What Is Whole Life Insurance?
Whole life insurance is a financial contract that helps you save money for your future while also providing a death benefit for your heirs when you die. Some whole life policies provide accelerated death benefits which are triggered when you suffer a permanent chronic, critical, or terminal illness. The accelerated death benefit may be used for any reason, including to pay for long-term care expenses.
In principle, whole life insurance acts as a financial hedge against the loss of future income and savings. A loss of income or savings could occur due to injury, illness, job loss, or some other reason. To accomplish this feat, all traditional whole life policies have built-in guarantees which protect you by shifting various kinds of financial risks away from you and onto a life insurance company. For example, the cash value of a whole life policy is guaranteed to grow every year. This cash value can act as a hedge against other bad investments unrelated to your life insurance policy. The death benefit of the policy is also guaranteed for life, allowing you to provide for your spouse or family (or maintain their standard of living) regardless of when you die.
At its core, a whole life policy combines elements of decreasing pure life insurance (called "net amount at risk") and increasing cash value. Together, these two elements form the death benefit of the policy. Like all life insurance policies, the benefits of the policy are provided to the policyholder (policy owner) in exchange for a premium.
With each premium payment, the pure insurance inside the contract decreases, and the cash value increases by an equal amount on a guaranteed basis (causing the net death benefit to remain level). At age 121, the cash value equals the death benefit, and there is no pure insurance left inside the contract.
Here is an example of the relationship between the cash value, the pure life insurance, and the death benefit inside a whole life policy starting with $0 cash value and $100,000 pure life insurance:
Total Death Benefit
As the cash value grows, the pure life insurance amount decreases by an equal amount:
Total Death Benefit
Here is how the relationship between the cash value, the pure life insurance, and the death benefit changes over time as the cash value of the policy increases:
Total Death Benefit
When the policy matures or endows, here is how that relationship looks:
Total Death Benefit
Regardless of when you die, the policy's death benefit is always worth $100,000 in this example. This feature of whole life insurance means that you can make a long-term savings plan, and be assured that you reach your future savings goals, regardless of whether you live or die.
In addition to the basic cash value and pure insurance benefit, some policies can be enhanced (sometimes significantly) with annual dividend payments from the issuing life insurance company, special policy riders, or both.
Sometimes, you'll hear or read that whole life insurance is a "bundled" insurance product. This means the cash value and insurance are "bundled" and inseparable. A policyholder cannot just have the cash value (or death benefit) portion of the policy. The policyholder must have both.
Cash value of a whole life policy is often called the "savings component", and is money that the insurance company must legally and contractually set aside to pay for the future death benefit. While the insured policyholder is alive, the policyholder can use this money. The cash value can be borrowed against for emergencies, major purchases (e.g. cars, computers, vacations, homes), to make any kind of investment in your own business or someone else's (e.g. stocks, bonds, a stake in a privately owned business, etc.), or for any other purpose without restrictions or permission from the insurance company. The policyholder has a contractually guaranteed "first dibs" on the money inside the policy.
This is very different from term life insurance, which has no cash value, and universal life insurance which has a cash value account associated with the policy, but with no built-in contractual guarantee against loss.
Why Does Whole Life Insurance Matter?
The tl;dr version:
- A whole life policy is a safe, convenient, and predictable way to build a long-term savings while also protecting against the financial risk of death.
- Whole life insurance is not an investment. Its cash value and death benefit are guaranteed to grow every year, will never decrease in value, and has certain tax advantages. Instead of risking your money, a whole life policy protects you from financial risk, and provides both immediate and long-term financial protection for you and your family.
- Whole life insurance gives you more certainty about your future. You can match known (or expected) future expenses to your whole life's guaranteed cash value, death benefit, or both.
- Most whole life insurance has guaranteed level premiums and provides both guaranteed and non-guaranteed growth of cash value, so you can better plan for your future.
- Whole life insurance helps you build personal credit, which you own and control. The credit is accessed through the policy loan function, and can be used as unique financing tool for personal or business purposes, allowing you to augment the inherent benefits in the policy, further growing your guaranteed cash values.
- Whole life insurance provides an insurance death benefit that is generally tax-free, so you can pass on any unused savings to your beneficiaries when you die. This death benefit can be used by your family to pay bills and other expenses or it may be given to a charity or non-profit you believe in, allowing you to leave a legacy you can be proud of.
