A Closer Look at Cash Value vs Term Life Insurance

“I’ve been running the numbers, and I’ll be better off buying term insurance and investing the difference.”
“Maybe, but the problem with that is that nobody actually does it. Cash value insurance is like a forced savings plan.”

This is the gist of conversations I’ve had with various financial professionals trying to sell me cash value life insurance. All of them seem to think that I will lack the discipline to keep investing over time and I should preemptively force myself to do it. I tend to disagree.

In a nutshell

Term life insurance is the most simple, cheapest, no frills, pay your spouse if you die, insurance policy available. Half a million in coverage costs me about $20/month and covers me if I die during the 20 year term. If I die even a day after the term is up, however, the beneficiary (my wife) gets nothing. Some policies allow you to continue after the fixed term is up, but the premiums usually go up substantially. If you’re on your death bed and just need to prolong the policy a few more months it might be smart to do.

Cash value insurance policies generally combine a standard term policy with an investment account in order to provide life insurance for your “whole life”. The specific type of investment account varies between the different types of insurance (whole, variable, universal, comprehensive, etc). As the value of the investment portion grows the risk to the insurance company decreases, which is why they don’t go broke from offering these policies.

Insurance Companies Aren’t Stupid

Any life insurance company assumes that at some point their client will no longer be a client (in other words they know you’ll die). From a business standpoint expenditures must be less than income. If the insurance company wants to stay in business, they need to structure their premiums such that they are paying out less in benefits than they receive in premiums. They are betting on the insured person either outliving the terms of the life insurance contract or paying enough into the contract that they still generate a profit when the person eventually dies.

Why We Have Life Insurance

We have life insurance so that if one of us dies early the other isn’t stuck with a mortgage and will be financially OK despite the loss of income. That’s it.

Since over 90% of people who have ever lived have also died (and it’s probably safe to assume this statistic will asymptotically approach 100%) I assume that at some point in my life I will also die. Insurance is a product designed to spread risk among the population, not reduce it to zero. At some point when we have sufficient assets and no more debt, either of us dying will still be sad but won’t create financial hardship for our survivor(s). That’s the point when life insurance is no longer necessary.

Nobody seems to agree on this

showdownA few minutes of searching for the differences between term and cash value insurance policies will reveal the substantial controversy around the topic. Dave Ramsey is a well known critic of cash value insurance policies and minces no words calling them “one of the worst financial products available.” On the flip side proponents claim that they are a “safe” investment and while the returns are lower than the stock market they are more consistent and therefore “safe”.

Since there is a lot of conflicting advice out there but very little in the way of actual numbers I decided to do my own comparison. I’ve already had a few interactions with insurance salespeople so I had some illustrations showing cash value returns and insurance values. The cash value policy I chose to compare to had a $10,000/year premium and an initial payout of about $740k  that started to get larger after 15 years due to the increasing cash value of the investment portion. The term policy is a 20 year level term life policy with a payout of $750k and a premium of $330/year, leaving $9,670/year left over to invest.

My setup

I created a spreadsheet with 2 sheets, one copied directly from the cash value insurance illustration and another to estimate what my investment returns would be over the same time period. Since the cash value plan becomes paid up after 15 years and no longer requires additional payments I stopped all investments after that point as well (in reality I would not do this but wanted to keep the comparison as apples to apples as possible). I assumed between 8-12% annualized return on investments which is very reasonable over a 15+ year period.

I had 2 goals in mind when setting this up:

  1. See what my spouse would receive if I die in any given year from now until the term policy is up.
  2. Compare the “investment” portion of a cash value insurance policy with good old fashioned stock market (mutual fund) investing.

What I Found

Cash Value Insurance Gremlin
From an insurance perspective, whole life makes sense assuming you die right after that foolish term policy would have expired (age 48 in my example). Since the expiration of the term policy would mean an immediate $750,000 drop in insurance value your survivors would be left with a paltry sum of around $400k-700k depending on how the market has performed. Say you survive past 48 though… Whole life would continure to have an advantage over term+investing until about age 55 assuming 10% returns (or 62 at 8%). If you do well, say by minimizing your expenses and averaging 12% returns, age 51 is the break-even point.



