It feels like the cost of whole life insurance vs buy term and invest the difference debate has been done to death, but... look over the landscape.
A complete breakdown of the actual costs of both strategies over a long period of time. By "cost", I mean the total costs associated with mortality and expense, not just commissions paid to agents, fees paid to financial advisors, or worse... a perfunctory glance at the difference in premiums. Premiums do not represent just costs. Premiums include amounts set aside for cash reserves (even for term insurance) and, sometimes, they can hide certain costs. This makes some options appear better (or worse) than they really are.
OK, let's get into it.
Summary: Cost Of Whole Life Insurance vs. Term Insurance Costs + Investment Fees
Summary: Cost Of Whole Life Insurance
I found the lifetime cost of a whole life policy (76 years in this analysis) was $2,765,390.50. This includes a calculation of the full mortality and expense charges of the policy, which includes commissions paid to the life insurance agent.
I also looked at a more narrow, "real world", scenario where a policyholder chooses between buying a whole life policy and paying premiums for 30 years versus buying a 30-year level term and investing the difference for the same period of time.
Let's be real. This is what most people will do.
Mortality and expense (M&E) charges for 30 years totaled $209,092.16, before adjusting for M&E credits. Commissions paid to the insurance agent (which are included in M&E) totaled between $17,815.42 and $28,453.52, depending on the commission structure for the insurance agent. Life insurance agents get paid different amounts, based on their contract with the issuing life insurer or their general agent. In general, new life insurance agents get paid less than seasoned insurance agents.
Summary: Cost Of Term Life Insurance + Investment Fees
I shopped multiple insurance companies and found the total lifetime costs (76 years) for term and investing fees to be between $5,093,306.09 and $10,450,740.64, depending on the rate of return earned and the fees charged, a significant sum compared to the whole life policy.
The cost for term and the fees paid to a plan administrator or financial planner for a buy term and invest the difference plan over the same 30 years ranged between $186,274.92 and $307,113.01. The large discrepancy is the result of the large difference in both assumed rate of return and the fee structures of financial planners. Higher rates of return result in more investment management fees being paid on larger account balances.
Total commissions paid to the life insurance agent + investment fees (which will be slightly lower than the total premiums + investment management fees) were between $89,324.73 and $213,107.73.
Although this analysis showed whole life was mostly (but not always) cheaper than an equivalent buy term, invest the difference strategy, this doesn't necessarily mean a whole life policy is better than investing or buying a term policy, as I'll explain later. But as far as cost is concerned, whole life tends to be cheaper in every instance except when a 4% return assumption is used and taxes are excluded from the cost analysis.
Basic Assumptions And Limitations Of This Analysis
What's an analysis without assumptions?
Every analysis has to make some basic assumptions. Problem is, the way these kinds of analyses are usually done leaves much to be desired.
Here's what I mean: usually, life insurance agents and financial planners will explain the costs of whole life policies in simplistic terms—quoting the premiums for each. Since whole life premiums are always higher than term premiums, the assumption is the cost for a whole life policy must be higher.
This is a non-sequitur.
Premiums for whole life are higher than for term because a large portion of the premium must be set aside for the cash value of the policy. A term policy has no cash value. This is why "invest the difference" looks at investing the money saved by not buying a whole life policy.
If you want a good sense for how much each strategy costs, look at the total costs for both strategies over a long period of time. "Cost" means embedded costs in the policy, which includes not just commissions paid to the life insurance agent but also the actual mortality and other policy expenses (i.e. M&E).
This is not nearly as easy to do as a perfunctory glance at the premiums, but it's far more accurate.
For whole life, I reverse engineer the mortality and expense charges of the policy using the known premium, cash value, and compounding rate (i.e. the dividend rate)—a little trick I learned from my fellow insurance agent, Brian Fechtel. I then isolate and add back in the mortality and expense credits from the insurance company.
For buy term and invest the difference, I look at the term premium and commissions earned, plus the investment fees associated with investing in a tax-favored investment account, which includes fees you will typically find inside a 401(k) or other retirement plan as well as fees a financial planner might charge you to manage your investments. The calculation of these fees is based on the latest research available from the Investment Company Institute, 401(k) Averages Book, 23rd Edition, and data compiled by AdvisoryHQ.
I compiled the data, and did this analysis, so you could get an idea of how pricing for life insurance and investments work, and get a sense for the relative costs of each. This is not meant to be financial, tax, legal, or insurance advice. Just an informational analysis. All life insurance numbers (i.e. tabular values, illustrations) were obtained using quoting software commonly available to licensed life insurance agents, so the numbers are accurate insofar as the illustrations go.