With whole life insurance, the primary risks being insured against (and thus the risks being transferred away from you) are the financial risks associated with your death and also the financial risk of you not saving enough money to replace the insurance amount you're buying.
This is an important (and often ignored) aspect of whole life insurance. Whereas term insurance primarily has one function, whole life has two functions.
Beyond the obvious death benefit, whole life insurance also insures against other financial risks like:
- Chronic illness
- Terminal illness
- Future uninsurability (due to an illness or some other health problem)
- Loss of personal savings
- Interest rate and investment risk
- Credit and financing risk (the ability to get a loan on terms you find favorable)
You pay the insurance company an annual premium (which can be paid in advance each year or broken up into semi-annual, quarterly, or monthly payments for a fee, calculated as an annual percentage rate (APR)) and in return you receive a whole life insurance policy. In a sense, these premium payments are sort of like a loan to the insurance company (though premiums are not technically considered a loan to the insurer). The insurer temporarily uses your premium dollars to make money and then returns that money to you, with interest. Specifically, the premiums are invested on your behalf to help pay for the future death benefit of the policy and to generate profits for the insurer. Some of the premium, and the investment profits, are set aside and used to establish a cash reserve for the policy, called the "cash value," which will be used to pay for the future death benefit.
The cash value is a guaranteed sum of money you receive while you're alive, regardless of what happens to you, the stock or bond market, or the economy. This guaranteed cash value grows at a guaranteed rate of interest and is available for you to use whenever you want or need it, without a penalty.
Meanwhile, the life insurance company promises you the insurance amount for a set period of time until the cash value fully replaces it. At that point, the insurer will give you the option of receiving the full death benefit (which is now 100% cash value) as cash.
As is the case with term insurance, the whole life death benefit amount represents an amount of money equal to some amount of your future income.
Unlike term insurance, the whole life insurance death benefit is comprised of two things:
- Pure insurance ("net amount at risk" or "at risk amount") and,
- Cash value.
Like term life insurance, you are charged more than what it actually costs to provide the insurance death benefit. In other words, both term and whole life are paid for through a level premium funding scheme. Unlike term life insurance, however, the excess premium is returned to you as cash value. That cash value remains inside the policy and is credited with interest from the insurer's general investment account. In some whole life policies, the insurance company will also return expense and mortality savings, along with additional excess investment returns, at the end of the year through a dividend payment. More on this later.
As I mentioned earlier, cash value builds up in a whole life policy, the pure insurance amount (net amount at risk) decreases until the cash value has completely replaced the insurance component of the death benefit. Here's a more conceptual look at the relationship between cash value, pure life insurance, and the death benefit:
Some whole life policies are eligible to earn dividends. Dividends are a share of the life insurance company's earnings. These dividends represent savings from operating expenses, savings from mortality (fewer people died than was expected), and investment gains from the insurer's investments and other business-related activities.
When dividends are paid, they are generally used as premiums to buy small, single-premium, whole life policies which are added to the original whole life policy (called the "base policy"). As the name suggests, single-premium whole life requires only one premium, which is paid for by the dividend payment from the insurer.
Each year the company declares a dividend, the dividends are used to buy more single-premium life insurance of the same type as the original whole life policy . Each "block" of single-premium whole life also enjoys the same dividends, guaranteed cash value growth, and tax benefits as the base policy.
Here's a conceptual look at the relationship between cash value, pure life insurance, death benefit, and the paid-up additional insurance of a participating (dividend-paying) whole life policy:
Do you have to use dividends to buy more life insurance?
Heck no, but most policyholders do. Still, there are times when it makes sense to not buy single-premium life insurance. More on that later.
Back to the base whole life policy and death benefit…
The death benefit of the policy represents the present value of your future income (your future income, adjusted for inflation and presented in today's dollars).
For example, if you buy $1 million of insurance, you are buying $1 million of your future income (in today's dollars) before you've actually made it. Or, to state it another way, you want or need $1 million dollars (in today's dollars) saved up before you die but… you don't have it (yet). However, the insurance company does have this money and they're willing to give it to you in the form of a death benefit (yay!)… or rather, they're willing to "lend" it to you, for a price - the premium.
At the same time, a portion of your premium is returned to you each year, with interest, and becomes part of the guaranteed cash value of the policy.
Every year, a higher percentage of your premium is returned to you, with interest, until all of your premium is returned to you and… eventually your cash value grows at a faster rate than the premiums you're paying.
As this happens, the insurance company decreases the amount of pure insurance it's selling you. The combination of the insurance and the cash value equals the total death benefit of the policy.
