Why We Dislike Whole Life Insurance
We often see clients who come to us with a whole life insurance policy already in place. This blog will discuss why we dislike whole life policies by discussing the general purpose of insurance, features of term and whole life insurance, and strategies available to you if you want to get out of your whole life policy.
Why own life insurance?
The fundamental purpose of life insurance is to transfer the risk of a potential catastrophe to an insurance company. It is suitable for risks that have a relatively low probability of occurring, but also a high loss severity.
Take a husband and wife with 2 young children as an example. The wife is a stay-at-home mom while the husband provides income for the family. If the husband were to pass away prematurely and without life insurance, likely he would leave his family in a vulnerable financial position. Thus, the need for life insurance on his life is vital.
What type of insurance is best?
Most people easily understand why life insurance is necessary in a scenario like the one described above. However, the type of life insurance to purchase is often overlooked. We believe a term life insurance policy is the best option in most cases.
Term life insurance is offered usually in multiples of 5 years (10 – 30 years). Once that period or “term” is over, the policy expires. The benefit is that because you are only funding the years in which you have a true need for insurance (rather than your entire life), the policy is much less expensive and allows you to get more death benefit for the premiums you pay. All while still serving its intended purpose of transferring the risk of the catastrophe to the insurance company.
What is bad about whole life insurance?
The alternatives to a term policy reflect policies that either:
- Remain in place for the rest of your life (permanent/whole life policies), or
- Offer an investment option in addition to the insurance coverage (variable life policies)
But why are either necessarily bad? Well, with #1, you likely won’t need life insurance for your entire life. In the example above, your children will eventually be on their own and providing for themselves. At that point in time, the downside risk of you passing away prematurely likely would not cripple your spouse financially because your kids no longer rely on your support. Couple that with the fact that you and your spouse likely have accumulated a sizeable net worth by the time your term policy expires which the surviving spouse can use to support him or her.
Addressing #2, why wouldn’t I take an investment feature if it was offered? It only sounds like a benefit if anything, right? Not necessarily. These investment options can become costly as you are paying a higher premium to not only cover the death benefit, but also to start accumulating a “cash value” for the insurance company to invest on your behalf. The cash value, in many cases, has a guaranteed level of growth. But think about that – for the insurance company to guarantee a return on your cash, they must know with a high degree of certainty they will generate a return significantly more than the rate promised to you so they can get paid (they want to make a profit just like any other company!). In essence, your return is capped even when the market is doing really well.
Generally, you can expect it to take 15-20 years before a whole life policy’s cash value will be worth more than the premiums you’ve paid into it. This is because of fees, commissions and other expenses associated with the policy. Additionally, whole life policy premiums can be up to 5-15 times the cost of a comparable term policy’s premium.
Those who sell insurance will say “tax-free growth” is a reason why this investment feature is a good idea for you. While tax-free growth does occur, there are other vehicles that offer that same benefit like retirement vehicles such as IRAs and 401(k)’s – in many cases the retirement vehicles offer the benefit at a lower cost.
Strategies to consider to get out of your whole life policy
A 1035 exchange refers to a provision in the Internal Revenue Code allowing for a tax-free exchange of an existing life insurance policy, annuity contract, or long-term care product for another similar policy. The benefit is that it allows the policy owner to trade one product for another with no tax consequences.
The most common scenario we see where this exchange might make sense is with someone who is just a few years away from retirement. In many cases, their children are on their own and they have accumulated a sizeable net worth to where the surviving spouse does not need the life insurance proceeds to survive at the death of the first spouse. In this scenario, the need for life insurance is not as critical as when they first bought the policy. Executing a 1035 exchange to transfer their whole life policy into a long-term care policy, as an example, may be a good decision given that funding long-term care is a more pressing need than life insurance at this stage of their lives.
On the contrary, if you are younger and just starting your career with an existing whole life policy, you likely still need life insurance (just not whole life). In this case, it may be beneficial for you to surrender your whole life policy. Keep in mind that there could be surrender charges associated with the surrender if it is early in the policy. In a surrender, you, as the policy owner, receive the cash value while giving up the death benefit. If the cash value received is greater than the amount of premiums paid into the policy, the difference is subject to ordinary income tax. In this case though, a term policy is usually much cheaper.
If you have any questions or concerns about your particular situation regarding life insurance, reach out to your advisor to make sure you are covering your bases.