (your cash value never decreases) and you get higher than AAA bond returns then they are either lying, they’ve found a magical investment opportunity that no one else knows about, or they’re investing your money in riskier investments. They can smooth out returns by keeping all the returns above 4% in good years and paying you out of their own pockets in bad years but the risk is still there, just hidden.

I’m Canadian so I don’t know too much about the American tax system. But you’d have to save more in taxes than it costs in fees, commissions, and excess insurance. I believe that’s a pretty small chunk of the population.

11

You don’t buy life insurance; you rent it.

And this is coming from someone who has two whole-life policies, both purchased in the early 1980s. The one I bought, I was finagled into it back when I didn’t know any better, and cursed myself every January when I wrote out that check for $211, which when I was in college was two weeks’ income, but I’m glad I kept it now that I took early retirement. The cash value is more than the money I’ve put into it, although probably not with inflation taken into account - yet.

The other was purchased by my parents (they bought one for my brother and sister too) on the premise that there would be a boatload of grandchildren by the time the policies matured. There weren’t (my brother has two kids, and they will be the only grandchildren) and my sibs cashed them in but I kept it too, for the same reason.

12

This loophole was deliberately created so that people above the income cap could have the advantage of a Roth and to get immediate tax income for the government. The problem that exists is that if you have an IRA where the funds were partially deductible or you have earnings on an IRA, you must pay taxes on those funds when you convert. You are not allowed to specify what money you are converting. If you open a brand new IRA and put the new funds in there then of course you can convert those funds with minimal taxes. If you want to convert existing IRAs, however, you may end up paying. The government essentially traded short-term increased taxes for a long-term decrease. Overall, though, the conversion is fairly easy. I had 3 IRAs ( 2 rollover from 401K plans and my regular IRA) and to avoid having distributions and then reinvestment I basically created a Roth IRA with each company where I held the original IRA then over the course of the past 5 years I have gradually rolled over the funds from each to minimize taxes. I only got hit badly once, in 2008 where I rolled over the funds just before the market crashed and ended up paying taxes on gains that were esentially completely wiped out 3 months later. I’m still happy to have those funds growing tax-free, though.

I really doubt that this loophole is going to be closed soon as the government has been expanding it by creating Roth 401Ks.

13

Thanks psychobunny. I’ve not maxed my 401k so I wasn’t seriously considering these life insurance products, but I might be interested in this Roth rollover method (as I have no other IRAs), so this thread was unexpectedly very useful.

This seems to be the nub of it. They really are saying that the cash value is guaranteed and that not only do they historically return better than AAA rates, but that there’s also a minimum guaranteed return of a few percent after the period necessary to prevent it from becoming a Modified Endowment Contract (which can vary from 7-15 years based on the structure).

I gather that this is a function of exactly the smoothing you describe–they invest in a whole portfolio that typically has much higher returns than the dividends offered. But why would the participant care if it is the result of such smoothing?

Isn’t the risk really just the company will fail?

14

Fail, default or just pay the minimum guaranteed return. I’m sure the worst-case scenario varies based on the wording of the contract and the laws/regulations in that state.

If that’s what the insurance company is doing, your investment is essentially just a loan to the insurance company with a complicated interest rate. It’s just disguised as an investment in outside stocks/bonds. That’s not necessarily bad, but you could accomplish nearly the same thing by simply buying a bond issued by the insurer.

15

That is precisely my impression. Obviously then the chief benefit is that, unlike a corporate bond, the interest is tax-free.

I found this incredibly interesting website digging into all of this: The Visible Policy: Participating Whole Life Insurance Explained