Even so, there are some limitations to this kind of analysis. Here are the big ones:
- This analysis looks at only one age, gender, risk rating, and policy type. Policy type and design by the life insurance agent can affect a policy's internal costs. It also assumes the dividend rate for whole life remains level.
- In my almost 20 years of doing this, I've never seen dividend rates stay flat. They will vary greatly depending on the bond holdings of the company, current interest rates, profitability from supplemental lines of business, and several factors that are outside the scope of this analysis. Even in a falling rate environment, I've seen insurers raise dividends. So... a flat dividend rate is unlikely to occur for decades at a time. In a rising interest rate environment, dividend rates do tend to rise. In a falling rate environment, dividend rates do tend to fall. Though, dividends can and do fluctuate up and down contra interest rates.
This will affect the overall costs of a whole life policy. Cost of insurance is also highly sensitive to age, gender, and risk rating, so it's very possible a different age, gender, or risk rating will show radically different results.
For example, coverage for a 45 year old (both term and whole life) will be more expensive than for younger ages. Likewise, the cost for coverage would be higher for older ages. Also, males pay more (sometimes, substantiallymore) than females, which would alter the results (possibly significantly). If dividend rates rise from the initial projected rate, it can reduce the illustrated costs of the policy. The reverse is also true. Finally, a preferred, or better, rating will dramatically reduce the cost of insurance (especially for whole life).
- In this analysis, I used a flat-fee assumption for investment fees, which understates the fees charged for investment management, particularly for professionally-managed investments. In reality, fees are higher (sometimes substantially higher) for smaller portfolio amounts, with fees increasing and decreasing at various portfolio sizes. I assumed a lower overall fee structure rather than using different fees at various portfolio sizes.
- Commissions can vary greatly depending on the actual commission structure of the agent, the insurance company, and the product itself. This won't affect the total costs of the policy shown in this analysis (since commissions are inclusive of the total M&E), but a different commission rate might make the commissions look higher or lower than illustrated in this analysis. For example, one insurance company might pay life insurance agents a lower or higher commission than another, even for the same product. The insurance company might have different "tiers" or grid systems it uses to pay insurance agents based on personal production or sales performance.
- Taxes are not included in this cost analysis. Taxes will tend to increase the cost of the buy term and invest the different strategy only if or when the investment is "cashed out" and spent. In contrast, a whole life policy offers a couple of different options to use the cash value but avoid taxes. Since this analysis did not include a "spend down" of the investment or cash value, these costs were omitted.
Life Insurance Policy + Investment Assumptions
Here are some basic assumptions I made when assembling the insurance quotes and investment data:
- Insurance is on a male, age 45, standard, non-smoker buying a $1 million life insurance policy. For the whole life illustration, I use a term blend and paid-up additions rider to fund the policy with the required premium.
- I shopped multiple companies for term quotes using CompuLife®, a trusted quoting service/software that many agents use. I also obtained term quotes from the major mutual carriers, including Penn Mutual, MassMutual, and The Guardian. For whole life, I compared quotes and prepared illustrations from MassMutual, The Guardian, and Penn Mutual.
- Unless otherwise stated, all premiums are paid annually and all investment contributions are received at the beginning of the year, in full.
- Commissions are based on a percentage of annual premiums paid rather than a payment grid or any of the other commission structures available to agents.
- Investment assumptions for "buy term and invest the difference" use a 4%, 6%, and 8% compounding rate.
- Investment fees will be based on data obtained from the 2022 Investment Company Institute report on 401(k) fees and the 23rd edition of the 401(k) Averages Book. For self-managed tax-advantaged retirement accounts, I assume the average "all in" (mutual fund + admin) fee for large plans equal to 0.88% of account assets annually. For professionally-managed investments, I assume a median expense ratio of 0.33% and a 1.02% AUM fee.
- This analysis will show the full cost for carrying term to maximum insurable age (94), as well as costs for investing to age 121 to match the whole life policy illustration. Most people who buy term and invest the difference will purchase (at most) a 30 year term insurance policy, then drop the term, so I also show the costs associated with this scenario.
How Much Life Insurance Costs
Let's get this out of the way first.
The cost of insurance always increases over time, regardless of the type of policy you buy. Older = higher risk of death, and thus, higher mortality costs which translates into a higher premium for the coverage.