Anyway, eventually, this cash value will equal the $1 million of insurance you originally purchased, leaving you with a death benefit which is comprised entirely of cash value and no insurance. At that point, no more premiums are due, the policy has "matured" or "endowed," and the insurance company will either hold the money until you die or offer to pay this money to you, even if you're still alive.
What Is The Purpose Of Whole Life Insurance?
Whole life insurance exists (ultimately) to create certainty out of the greatest financial uncertainties you face in life. These uncertainties include not saving up enough money for various financial goals, or… the financial risk of your own death, disability, or chronic illness.
Most investments come with no guarantees, so you can never be sure you'll accumulate enough money for your future. Even the probabilities of earning a specific rate of return (which have been well studied), leave significant room for error.
At the same time, no one knows exactly when they will die, become sick, or if they will become disabled and unable to work. And, that fact has a "trickle down" effect which makes it difficult (and in some cases impossible) to make long-term financial plans - plans you need to make in order to be (and feel) financially secure. In some cases, this uncertainty affects even short-term plans.
But… if you buy an insurance death benefit equal to all the income you can potentially make over your entire lifetime, you're fully insured against this financial uncertainty. You have purchased as much future income as you reasonably expect to earn. Thus, no matter what happens to you, your future earning capacity or earning potential is guaranteed to materialize. This amount, called your Human Life Value (HLV), represents your full or total earning capacity or potential. Anything less than this amount leaves you underinsured.
Now… there are oodles of opinions on the Internet about what life insurance "should" do for you, from protecting your spouse in the event of your premature death to providing money for your kids' college education in the event of same.
But, let's look at the fundamental reasons why whole life insurance exists.
The way whole life insurance creates certainty out of uncertainty is twofold:
- It provides a guaranteed death benefit to your beneficiaries when you die, and…
- It provides a guaranteed cash value (savings) you can use while you're alive.
Depending on how the whole life policy is designed, it can serve as a tool for estate planning, a tool for savings and supplemental retirement income, or a combination of both. There are two basic ways a whole life policy can be designed: high initial death benefit focus or... high initial cash value focus.
High Initial Death Benefit Focus
A basic use of whole life insurance is to use its guaranteed death benefit, and non-guaranteed dividend payments, to offset estate taxes and other final expenses at death. Most types of whole life insurance sold today are dividend paying (participating) whole life insurance.
This allows you, as a policyholder, to buy your future death benefit discounted to today's dollars instead of having to pay for more death benefit than you want or need right now.
For example, let's assume at age 50, you discover you'll probably want or need $250,000 of death benefit by age 90 because you believe you have a high probability of living to at least this age based on your family history and your own current lifestyle and habits (i.e. you're currently very healthy and all your relatives lived beyond age 90).
You have 2 basic choices:
You can buy $250,000 of level death benefit today using a guaranteed universal life (GUL) policy designed for guaranteed death benefit or an extended term life insurance policy. The downside to this is you have to pay for $250,000 of death benefit from now until the day you die. That much death benefit at age 50 might cost anywhere between $2,800 and $5,300 per year, depending on the insurance company you buy it from, assuming you're rated standard, non-smoker.
Your other option is to buy $250,000 of future death benefit, discounted to today's dollars. That might mean buying just $117,000 of death benefit. That lower death benefit amount means you only pay premiums of $2,572 per year. Those premiums are guaranteed to never increase. The benefit here is you're only paying for $117,000 of guaranteed death benefit and allowing the dividends of the policy to grow your death benefit to $250,000 by age 90.
This basic illustration shows how a simple dividend-paying whole life policy can be a powerful tool for estate planning:
|Year||Age||Premium||Cash Value||Net Death Benefit|
If you live beyond age 90, the whole life insurance death benefit keeps growing.
With a guaranteed universal life (GUL) or term life policy, you'll only ever get $250,000. No more, no less.
Of course, the risk with the whole life policy in this scenario is that the dividends are less than projected and you may end up with a lower death benefit than you wanted at age 90. However, if dividends at least match the current dividend scale, you'll always be assured enough death benefit for your needs, regardless of how long you live. In some cases, additional premium can be added to make up for lower-than-expected dividends. If you decide later you no longer want your whole life policy, you can surrender it for its cash value. After age 77, in this illustration, you get back all the premiums you paid into the policy, making your net cost $0.
