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