Permanent Life Insurance is one of my least favorite financial products. It’s an unnecessarily complicated and horribly expensive product that is inappropriate 99% of the time. These policies almost never make financial sense for the consumer.
The gold standard of life insurance is term insurance. With a term policy you receive a death benefit over a specified time frame such as 20 years and pay a relatively low, fixed premium. For anyone who actually needs life insurance (e.g. parents accumulating wealth), term insurance provides a simple, inexpensive way to ensure they’ve taken care of their family or met their needs.
But selling a product that is simple and inexpensive isn’t very lucrative. Enter permanent life insurance! Permanent life insurance crams together an insurance product with a sort of investment vehicle, creating a frankenstein of high fees and complexity with sub par investment returns and inferior insurance. It’s a salesman’s best friend. Insurance agents typically get paid a commission on permanent life insurance equal to 30-90% of the premium during the first year they sell the policy. The agent then usually gets a renewal commission of 2-5% of the premiums after the initial year.
Think about how ludicrous those commissions are in the context of an investing vehicle. What if you paid similar fees on a 401(K) plan? Would you like to pay a custodian like Charles Schwab 30-90% of your 401(K) contributions the first year you contribute to a retirement plan and then deduct 2-5% of your contributions from then on? And that’s just for the agent! That commission doesn’t even cover the hefty fees that the insurance company collects. And have no doubts the insurance company will get their hefty fees – there is a reason they encourage their salesmen to push permanent life insurance products!
Types of Permanent Life Insurance
Whole life insurance– Whole life insurance combines a permanent death benefit with a cash value that typically grows at a low fixed rate (e.g. 4% at Massmutual). The premiums for a whole life policy are fixed for life (although the amount that goes to insurance policy vs the cash value can fluctuate). The one benefit of this type of plan is that the cash value growth is tax deferred just like in a retirement account. You can also take a loan against the cash value in your account without paying taxes, although rates on this borrowing are usually high.
Universal Life Insurance – Universal life insurance premiums and death benefits can be adjusted over time. The growth rate with universal life insurance is usually benchmarked against a set of mutual funds and thus has higher return potential than whole life policies. To make these policies more attractive the companies often put a floor under the investment growth as well to seemingly offer downside protection to those with lower risk tolerances.
Cash Value is Misleading and Earns Inferior Investment Returns
The cash value part of permanent life insurance policies is usually sold as an investment that will help you build wealth. But I think that’s highly misleading. First of all, thanks to the tremendously high fees and punitive policies on most insurance plans, you generally won’t build any cash value that you can touch the first 3-5 years of your policy. Even if you have a stated cash value inside your policy, if you surrender the policy in the first five years in an attempt to access that cash, you’ll find that with the surrender fees you don’t have any money you can withdraw.
Also, the cash value inside your plan belongs to the insurance company, not you. Any withdrawals you make from your cash value reduce your death benefit amount. When you pass away, the insurance company keeps the cash value of your plan. Your beneficiaries get nothing from your cash value. They only get the death benefit on the insurance, not the cash value of the supposed ‘investment’ you were pitched.
Also, the growth of your ‘investment’ is always lower than what any reasonably managed portfolio would earn. As the White Coat Investor points out, “The poor returns on whole life are heavily front-loaded. Most policies won’t even break even for 10-15 years and due to surrender fees, you may not even get anything you paid back on a policy you surrender after just 3-4 years.”
With your cash value you are an unsecured creditor of the insurance company. If the insurance company makes bad investments or otherwise runs into trouble, they might not be able to pay you. Most insurance companies are highly regulated and are rated in the middle of investment grade credit with an A rating, a couple notches away from the highest rating of AAA but a couple notches from junk bond status (BB). While it may not seem like a major risk, I think some insurance companies are essentially providing you with bond-like returns (or lower) while taking equity-like risk for themselves. Heads they win, tails you lose. If the insurance company does poorly in the market, they might have trouble paying you in the future. If they do well, you would’ve been much better off just investing in the market yourself.
But surely ____ agent I know is a good guy and wouldn’t sell me a bad product, right? Right?!
“Never, ever, think about something else when you should be thinking about the power of incentives.” Charlie Munger
I’m sure your nephew/friend/whoever fresh out of school has great intentions. The problem is that if they work for a company that sells insurance then you can be assured that virtually all of their training is in sales, not financial planning. They have no fiduciary duty. Their company is pounding into them the idea that these policies are great for consumers. It often takes a few years for them to become disenchanted and look under the hood and realize what a bad deal these products are. Plus, it’s nearly impossible to make it as a new agent without the commissions of these products.
“But my agent told me he/she owns this very same policy!” It’s not hard to see the pressure a new hire gets to put their own money in the company’s products, especially when they’re encouraged to do so by seemingly more experienced and successful people above them. Just because someone persuaded them to put their money into this product doesn’t make it appropriate for you.
Does Permanent Life Insurance Ever Make Sense?
There are only a couple niche circumstances in which Permanent Life Insurance is actually appropriate. Because the death benefit is tax free, guaranteed universal life is sometimes a viable estate planning tool for the ultra wealthy with taxable estates. It can also help with very illiquid estates and in some business scenarios.
Permanent life insurance virtually never makes sense. Unless you’re thinking about using it as part of your estate plan and have discussed it with your advisor/CPA/estate attorney then you should not even consider it.
Scott Caufield, CFA, CPA