With a term or universal life policy, you have no recourse if you live beyond age 90… your death benefit will be eroded by inflation. And, you generally do not have the option of getting back any of your premium dollars if you later decide to cancel or surrender your policy.
Whole life insurance can also be used at older ages to reduce the amount of money you must remove from your investments to pay for estate taxes. For example, if your estate tax bill at death is $250,000, you must use $250,000 from your investments to pay for future estate taxes. In essence, the taxes are paid at a ratio of $1:$1.
However, by using whole life insurance, you only pay ~$102,000 in premiums but receive the benefit of $250,000 - less than half the cost of paying for the taxes out of your investment earnings… meaning more of your money passes along to your heirs.
High Initial Cash Value Focus
A more advanced use of whole life insurance is to have a custom policy designed for you that rapidly grows the cash surrender value of the policy while also reducing the cost of insurance in the early years of the policy. This places the focus on cash value growth in the early years of the policy rather than death benefit. These policies, sometimes referred to as "high cash value whole life insurance" or "custom high cash value whole life insurance" often result in a low initial death benefit relative to a death benefit focused policy and a high internal rate of return (IRR) on cash value.
Using whole life insurance in this way allows you to grow a personal savings you can use throughout your entire life (not just during retirement) as well as a substantial death benefit for end-of-life needs. In some cases, the death benefit of a cash value driven policy can be substantially higher in the later years of the policy than the death benefit in a death benefit focused policy.
Whole Life Insurance, Risk Capacity, And Risk Control
Life presents you with a great many risks, many of which you cannot predict.
Will your investments perform well for the next 20 - 30 years? Will you be able to save up enough money to become financially secure and independent? Will your water heater die or car on you unexpectedly? Will you need long-term care when you're older? Will you become unemployed, become uninsurable, or will the unthinkable happen… will you be diagnosed with cancer or some other debilitating illness that doesn't immediately kill you?
If you were to isolate each of those risks, and look at them individually, you'd find the risk of any one of those things happening is small. But, collectively, the risk of at least one of those things happening to you at some point during your life is huge.
Some risks are worth taking, of course. However, there are many risks you cannot objectively afford to take.
For example, if you know for a fact you'll need a new car in the next 3-5 years, and you know what that car will cost, and you have not saved up enough money to buy that car yet, then you also know you cannot afford to lose any of the money you've save up so far to pay for this vehicle.
In financial planning, this concept is called "risk capacity" and refers to how much financial risk you can objectively afford to take or how much risk you must take in order to meet your financial goals. This is why the cash value of whole life insurance is so important. It minimizes or completely removes the risk of not saving up enough money for known future expenses. Since there is no risk of loss in whole life cash values, you know that you'll achieve your future savings goals if you make your premium payments.
That cash value is there to provide you with cash when you need it, regardless of what's happening in the economy or the stock market, and regardless of what you need it for.
Additionally, the cash value of your whole life policy can be used to finance anything from your future car purchases, to repairs for your home, to your child's college education, to a business, or even other investments.
Typically, cash value is accessed through policy loans, which do not require a credit check (and are guaranteed as long as you have cash value available to borrow against), and which are not required to be repaid. If you do repay them, your cash value is restored and you're able to re-borrow the money at any time for any reason. In some cases, you can structure repayments so that they add to your cash value (over and above what was originally there). This means each policy loan and repayment cycle helps grow your policy's cash value faster than it otherwise would grow. More on this later.
Common Types Of Whole Life Insurance
Life insurers offer a few different whole life options today:
Participating Whole Life (Dividend-Paying Whole Life)
This is, by far, the most common type of whole life sold today and the one covered most extensively in this guide.
Most insurance companies that sell whole life, sell this iteration and… for good reason. It's very competitive, offers some unique features not found elsewhere and… it's 30% more awesome than other types of whole life. Dividend-paying whole life pays dividends to policyholders (based on company profitability and performance) which can be used in a variety of ways… one of which is to add substantial growth to the guaranteed cash value.
Graded-Benefit Whole Life
Graded-benefit whole life allows you to get life insurance if you have a medical condition that would otherwise prevent you from buying insurance. Basically, the insurer will allow you to buy the face amount (the total death benefit) over time. In the first year of the policy, benefits are "graded," meaning you don't have the full benefit yet. If you die before full benefit maturity, your heirs only get the graded benefit that's earned thus far. So, on a $150,000 policy, if your benefits start out at $50,000, your heirs would only get $50,000 if you died. It's not great, but it's better than nothing.Over time, the death benefit increases so that by the 3rd, 4th or possibly 7th year, you have the full death benefit.
