If you were to die tomorrow, who would suffer financially? This is the planning question you use to decide whether or not you need life insurance.
If the answer is no one, it’s simple. You don’t need life insurance. If the answer is someone – your spouse, children, parents or business partners – you do. When the answer changes from someone to no one, your need for life insurance just went away. So should the policy.
So, let’s suppose, at this point in your life, the answer is still someone. You need life insurance. But what kind of life insurance? Agents are showing you all kinds of exotic, enticing plans that have all kinds of bells and whistles. Should you buy them?
The title of this piece clearly tells you where we, at Snider Advisors, fall on this issue. To be clear, we are comparing permanent insurance, also known as a cash value policy, against term life insurance, for the purpose of providing a death benefit.
I’m not saying that it is never acceptable to purchase a cash value policy. Permanent insurance does make sense for a very small minority of people. A family with a special needs child will need to provide for that child’s care for the rest of his or her life; special needs trusts are typically set up with cash value life insurance policies to accomplish this. Wealthy individuals also utilize cash value life insurance policies to pay their estate taxes, and business owners often need permanent policies for their succession planning. These people are using the product to accomplish a specific goal, which is likely different than yours.
If you need life insurance, your goal is probably much simpler: to leave a check for your dependents in the event you should die. The death benefit that your family needs can be accomplished with term insurance for a pretty darn good value.
For example, a 35-year-old healthy male, who does not use tobacco, will pay about twenty dollars a month, for $1,000,000 of term coverage, for 10 years. A permanent policy premium for the same amount of coverage would be about twenty times that much!
Term insurance is pure risk management. It pays for the cost of insurance during the specified period of coverage. Wasn’t that your goal?
Permanent, or cash-value, insurance policies are meant to be a long-term vehicle that combines insurance with an investment account. A portion of your premium goes towards your insurance coverage, while the rest is directed to a separate savings account.
There are three types of permanent life insurance: whole life, universal life, and variable life. The difference between each of these policies is essentially how the separate savings account is invested.
Whole life is invested very conservatively in cash, money markets, and bonds. Universal life tracks an index, such as the S&P 500, and variable life is invested directly in the stock market. With variable life, the policy owner can self-direct his or her investment choices.
All the “benefits” of permanent, cash value life insurance need to be carefully scrutinized:
In the first three years or so of a permanent policy, the cash value is eaten up by commissions and expenses. Be aware that an insurance agent will receive 50-100% of your first year’s premium.
How about return? James Hunt, actuary for the Consumer Federation of America, who has analyzed thousands of these policies, notes that permanent policies hardly ever yield a reasonable return unless held for twenty years or more. And what exactly is “reasonable?” Be sure you are analyzing the internal rate of return of the policy, which is the return net of fees and expenses.
Most Americans cannot get by with a 4% withdrawal rate. In fact, the vast majority will need a low double-digit yield from their portfolio to sustain thirty or more years of retirement. This would be nearly impossible to accomplish with a permanent life insurance product.
The words “professional management” should scream high fees to the consumer. What are these fees? I can bet it’d be a surprise to the agent, if he or she could find out. These almost never get discussed because they are hidden and blurred in the product.
On top of these fees and the commissions paid to the agent, you will pay surrender charges to get out of the policy. These charges often apply for 10 years or more.
Add inflation to the picture, and it’s easy to see that the investment portion of these policies almost certainly do not match up well to your financial objectives. Moreover, the investment choices in these policies are usually lousy. In our opinion, you are much better off self-directing in an IRA.
Cash value life insurance does come with favorable tax treatment, often called a “turbo-charged Roth IRA” by agents. In theory, it is. You pay the premium with after-tax dollars and the earnings grow tax-deferred; however, the cash value is not always “tax-free” as many agents claim.
If you surrender or cash-in the policy, and the total amount of cash value returned to you is less than the total amount of premiums paid, it is considered a return of principal and is not taxable. If the cash value returned to you is greater than the amount of premiums paid, the amount in excess of premiums paid is considered a “gain” and is taxable as income. If the policy you surrender is considered a Modified Endowment Contract (the company can inform you if it is), cashing-in or borrowing against the cash value may be fully taxable. You should consult a tax advisor if this is the case.
You can take out loans from your cash value tax-free, but agents fail to mention that by doing this, you are greatly increasing the chances that your policy will lapse long before the nice illustration shows, meaning that the coverage you think you have to a certain age will expire unless you pay a higher premium (often prohibitively so). If you do not pay the loan back, it is subtracted from your death benefit.
Don’t forget one other potential tax trap. If you’ve borrowed from the policy and then let it lapse, the investment earnings you’ve withdrawn become taxable. So if you aim to use the policy for income in retirement, you could end up facing a substantial tax bill late in life when the last thing you need is to be shelling out the big bucks to the IRS.
Now, let’s talk about risk. Just because the premiums are invested in short-term money instruments does not mean there is no market risk. There is less market risk than, let’s say, a mutual fund. There is, however, substantial interest rate risk.
If interest rates are high, the cash value of the policy will grow accordingly. However, a low interest rate environment will diminish the cash value of your policy as company fees and insurance coverage costs are applied. If this happens for any prolonged period of time, you run the risk of losing the bulk of your cash value, if not all of it.
Another hidden aspect of cash value life insurance is that if you, the insured, die, the only death benefit your beneficiaries will receive is the face value of the policy.
But what about all that cash value? In most scenarios, the insurance company keeps the cash value to help pay out the death benefit, which wipes out all that hard-earned savings. Some policies specify that beneficiaries will get both the face value and cash value, but it comes with a price.
Now for a word that insurance agents love: guarantees. Most insurance agents only highlight the non-guaranteed illustration showing a return of 8.5% or so. They spend very little time showing the guaranteed illustration because it doesn’t look so hot and would likely kill the sale.
Put bluntly, insurance agents are salespeople. While they are noble in their efforts to protect families in the event of premature death, most permanent life insurance recommendations are more beneficial for the agent, in the form of generous commissions, than they are for you.
In our opinion, cash value life insurance is simply not the most efficient and effective way for you to manage the financial risk, to your family, of your premature death. The truth is the policies almost never work the way they are explained in the sales pitch and you’re much better off following the old saw, “Buy term and invest the difference.”