All policies are built on the 1-year annually renewable/yearly renewable term life chassis. This means when you buy a 1-year renewable policy, you pay the premium for one year's worth of insurance. The following year, the insurer renews your policy at a new rate that reflects your new (older) age and you pay the premium for that year's worth of coverage. Each year you renew your policy, the premium (and cost) of the policy increases until you get mad and quit.
The only real difference between level term and whole life is how the insurance company chooses to levelize the premium, and what other benefits or bells and whistles the company wants to add to the policy. Policies with lots of benefits have a higher premium than policies with fewer benefits.
Annual Cost For An Annually-Renewable Term Policy
Here's what the annual costs look like for an annually-renewable (also called "yearly renewable") term insurance policy (45 yr-old male, std, non-smoker):
For this particular policy, the first year non-guaranteed premium is $1,530. The premium rises each year until the 50th year, when the annual premium is $335,240. However, the annual premiums could be much higher. If the current assumptions change, the 50th-year guaranteed premium could be $485,080.
Cumulative Costs For An Annually-Renewable Term Policy
Cumulative costs for this annually-renewable policy over 30 years is $655,790. The cumulative lifetime total cost over 50 years is $4,092,260, but these premiums could be higher under the guaranteed assumptions, up to $5,930,610.
Costs For 30-Year Level Term + Annually Renewable Policy
Many (but not all) people drop their term policy after 30 years because the cost skyrockets. But to give a true "apples to apples" comparison, I looked at the total costs for term. Even 30-year level term gets expensive after a while (click image to enlarge).
Total costs for 30-year level, then yearly renewal thereafter is $7.7 million.
If that sounds like a lot of money, it's because it is. Even a 30-year level term policy with renewal options is going to be expensive. In fact, the 30-year level policy is more expensive than the regular yearly-renewable policy.
Many life insurers break even or lose money on the level premium period in anticipation of policyholders renewing at the (much) higher yearly-renewable rate. Contrary to popular opinion, not everyone drops their policy after 30 years. Insurers have found a significant percentage of policyholders keep paying the increasing cost of the term policy... enough that it's worth it to sell the policy at a loss or break even for the first 30 years. The company simply makes their profit on the back end of the policy when premiums skyrocket.
All other things being equal, the lifetime cost for $1 million of life insurance for a 45 year old male (standard rating) should be between $4 million and $6 million, regardless of the policy type you're buying. This is why life insurers levelize premiums and use their general investment account to "flatten" or "hold down" the rising cost of insurance for policyholders. Trying to pay for the pure cost of insurance each year is insanity.
Levelized premium payments allow the insurance company to collect more than the cost of insurance in the early years of the policy. The higher premium paid in the early years of the policy is invested, and a portion of the investment earnings is used to pay for the rising insurance costs. In essence, the insurance company overcharges the policyholder in the early years of the policy so they can undercharge them later.
This is true of all level term policies, universal life, and whole life policies sold in the U.S., with the primary difference being how much more the insurer collects from the policyholder to invest.
With term, the insurer collects just a little bit more, and keeps any overage that's left over when the policy expires.
With universal life and whole life, the insurer returns the excess to the policyholder through the cash value of the policy. Something else happens in a whole life policy and some forms of universal life, too. The cash value of the policy becomes the reserve used to pay for the future death benefit, so the pure insurance component of the policy is reduced as cash value increases. This reduction in the pure insurance amount effectively lowers the total cost of insurance, especially over very long periods of time.
Whole Life Insurance Commissions
Yay! Everyone's favorite topic.
Here's the breakdown on how much life insurance agents get paid on whole life (click image to enlarge):
Whole life is sold by either a captive or independent agent. However, most whole life is sold by captive agents (though, some independent agents do get direct appointments with insurers or work through general agents to get access to whole life carriers).
Life insurance agents typically earn a commission based on the first year premium amount as well as premiums paid in subsequent years. The exact commission earned will depend on the agent's compensation plan.
A captive agent will work exclusively for one insurance company, and will have compensation tied into his salary, which might include other company benefits, like a retirement plan, disability coverage, and other benefits. An independent agent, however, typically doesn't get company benefits since they don't work directly for an insurer. Instead, the independent agent might represent multiple different insurance agencies, and receives compensation from either the insurer directly or from a general agent associated with the insurer. The compensation may only include basic "street comp", or it might include "street comp" plus an override (additional money paid to the agent to offset marketing and other costs).