Graded Premium Whole Life
Graded premium whole life lets you buy the insurance and rig the premium payments so that they're cheaper in the early years of the policy. So, for example, you might only pay half of what you normally would pay for the first 10 years of the policy contract. After that, your payments gradually increase to the full payment. Actuarially (mathematically), your total premium outlay will be the same as any other straight whole life plan so you're not getting jipped in any way. It's just a flexible way to pay for the policy.
Indeterminate-Premium Whole Life
Let's say you want really cheap whole life and you think there's a company out there that can afford to charge you less than everyone else. Indeterminate whole life might be your savior. It's a policy where the premiums are based entirely on the insurance company's expenses, mortality experience, and other costs. So, if your insurer runs a tight ship, you could see your premiums drop substantially over time. The contract specifies a maximum premium that you only pay under a worst-case scenario. Otherwise, you pay a premium that's less than the guaranteed maximum with the potential for it to go down from there. Sometimes, it won't budge though - especially if the insurer is having a hard time controlling internal costs. Sometimes, it will increase. But, it will never go higher than the guaranteed max premium stipulated in the contract.
Limited-Payment Whole Life
The insurance company figures out what it would cost to provide you with coverage for your whole life and then schedules premium payments for a set number of years. For example, a 10-pay whole life has you paying premiums for 10 years. After that, the policy is paid in full, and no further premiums can be made and… you get to keep your insurance policy forever. A 20-pay whole life requires you to pay premiums for 20 years. Life paid up at 65 requires that you only make payments to your age 65, and life paid up at 85 requires you to pay until your age 85. Life paid up at 95 requires you pay premiums until age 95.
Minimum-Deposit Whole Life
This policy is for you if you don't have a lot of money to spend on premiums. Basically, as soon as you make the first premium, cash value starts building in the policy. Then, that cash value is used to pay for future policy premiums. This keeps the death benefit level, but it also reduces your total out of pocket costs. I don't actually see this one very often, but I think it's a cool concept for young people just starting out who only want death benefit and don't care about cash value growth.
Single-Premium Whole Life
This is the outlier of the bunch. Unlike other whole life policies, this one only requires one premium payment. In that sense, it's sort of like a limited-pay policy but actually more like paid-up additional insurance on a dividend-paying whole life policy. The insurance company calculates the premium payment, called "net single premium", required to maintain insurance coverage for the rest of your life. It's just one premium payment and you're done.
The downside is that the IRS reclassifies this type of policy as a "modified endowment contract" or MEC. Because of that, you lose the most important aspects of the tax benefits associated with the cash value (which is only important if you plan on drawing cash value for any reason during your lifetime).
Money will accumulate tax-deferred, but you cannot withdraw or borrow from the policy prior to age 59 1/2 without paying a penalty. Also, all cash value withdrawals are subject to ordinary income tax.
Major suckfest right there if you're looking for supplemental retirement income, but… this type of policy can be used very effectively in estate planning cases or if you want to make a charitable donation after your death.
Interest Paid To Whole Life Cash Values
As mentioned earlier, whole life insurance cash values earn guaranteed interest but… insurance companies also have the option to pay additional interest or credit more money to the policy through one of several methods:
The Participating Rate
The participating rate is also known as the dividend rate. Mutual life insurance companies are usually the only companies that offer this type of policy. Whole life insurance sold by a mutual insurer represents both a life insurance policy and partial ownership of the insurance company. Meaning, owners of dividend-paying whole life insurance are (almost) always part owners of the issuing life insurance company which is why they are entitled to dividends.
Insurers that pay dividends on their whole life policies do so based on company performance and then divide payments meritoriously among policyholders according to each policyholder's death benefit, cash value, length of time the policy has been held, and other factors.
Generally, the more a policyholder contributes to the dividend pool (called "divisible surplus"), the more dividends they receive when the insurer declares a dividend payment. Dividends can be used in a variety of ways. For example, the policyholder can choose to:
- Buy additional paid-in-full insurance (paid-up additional insurance), which increases the death benefit and, as a consequence, the cash value and future potential dividends, of the policy;
- Receive dividends as cash;
- Invest with the insurer in either a fixed or variable-rate investment account;
- Buy supplemental term insurance;
- Pay premiums due on the policy.
- Pay down policy loan interest, principal, or both.
