When discussing life insurance with our clients, one of the most common questions we hear is “Should I buy a term policy, or a whole life policy?” The question certainly isn’t confined to walls of our conference room. The “term versus whole” debate is a hotly contested topic, with many insurance agents, financial advisors, and consumer advocates taking extreme positions one way or another. At one point, proponents of whole life referred to insurance agents who only sold term insurance as “termites,” and the termites referred to the cash value component of whole life policies as “trash value.” Who knew insurance could be such a divisive topic? As a fee-only financial planner who doesn’t sell insurance, here’s how I see it.
Term and Whole Life Insurance Policy Characteristics
For those of you who need a quick reminder of the characteristics of life insurance products, I’ll provide a very brief summary. Term life insurance is a type of product that provides a death benefit over the life – or “term” – of the policy. A 25-year $500,000 term policy purchased by a 35-year-old would pay a $500,000 death benefit if the insured dies before he is 60 (25 years later). When the client is 61 and the policy expires, there is no longer a death benefit.
Whole life insurance is very different, and it’s more complicated. Whole life has an insurance component, but it’s usually permanent. So, if the 35-year-old in my previous example doesn’t die until he’s 70, that term policy won’t pay him a dime, but if he had purchased a whole life policy instead, it would pay a death benefit. Whole life policies also have a savings component called the cash value. For example, when our 35-year-old is 45 years old, that $500,000 policy might have a $500,000 death benefit (which can actually grow to be larger depending on the policy, the insurance company, and other factors), but it might also have a cash value of, let’s say, $75,000. The cash value can be borrowed against during life, so some insurance agents sell it as a retirement savings option.
Given the information above, it’s obvious why some people gravitate towards whole life policies. The policy owners feel like their premiums aren’t going to waste. They know that eventually they’ll recover some of their cost of the insurance, unlike their counterparts who only buy term policies and then don’t die until after the policies expire. However, the debate isn’t that simple because we haven’t yet considered the cost of the two types of policies.
Term and Whole Life Insurance Policy Costs
Whole life policies can be expensive. Depending on the person’s age, health conditions, and many other factors, whole life policies can be anywhere from 4x to 20x more expensive than term policies. To illustrate my point, I got some actual quotes from AccuQuote, an online insurance brokerage. For our 35-year-old friend in our example above, he could get a $500,000 25-year term policy for $357 per year, but a whole life policy would cost him $7,004 per year.
Savings Growth Rates
If our friend can afford to pay seven grand a year for insurance, he’s in a pretty good spot. Most people purchasing insurance for the first time aren’t in that position. However, there are other options that he could consider with that kind of money. He could (not necessarily should) buy the $500,000 term policy for $357 per year, and then invest $6,647 per year in an investment vehicle that has a higher expected return than the cash value of the whole life policy. The chart below shows what might happen in a few different scenarios.
The blue line represents the cash value of a $500,000 whole life policy if it grows at a rate of 1.47%, which is the implied guaranteed rate of the policy that I looked at from AccuQuote. The cash value grows to about $260,000 by age 65, and $583,000 by age 90. Keep in mind that the whole life policy also has a death benefit which isn’t shown in the chart above. Depending on the policy, it could grow from $500,000 and be greater than the cash value, but the chart is primarily meant to compare the savings components of the different strategies.
Then there is the orange line, which is a different way to calculate the cash value on the $500,000 policy, and accounts for the fact that many insurance companies pay dividends that help grow cash values. They aren’t guaranteed, but they’re common. When insurance companies pay dividends, a growth rate of about 3.5% might be expected (but not guaranteed). You can see in the chart that the cash value grows to about $360,000 by age 65, and more than $1.1 million by age 90.
Finally, there is the grey line, which represents what happens when our friend invested $6,647 per year – the difference between the cost of the term policy and whole life policy. I assumed a growth rate of 6.5% until he retires, which might correspond with a stock-heavy portfolio, and then I reduced the growth rate to 5.75% at age 65 to account for the fact that most retirees reduce the risk in their portfolios compared to when they were employed. With those theoretical rates of return, the account would be worth $574,000 more by age 65, and more than $2.6 million by age 90.
It’s important to note that investing in something that earns 6.5% is probably way riskier than a whole life policy, because it probably is heavy in stocks, which are by no means a guaranteed investment, whereas the whole life policy has a modest guaranteed cash value. The reason is I used 6.5% is not because the risk is the same as the whole life policy, it’s because many 35-year-olds are investing in the stock market within their 401(k)s or IRAs.