Regardless, both types of agents sell insurance on commission.
A captive agent might earn more or less than an independent agent, depending on the policy, and whether the insurance carrier bases the commission off of a target premium, a special payment grid, or as a percentage of the base premium + overrides.
This commission structure assumes commissions are paid based on a percentage of the first year's premium, plus overrides and renewal commissions in years 2+
However, notice the first year commission (FYC) is much higher than in subsequent years. This is called a "heaped" commission. The commission percentage in the first year is high, then drops off for the renewal commissions earned in years 2+.
The total commissions paid to the life insurance agent over 30 years might vary between $17,815.42 for insurance agents earning "street comp" (the lowest commission tier) and $33,722.05 for insurance agents earning a high override on all base premiums.
Annual And Total Lifetime Costs For A Whole Life Policy (Cumulative M&E)
Summary Of Costs
- 76-year (gross) cost: $2,858,129.50
- 76-year (net) cost: $2,765,390.50
- 30-year (gross) cost: $229,391.16
- 30-year (net) cost: $209,092.16
Annual M&E is laid out in the following chart (click image to enlarge):
See how expenses start high, then fall, then rise again into the stratosphere? This is the normal trajectory for these costs, which is why levelizing premiums and doing a good job managing the general investment account at the insurer is so important.
Here is a breakdown of the annual costs by the numbers, as well as the lifetime and 30-year totals (click image to enlarge):
Mortality and expenses for this policy were calculated based on the following formula:
Annual Illustrated Costs = (Prior Year-End Cash-Value + Current Premium Paid) - (Current Year-End Cash-Value / (1 + Illustration's Compounding Rate))
This formula essentially reverse engineers the internal costs of the policy. Then, dividend credits were added back in.
Why were dividend credits added back in?
Well, virtually all whole life insurance dividends incorporate 3 factors.
The 3-Factor Dividend Model
- Morality savings
- Expense savings
- Investment gain
The column titled "M&E credits from dividend scale" refers to the portion of the annual dividend that represents mortality and expense savings (Factors #1, and #2). I was able to strip out the investment component of the dividend scale using the insurer's illustration software and show only the part of the dividend representing M&E credits. These credits are essentially a refund of expenses to the policyholder, which lowers the cost of insurance.
The first year's cost is fairly close to the first year's premium. This is to be expected since the first few years expenses are very large. The capital reserve must be established, plus insurance agent commissions paid, and so on. Although I don't discuss cash value growth in this analysis, I do want to mention here that these costs are irrespective of the cash value buildup. Some policies with this cost structure have little to no cash value buildup in the first year, while others have high first-year cash surrender value. This particular policy had high early-year cash values.
BUY TERM AND INVEST THE DIFFERENCE 30-year and TOTAL COSTS
LIFETIME COSTS FOR TERM LIFE INSURANCE + INVESTMENTS
Summary Of Costs
- 76-year cost: Between $5,093,306.09 and $10,450,740.64, depending on the rate of return earned and the fees charged
- 30-year cost: Between $186,274.92 and $307,113.01
- Commissions and fees paid to life insurance agents and advisors: Between $89,324.73 and $213,107.73
For term policies, this is relatively straightforward. The cost is the premium. The insurance agent earns a commission on the sale of term insurance, which is a percentage of the premium. The following illustration shows the "all in" costs for 76 years (a lifetime for a 45 year old) of term plus the fees for investing at various growth rates and fee/AUM percentages.
The first 30 years of the term policy are level premium years. After the level premium period is over, the policy automatically switches to yearly-renewable, which tops out after 50 years, and terminates (the policyholder is no longer insurable). The investment fees continue for the rest of the policyholder's life to age 121.
This long time period was used to match the whole life policy illustration (click image to enlarge).
30-Year Cost For Term Insurance + Investments
Many (but not all) policyholders cancel their 30-year term once the level premium period ends, so it's helpful to see what those costs look like, too. The above graph shows how the cost remains somewhat modest for the first 30 years, then explodes upwards. The following tabular illustration shows the combined 30-year cost and 76-year cost for term life insurance plus the fees for a hypothetical investment at various growth rates and fee/AUM percentages. The 30-year cumulative total cost is between $186,278.52 and $307,116.61 and depends on the assumed growth rate and fees charged for the investment management.