Since dividend payments are based on company performance, they're not guaranteed in any given year, but… when the insurer does pay them, they become part of the guaranteed cash value and you cannot lose them.
Calculating Dividend Payments
OK, time to geek out.
There are several different methods insurance companies use to determine who gets what:
- The asset share method
- The source of earnings method
- The fund method
- The percentage of premium method
- The experience premium method
- The reversionary bonus method
One of the more popular methods is the classic "three factor method." The three-factor method uses - wait for it - 3 factors (Oh my God, unbelievable!) to determine the dividend you receive from the insurer.
These 3 factors are:
- The investment factor
- The mortality factor
- The expense factor
Investment factor is exactly as it sounds. It's earnings from the insurance companies investments (which also include various business activities that are not normally associated with traditional investing).
The mortality factor refers to how many people died during the year. Morbid, I know.
But, here's the good news: If fewer people die than expected, everyone benefits by getting more money back in the dividend. Incidentally, This is why life insurers don't want people to die - there's less money for the insurance company and, by extension, the owners (i.e. you).
The expense factor refers to operating (and other) expenses. One of the largest expenses is issuing new life insurance policies. On average, it takes a life insurance company 10-15 years to recoup its costs for issuing a new policy, especially if it's a whole life policy.
Which, again, is why insurers don't like it when people cancel their policies… it costs everyone money.
If expenses come in lower than expected for the year, then this money is added to the dividend.
Of course, these factors can also be adjusted for other variables and may include other costs or credits. It's unusual for an insurance company to tell anyone what the exact formula is for determining dividend payments because that's considered proprietary information and a competitive advantage in the marketplace.
However, insurance companies are very willing to tell you the general formula for determining your cash value increase and dividend payments. This is awesome because it means you can geek out on some of the finer details of your whole life insurance policy, if you want to.
For example, a common formula for calculating the total cash value increase (including dividends) is to apply the dividend interest rate to the previous year's cash value plus current year's net premium after mortality and (other) expense charges:
While insurers do not itemize mortality and expense charges, agent commissions, and other miscellaneous charges for whole life, you can very easily calculate these costs based on this simple formula:
Annual policy cost = (Current year net cash surrender value - Current year cash value increase) - (Previous year cash surrender value + Current year premium)
The net result of this calculation is the annual cost. From here, you can calculate the cost per $1,000 of insurance each year as well as the average cost per $1,000 over many different years (or over the life of the policy). For some, this is a meaningful way to compare the cost of whole life insurance to term insurance over time.
Back to the dividend.
Dividends are paid retrospectively (after the fact) so… money used to pay the dividend is usually accumulated in the surplus account until the end of the year when the dividend is declared.
Insurers are generally very conservative and use the company's surplus to protect the mutuality (the company and its policyholders) from a variety of economic and business shocks.
Even so, when the board of directors declares a dividend payment, those dividends tend to be very generous relative to the guaranteed interest paid to policy cash values. In dividend-paying whole life, it's assumed that the dividend is what will drive current and future policy performance.
For this to happen, insurers need to protect the long-term viability of dividend payments for its owners (the policyholders), which is why most mutual life insurers have a history of paying dividends for over 100 consecutive years. Some of the older mutuals in the U.S. have paid dividends for over 180 consecutive years.
The Interest Sensitive Rate
Oh great. Whole life insurance with feelings.
No, no. Just another method to credit excess interest to a whole life policy.
Interest sensitive whole life credits interest to cash values, in part, by pegging cash value performance to current market interest rates. As these rates fluctuate, the whole life policy's cash value may be credited with more or less interest.
This method is not nearly as popular as it once was because of the fact that interest rates have fallen for the past 37 years and have remained too low to make this type of policy attractive to buyers.
The Variable Interest Rate
Whole life may be credited with interest tied to the performance of the stock market.
The insurer may allow part or all of the premium to be invested directly into the stock market. The direct investment in the market typically allows some of the premium to be invested in the insurer's separate account consisting of mutual funds.
The separate account is different from the insurer's general investment account and is not guaranteed against loss. Because of this, variable interest earnings in whole life can cause whole life cash values to fluctuate both up and down and may put you at risk of losing some or all of your cash value.
The Equity-Indexed Rate
An equity-indexed strategy requires the insurer to take full control over the investment strategy. You are paid based only on the upward movement of a stock market index. All market losses are ignored.
Some insurance companies also offer indices that let you capture gains based on market downturns, incorporate volatility control in an attempt to smooth out crediting rates to cash values, and other more complex crediting strategies which affect cash value growth in different ways.