In reality, the cash value of the whole life policies above likely won’t grow as quickly as the chart illustrates. During the first few years of the policy, much of the premiums paid goes toward the insurance agent’s commission; it doesn’t help grow the cash value of the policy. It’s hard to know how much of the premium goes towards a commission, because the policy documents don’t disclose the amount, and agents typically aren’t required to tell you. With that said, many professionals in the industry believe that commissions can be between 80% and 120% of the first year’s premium, and then they are reduced as time passes. Insurance companies are actually underwater during the first year, so if the insured cancels the policy in the first year, often times agents will be required to pay back the commission they received to the insurance company.
Let’s get back to the growth of the account, though, and summarize the differences. The term policy alone provided enough insurance coverage, and it was inexpensive. The whole life policy was expensive, it provided the coverage needed, and it provided some savings. The term policy plus investing was the same cost as the whole life policy, it provided the same death benefit (but only until age 65), yet it provided $1.5 million more than the whole life policy by age 90.
The main counterpoint that you’ll hear from many insurance agents to this idea of “buy term and invest the rest” is that people don’t actually go invest that difference. They end up just buying the term policy, and then spending the rest. That’s probably true. But if you’re going to sign up for something that requires you to pay $7,000 per year, consider all of your options.
The Term-Whole Life Hybrid Option
If the $7,000 cost of a $500,000 whole life policy is prohibitive, a solution proposed by some insurance agents is to buy a term policy and supplement it with a whole life policy. For example, purchase a $400,000 term policy that is pretty cheap, and get $100,000 of whole life insurance coverage. It creates somewhat of a hybrid policy, and the premiums will be much lower. On the surface, it sounds like a decent way to get the amount of coverage you need. It’s affordable, and because you have a savings component to your policy, you know you’ll recover some of the cost. Let’s address that option.
I got a quote for a $100,000 whole life policy, and a $400,000 term life policy for that same 35-year old. The whole life policy was $1,308 per year, and the term policy was $308 per year, for a total cost of $1,616. Here’s that that chart looks like.
I won’t get super detailed with explaining this chart since it’s similar to the previous chart. You can see that if you buy a $500k policy and invest the difference (which, coincidentally in this case ended up being exactly $1,000 per year), the investment ends up exceeding the cash value of the whole life policies. The investment balance is smaller than the previous example, because the annual investment is $1,000 instead of more than $6,000. But in the end, investing still ended up being a favorable way to save compared to using an insurance product.
The discussion around whole life often involves the phrase “don’t buy whole life because you probably can’t afford a whole life policy for how much insurance you need.” I don’t like that argument, because it doesn’t get at the heart of the matter, and it implies that if you can afford it, it is better than term insurance. Even if you can afford whole life insurance, term insurance plus investing will often times be a better solution in the long-term.
In my example, it really boils down to a theoretical return of 6.5% compared to theoretical 3.5% return, which have very different levels of risk. It isn’t an apples-to-apples comparison. The bigger question one should be asking when saving for retirement is how much risk they are comfortable with, and then use a type of investment that fits their risk tolerance and time horizon.
Whole life insurance and other forms of permanent insurance do have their place. Whole life does a good job at paying for final expenses, it can be useful for leaving legacies, and it can be a helpful estate planning tool for the ultra-wealthy. But as a retirement savings vehicle, it often falls short of other investment options.
Finally, none of these illustrations take into consideration individual circumstances that would need to be considered before making a final decision, like risk tolerance, net worth, income, other assets, other insurance, and more. It’s important that you talk through your options with an insurance agent, and if you are trying to save for retirement, talk with an advisor or financial planner (preferably one who is fee-only!) to see what would work best for you.
The charts and graphs contained herein should not serve as the sole determining factor for making investment decisions. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, you are encouraged to consult with Flagstone Financial Management. All information, including that used to compile charts, is obtained from sources believed to be reliable, but Flagstone Financial Management does not guarantee its reliability.
The views outlined in this article are those of Flagstone Financial Management and should not be construed as individualized or personalized investment advice. Any economic and/or performance information cited is historical and not indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for a given client or portfolio. Any questions regarding the applicability of any specific issue discussed above should be addressed with Flagstone Financial Management. All information, including that used to compile charts and/or tables, is obtained from sources believed to be reliable, but Flagstone Financial Management does not guarantee its reliability.