Now lets assume that you have lived through the period where whole life wins the insurance payout battle and are going to retire at age 60. You have stopped investing over 10 years ago (please don’t actually do this) and are simply watching your investment grow. Sure you’ve seen some ups and downs in your mutual funds, but overall you’re up around 10% per year. You look over to see what you would have right now had you invested instead in the whole life policy and think “what a cute little account”. Instead of the $1.7 million your $145k has become (or $2.7 million at 12%), you would have had around $550,000 of “safe” money. Granted, getting that safe money could be a bit of a pain and you’ll still probably have to pay taxes on the gain.

Take a look at the graph below and you’ll see that even the best case estimation (the top yellow line) for returns on the whole life policy are terrible compared to a conservative 8% in a Roth IRA. In fact, when I calculated the actual return on the whole life policy it came out to around 5.4%, and that’s not even including any fees or taxes you would have to pay on withdrawal.


Conclusions

  • The graphs pretty much speak for themselves. Cash value insurance is a poor investment.
  • I suspect that this is one of the reasons that cash value insurance companies are so tight lipped about performance but you can easily look up returns on any mutual fund out there. If people could see ahead of time what the insurance dividends are actually returning nobody would buy them.
  • Cash value insurance may make some sense for very high net worth individuals where it represents a small fraction of their net worth, similar to why they may hold bonds instead of stocks for a portion of their portfolio. Then again you don’t get rich by making poor investments, just buy the bonds if you want something safe.
  • Don’t lie to an engineer about numbers.

I realize that I may sound a bit harsh in my critique of cash value insurance. As a product I have no more problems with it than I do with other low yield investments (aside from how long it takes to see an actual return). My problems are with the sales tactics used to get people to sign up for the policies. Commissions on the policies are huge, on the order of the entire first year of premiums, and I think it keeps the financial advisors selling them from making a recommendation that is truly in your best interest. I would find it hard myself to recommend a term policy if it meant cutting my commission down by 99% too. Financial advisors aren’t bad people, but I think many of them either don’t really understand what they’re selling or don’t care to find out.

Have you had experiences with the various types of cash value life insurance policies or people selling them? Disagree or agree with me? I’d love to hear about it, post a comment. I’d be especially interested in hearing about someone who has held a policy for a long time and what the returns have looked like.

5 thoughts on “A Closer Look at Cash Value vs Term Life Insurance

  1. Thanks for the follow up on our discussion over at JLC’s blog. Nice post.

    I think advisors are very well aware of what they are selling – commissions are the name of the game for most of them. These are the same type of people selling high-fee or “load” mutual funds.

    Others have been drinking the “kool-aid” too long and actually believe life insurance is a good investment. Based on stock performance during the 2008 debacle, I’m sure they sold (and are still selling) boat loads of whole life insurance by showing clients that it can be more stable than the market.

    In the end, life insurance should only be bought to fill a very specific need. Your example of buying term insurance to make sure your spouse is not strapped with debt if you die you is a good example. In fact, on the rare occasion I have agreed to be the guardian of someone’s kids if the parents die, I have required them to maintain term insurance. I don’t want to be stuck raising someone’s kids with no funding.

    If there is a genuine need for insurance . . . insure with “term” and dump it when the need is gone. If you want to “invest”, there are far better tools at your disposal than life insurance.

    Again, nice post.

  2. You’ve left out a number of important pieces of the puzzle. Allow me to clarify:
    1) the gains (and subsequent sale) of the cash value of insurance is tax free. So comparing “apples-to-apples” needs to have an adequate explanation between the differences between “after tax” and “tax free” values. Something akin to a regular investment account vs. Roth IRA. You’d tolerate a lower ROI on a Roth since it’s tax free.
    2) You’re only comparing your results to Whole Life insurance. WL is an antiquated product no longer really sold by any real insurance professional. There is a lot of misinformation out in the insurance world regarding different insurance products, and quite often the most misused product is variable life. Compare your results to VL or compare your WL results to an portfolio of index bonds.
    3) All insurance pays commissions. Term insurance also pays commissions in excess of the first year’s premium. That’s just how it is. There have been recent innovations in the insurance world and commission free insurance is slowly beginning to appear.
    4) You mention that “as the cash value increases, the risk to the insurance co decreases…” You fail to mention that this also decreases the cost of insurance since you’re buying less coverage, too.
    5) You say “we have insurance for the mortgage, etc. that’s it.” Not true. Insurance has many applications in charitable giving, estate planning, income tax reduction, and so on. To merely assume that insurance is a “one-size-fits-all” is a half-baked idea at best.
    I’m not an insurance salesperson or anything like it, but I know a bit about the financial world. I don’t know what’s right for you and your family, but I can assure you that the words “always” and “never” rarely work in the real world of finance.