The insurer is able to do all this by using a very precise mix of bonds and index call options. With an equity-indexing strategy, you are not credited with dividends on the underlying index. Instead, the insurer pays interest based on a proprietary or non-proprietary crediting formula.
If the underlying index options are profitable, they will credit your policy with interest based on their profit, up to a cap (which is specified in the contract). Insurers can also limit interest credited using participation rates, which limit your participation in the underlying stock market index.
If this sounds like a complicated method of crediting interest to your cash values, it's because it is.
So complex that almost no life insurer actually retains the risk themselves. Instead, they buy stock options that make this strategy possible and push the equity risk onto an investment bank.
Since there are only a handful of major investment banks in the world capable of servicing a life insurance company and the massive amounts of premium dollars flowing through their accounts, every insurer is essentially doing business with the same investment banks and counterparties when they do these deals.
To understand how equity indexing works, it's helpful to get a handle on some of the "lingo" used by agents and insurance companies.
An index represents a number used to measure the general behavior of stock prices by measuring the current price behavior of a representative group of stocks in relation to a base value. The Dow Jones, for example, measures 30 of the largest and most established companies in America; often referred to as "blue chip" companies. It consists of companies like Walt Disney, Wal-Mart, and Microsoft. The S&P 500, on the other hand, measures 500 large cap companies, most of which are American.
To make an equity indexed contract work, there needs to be two components: bonds (or bond-like instruments) and index call options.
A bond is a debt instrument - a loan if you will - made by the Government or a corporation to another party, usually an institution like a bank or a life insurance company. These pay a fixed rate of return. If the bond is going to pay (i.e. if the debtor - the Government or the corporation - does not default on the bond) it will pay the stated interest rate. There is no variance in what it pays.
Next is the call option.
The Call (or Put) Option
An index call option is a stock option. A stock option is the right - but not the obligation - to buy or sell stock for a preset price (which is set when the option is purchased).
There are two types of options: put options and call options.
A put option is the right to sell stock at a preset price, and a call option is the right to buy stock at a preset price. So, for example, if you thought that a company's stock was set to gain value, but you weren't 100% sure that it would, you could buy a call option for much less than buying the actual stock.
Conversely, if you thought a company's stock was set to plummet, then you might buy a put option.
Why buy stock options?
With options, you are able to control a large amount of stock with very little money up front. You don't actually own the stock and you don't ever have to buy the stock, which is what gives you protection if the stock doesn't do as well as you expected.
However, there is an expiration date for every option. And, the longer the expiration date, the more expensive the option will cost (i.e. a 3 month call option may cost $500, but a 1 year call option may cost $750).
An index call option is a call option on a stock index - usually the S&P500 stock index. But, it could be on any stock index.
Some insurance companies use call options on the S&P, the Dow, and even international indices. And, sometimes, an insurance company will buy put options if they want to offer policyholders the opportunity to gain from a downward movement in an index.
Insurance companies are able to use a very precise mix of bonds (to guarantee the contract owner's principal plus a small amount of appreciation) and index call (or put) options (to capture the upside potential of the stock market) to produce a new type of contract that gives the contract owner the upside potential of the stock market, without any of the downside risks associated with a direct investment in the stock market.
The insurance company purchases the index call options to ensure that all of the obligations of the index contract can be fulfilled. This is known as "hedging".
When an insurer hedges its risk, they are essentially moving that money out of their own general account and pushing the risk onto another company to fulfill the promises of their contract.
While equity indexed contracts do provide a guaranteed minimum interest rate, the guaranteed rate is usually weaker than in traditional 'declared rate' or dividend-paying contracts, but this is because the focus is on the upside potential of the contract and not the guaranteed rates.
If fixed rates, or the conventional dividend rate, is higher or comparable to indexed returns and you would like to take advantage of the dividend rates inside of an indexed whole life policy, some contracts provide the option to switch to fixed or a dividend rate or… the insurer will allow you to throttle the amount of dividends or paid up additional insurance that gets allocated to the equity indexing strategy.
Of course, it's not all fun and games. The party ends where the cap and participation rates begin.
Caps And Participation Rates
A cap is exactly what it sounds like. If an insurer sets an annual cap at 12%, it means you can never earn more than 12% per year in that policy. So, if the market delivers 15% returns, and your policy's annual cap is 12%, you earn… 12%.