30-Year And Lifetime Total Costs For Term Life Insurance And Investment Fees
(click image to enlarge)
Term Commissions And Investment Management Fees Paid To Life Insurance Agents And Financial Advisors
A common belief is that commissions on term life insurance and investment management fees are not just less, but much less, than commissions paid on a whole life policy. It is also assumed the high commission rates paid on whole life negatively influence the advice given to clients, with the conclusion being clients should always (or mostly) be advised to buy low-cost term insurance and "invest the difference".
The basis for this recommendation largely hinges on the cost argument.
This believe is so widespread, few even question it, much less investigate the origin of this claim. The following illustration shows the 30-year cumulative cost for term insurance and investment management, assuming different growth rates and fee structures (click image to enlarge).
Commissions were calculated using a standard BGA (Broker General Agent) contract. Fees were determined using the latest research and data from the Investment Company Institute, 401(k) Averages Book (23rd Edition), and data compiled by AdvisoryHQ.
Commissions and fees vary, but are substantial, even on the low end. In most cases, the cost of whole life insurance is lower than the cost for an equivalent "buy term, invest the difference" strategy for a 45-year old male. Younger ages result in even lower costs for all types of life insurance. Investment management fees are not impacted by age, but rather by duration of the investment (time horizon) and the size of the portfolio.
Assuming the national average "all in" fee (0.88%) for tax-qualified investment accounts (which includes a low-cost mutual fund), fees for "buy term and invest the difference" should be roughly $90,000 over 30 years.
The investment fees alone were roughly $87,000 on the low end, with term insurance commissions ranging between $2,316 and $5,261.
Final Thoughts About The Cost Of Life Insurance vs Investing
Life insurance and investing serve two different purposes.
Even within the life insurance product category, different types of life insurance serve different purposes. Some life insurance agents like to say that life insurance only serves one purpose: to protect those you leave behind.
This is a convenient narrative to sell term policies, which is fine. That's what term is for—to protect those you leave behind. It's simple life insurance. That's just what it is.
But permanent life insurance serves different purposes. For example, a whole life policy can be set up to provide a death benefit, supplemental savings (via the cash value of the policy), a dedicated line of credit you own and control (via the cash value of the policy), disability benefits, chronic, critical, and terminal illness benefits (i.e. an advancement of the death benefit for various permanent illnesses), and even long-term care insurance (which is similar to health insurance, except that it explicitly pays for long-term care, and other related, expenses which are not covered by normal health insurance policies).
Basically, permanent insurance can be set up to protect you from a variety of different financial risks instead of just one. And since the policy is permanent, it lasts your entire life and cannot be taken away from you.
The cost of life insurance coverage for both is high, but understandably so. Providing an insurance guarantee in the event of death costs money—a lot of money.
Regardless, investments cannot replicate this function.
Likewise, investments serve an important wealth-building function. They cannot replace life insurance, but life insurance also cannot replace investments. Ideally, your policies should protect your income and savings, and give you a solid foundation to build wealth. Your investments should augment your wealth-building ability, whether that's an investment in a business you own or someone else's business (i.e. stocks), or some other investment altogether (bonds, real estate, gold, etc.).
Insurance agents and financial planners (and really, the entire insurance industry) would be better off figuring out how to incorporate investments and life insurance in the same financial plan, rather than pitting one against the other. For decades, both the investment and insurance industry have spent valuable resources tearing each other down.
Investment advisors and financial planners accuse both captive agents and independent agents of selling life insurance products (particularly whole life insurance) that are harmful to consumers. Insurance agents, meanwhile, accuse investment advisors of misleading clients about the returns possible with more speculative investments, and potentially losing their client's money when an investment goes sideways.
Life insurance companies seem to straddle this issue, by owning both traditional life insurance businesses, and brokerage firms, each simultaneously publishing "hit pieces" about the other side of the business.
Honestly, none of this is necessary.
A big part of this battle has been over the costs associated with each strategy. While I did not cover every possible iteration of investing, term, and whole life insurance here, there's enough information here for you to understand the general principle and relative cost of each strategy.
While life insurance products tend to be very expensive over the long-term, whole life is, surprisingly, cheaper in the majority of cases compared to a "buy term and invest the difference" strategy. That doesn't mean you shouldn't invest your money. It means if you want to use life insurance as a "shield" for your investments, or if there are other reasons you want to remain insured for your entire life, then whole life insurance is (by far) the lower-cost option compared to term.
Of course, cost alone is not the sole reason to buy or avoid a particular financial product or to adopt or avoid a particular financial strategy. It's merely one piece of the puzzle.