“Like marriage, permanent insurance is designed to be a lifelong commitment.” – ForbesPlanning.com
Last week we started a two part series on life insurance in which we detailed the basic differences between term and permanent life insurance. We explained why term insurance is always cheaper than permanent insurance and the roll each can play in someone’s overall financial plan. At the conclusion of last week’s post we stated that, “Although most people could benefit from some amount of term insurance, the same isn’t necessarily true for permanent insurance.” In this week’s post we will unpack this statement in more detail as we explore the different types of permanent insurance and explain why they may or may not be appropriate for people.
The life insurance industry here in the US is almost as old as the country itself. Founding Father, Benjamin Franklin has been credited with introducing not only life insurance but other forms of insurance as well. For over a century, insurance companies offered either permanent insurance in the form of whole life or temporary insurance in the form of fixed-premium term. Then in 1979 the Federal Trade Commission issued a report entitled Life Insurance Cost Disclosure which focused on the cost of insurance (COI) and the somewhat inadequate returns being generated inside the more expensive “cash-value” insurance policies. This had a ripple effect through the insurance industry as it added fuel to the whole vs. term insurance debate and put pressure on whole-life insurance products. In response, the industry launched universal life insurance which combined the transparent COI aspect of term with the savings account feature of whole life. Since that point, there have been several alterations to the original universal life structure to include variable universal life and indexed universal life insurance contracts.
Whole life offers policy holders life insurance as well as a savings vehicle. It has a guaranteed rate of return for the savings portion of the policy, which is determined by the insurance company using conservative, worst case scenario assumptions for their business. This guarantee is the reason why whole life is the most expensive form of life insurance, but some would argue that the additional expense is justified by the lower risk due to the guarantee.
In addition to the guaranteed returns, a participating whole life policy will also be credited with non-guaranteed dividends which are tied to the profitability of the underlying insurance company. The way this works is that the insurance company overcharges everyone for life insurance based on very conservative mortality assumptions and then returns the overcharged funds to their policy holders based on their actual operating expenses, including claims paid out, in any given year. Life insurance companies also make money by investing their float, which is simply the monetary reserves held to pay future claims. Earnings on the float factor into the overall profitability of the insurance company and are therefore included in the dividend payouts to participating whole life policy holders.
As previously mentioned, universal life insurance is a variation of whole life which was born out of the demand for more transparency in pricing versus the black box that is whole life. A basic, interest crediting universal life insurance policy is very similar to whole life but offers more transparency, lower fees, and more flexibility. The COI for universal life is published by the insurance company every year and policy holders have more flexibility on raising or lowering their coverage and subsequent premium payments.
Premium payments in excess of the COI go toward the savings account which grows at a variable rate of interest. Rather than being fixed, the earnings on the savings account are driven by the prevailing interest rate environment in public markets. Universal life transfers the onus of generating returns for the savings account from the insurance company, which is the case for whole life, to the policy holder via the market. Think of whole life as a pension fund and universal life as a 401k plan.
The problem with this type of policy is that the illustrated annual premium payment may end up being inadequate to cover the COI for the life of the contract if the interest rate being credited to the savings account ends up being lower than what was originally assumed. If returns do fall short, policy holders will have to increase their premium payments to account for the increasing COI with age or else the policy will eventually lapse and expire worthless, which is one major difference between whole and universal life policies.
The insurance industry’s answer to the low interest rate environment was to launch variable and indexed universal life, which allows policy holders to go further out on the risk spectrum by having their savings accounts tied to a wide variety of investments such as stocks, bonds, and/or commodities. The fun doesn’t stop there as a wide variety of riders can be added to policies to change the overall risk profile while increasing the cost to the policy holder. In general, the more riders one puts on a policy, the more it will begin to act like a whole life policy with bond-like, low risk returns and a high cost to the insured.
We like to view permanent insurance as an excellent estate planning tool which can also act as a bond substitute in a well-diversified portfolio. What it is not, is a substitute for an entire portfolio of retirement assets. Insurance sales reps like to tout the dual benefits of insurance coverage and investing, but they rarely point to the opportunity cost of these contracts. This is why the popular “buy term and invest the rest” philosophy makes a lot of sense for people who are still building up their nest egg and have yet to max out the various retirement options at their disposal like a 401k or IRA account. These types of accounts offer similar tax advantages to a life insurance policy with lower fees and more flexibility on how the assets can be invested. That being said, for those that have built up their nest egg, can afford to pay the insurance premiums out of their savings, would like to utilize the tax advantaged aspect of permanent life insurance to replace some of their bond holdings, and plan on leaving an estate, whole or universal life can make a lot of sense.
Another thing to consider before pulling the trigger on a permanent policy is that it is a long-term commitment. Think of it as a marriage, not a high school fling. The majority of the investment value in a whole or universal life policy will be realized only after the age of the policy can be measured in decades rather than years. The numbers below were pulled from a whole life illustration we ran for a male in his late 50’s. The policy was constructed to maximize the cash value accumulation and is designed to be fully paid up after 10 years. The numbers below are also based on non-guaranteed dividend payments which assumes the insurance company will be able to maintain their current dividend rate.
It is easy to see that the cash value or savings portion of a whole life policy really doesn’t do much for the first decade and is solidly negative if the policy holder decides to cancel the policy five years out. This is in large part due to the fact that insurance companies kick back generous commission payments to the agents that sell the policies. That money has to come from somewhere, and that somewhere is the starting cash value.
In summary, permanent life insurance can play a complimentary roll as a non-correlated asset in someone’s overall portfolio while at the same time providing lifelong insurance for estate planning purposes. For those that are in the stage of life where paying the bills and saving for retirement takes priority over estate planning, buying term insurance to cover immediate liabilities and pushing savings into retirement accounts probably makes the most sense. Lastly, those that do take the plunge to purchase permanent life insurance need to make sure they are in it for the long-haul in order to fully realize the true value of the policy.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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