    • Thanks for the comments James, I’ll do my best to address them and clarify some of my points.

      1. I’ve asked all of the agents who have attempted to sell me these policies this exact question and the answer has always been that the gains on cash value policies are taxable if you take them out prior to death. The contract I used for comparison specifically states that the cash value grows tax-deferred (not tax-free). If you die then the insurance value paid to the beneficiary is income tax-free.

      Since both options involved after-tax dollars and I’m comparing to a Roth IRA, this is a disadvantage when compared to a Roth IRA for investing, not an advantage. The gains on Roth IRAs are not taxed. If you can point me to something that clearly says gains on a life insurance policy used as an investment are not taxable I will revise this post.

      2. I should have been more clear on my use of the term “Whole Life”. I mainly used it because it is one of the more common terms I’ve seen used and figured people would be more familiar with it. I will revise the post to clarify this. Regardless of the specific type, the example I used has a projected dividend of 8%, which is what it has averaged over the last 30 years or so according to the agent who prepared it. 8% is before the fees and other costs are subtracted, which ended up yielding around 5.5% when used as an investment.

      3. I realize that all insurance pays commission and I have no problem with it, I don’t expect anyone to work for free. That said, 100% of the first year’s premium of $10,000 is completely different than 100% of $330. Any other investment account where 100% of the first year of my contributions are handed over to the person who set it up would be considered obscene. I asked the agent who set up my current term policy and his commission is about 50% of the premium per year. For a 20 year term that works out to $3300 total, far less than $10,000. I don’t know if the cash value policy commissions drop off to nothing or level off to be closer to the term rates, but either way the total commissions are far greater than for term.

      4. You’re correct in this. This is why the policies become “paid up” after a while and you can stop contributing to them. My concern, however, is not the specific cost of insurance but the amount that my spouse receives if I die. I believe I’ve shown buying term and investing still has the advantage in this, let me know if you disagree.

      5. What I meant was that we have insurance to cover the remaining mortgage and provide some passive income for my family to supplement what I would have otherwise been earning. I know that other people use it for other purposes, but I don’t understand the reasoning many use. Why somebody would use an insurance policy that ends up being worth 1/3 what the money would have otherwise been worth when reasonably invested to save on income or estate tax is beyond me. I’d rather have 40% of $2 million taken away from my estate than 0% of $550 thousand.

      Thanks again for reading and commenting, let me know if I need to clarify any more.

  3. I love the comment about not being able to fool an engineer on numbers. I’m an engineer myself and regret to admit that I bought into the hype a couple of years ago and was convinced by a very slick salesman to buy a permanent life insurance policy from Northwestern Mutual. Over the first few months after I bought it, I kept trying to make sense of the numbers he was giving me. I couldn’t do it. I finally cancelled the policy after 6 months of premiums. There were multiple reasons that helped me come to my decision.

    1) I didn’t fully understand what I was investing in. I have my suspicions now that the numbers and figures they convince people with are a bunch of smoke and mirrors. In other words, you confuse people on the numbers but make the returns seem great with a bunch of nifty comparison charts and graphs.

    2) I had concerns about access to my money depending on my age. With a Roth, I can take my contributions out at any time without penalty. With permanent life insurance, I would have to take out a loan against my policy. Seemed fishy.

    3) I was really only in it for the investment portion. I realize now this should have been an immediate red flag for me. All I can say now is hindsight’s 20/20.

    4) Because of #3, I noticed that I didn’t even break even until about the 10th or 12th year of paying premiums whilst my investments in a Roth could have been generating 10% interest per year on average for those 10 years.

    5) The safe investment argument didn’t hold any water with me because I was 23 at the time with at least 30-40 working years ahead of me. Anybody who has looked at the historical performance of the stock market can tell you that investing in stocks is a very safe investment given 30-40 years to invest. Just invest in an S&P 500 index fund and watch those returns pile up over the long period of time.

    Thanks for your post. It’s nice to see the stark difference in the investment performance. I’m glad I finally saw the light.

    • The only number I was able to make sense of was the commissions they receive, around the first year’s premium. Just another reason it’s a bad investment, the first year goes straight to the salesperson. If I were in their position I would find it hard not to do the same, and in most cases it’s easy because people trust the “financial professional.”

      Glad you found it helpful.

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