That's it. Where does the rest go? It goes nowhere.
Insurers buy stock options to match their liabilities. So, an insurer may sell stock options struck at the minimum guaranteed interest rate in the contract and options struck at the maximum (capped) rate in the contract. In essence, the insurer is not looking to profit from the stock options in the say way any other investor might. Instead, they want to get rid of the risk while still satisfying the guarantees and terms of the contract.
Caps are usually designed with a minimum and maximum. Sometimes, there is no maximum and instead there is a spread.
With today's whole life indexed options, insurers tend to prefer caps over spreads.
Minimum annual caps (the lowest the insurer can set the cap) is usually between 3% and 5%. So, an insurance company could lower your cap from 12% to 7% or 5% if it wanted to. Insurers can also set monthly caps, which cap out your monthly earnings.
In addition to this, insurance companies set participation rates. A participation rate determines how much of the gain you receive from the call options.
A 100% participation rate is typical, meaning you get the full benefit of the options contract, but some insurers have minimum participation rates of 75% or less.
Is it too good to be true?
There is no magic, only magicians, as they say.
Once again, insurance companies all fish from the same basic investment pool. They all buy their call options from the same counterparties. Meaning, no one can offer an unusually high cap or participation rate.
And… if an agent does show you a "stellar" policy performance, there are a few reasons why this might happen.
First, agents can manipulate the crediting rate in the illustration software, showing minimum and maximum interest rates. Sometimes, the maximum interest rate is - how shall I say this - unrealistic.
Illustration software for these types of policies use "backtesting," meaning they look back over historical returns of the stock market to determine what crediting rate will be applied to current policy illustrations.
This is no bueno.
Historical returns are not a good way to assess the current market environment because… a lot of things change over time. For example, in the 1980s, interest rates were very high. This had a profound effect on bonds and stocks.
Today's relatively low interest rate environment has a completely different effect on the stock and bond market and thus… those past returns of the 1980s cannot be used with any sort of accuracy in determining hypothetical current or future returns.
At best, historical returns can be used to devise probability scenarios for future market returns and thus potential future crediting rates, or the potential for future interest crediting.
Another factor that affects the returns possible with an equity-indexed whole life policy is the cost of the options themselves. The stock options that whole life companies buy are the same ones that publicly-traded insurers use to fund their indexed universal life policies.
And… these contracts have become very popular over the last 10 years. As equity indexed whole life becomes more popular, and as indexed universal life and indexed annuities grow in popularity, the cost of the underlying stock options which drive the product become more expensive due to the increased demand for those particular kinds of stock options.
Cost are also affected by interest rates. Interest rates have been near historic lows for quite some time now.
And… they are starting to rise.
And… as insurers costs for financing the cost of buying the stock options increases, the total cost for implementing the equity-indexing strategy increases. Those costs ultimately get passed on to policyholders. In whole life, the only way to do this is to lower the dividend rate to offset the increased cost of options hedging (since all other costs are fixed and guaranteed) or… to increase the guaranteed costs on new policies.
And yet… most every insurance company's illustration software still uses backtesting as a hypothetical return assumption. They still rely on old options pricing or fixed options pricing over the life of the policy.
This is not realistic.
Other times, life insurance companies will show high cap and participation rates - higher than market averages - because they are charging higher internal policy charges. In effect, the insurer is subsidizing the higher cap and participation rate with higher policy charges.
This is the most obvious way life insurers can show higher crediting rates. If your policy charges are 2% higher than a fixed interest account, the insurer may be able to show a 1.5% or maybe even 1.75% higher potential crediting rate.
So… what should you reasonably expect out of an indexed crediting strategy?
Indexed crediting strategies can reasonably earn up to 50 basis points (0.50%) over a fixed-interest account (currently between 3% and 4%). They could, of course, earn more than that, but most insurers - on average - are not showing above-average earnings rates on their indexed crediting strategies.
Premium Payment Options For Whole Life Insurance
So… what are my premium payment options?
I get this question a lot…
Someone likes the idea of whole life, but is concerned that they won't be able to make premium payments every month, forever.
Never fear. Premium payments can disappear. But first, let's cover the basic method used to pay for your insurance policy.
Scheduled premiums are the most familiar way to pay for life insurance. The insurance company sets an annual premium schedule for you. Typically, for whole life, premiums are payable to your age 100.
The insurer will then let you make monthly, quarterly, or semi-annual payments. How does this work?
For annual premiums, you simply write in a check to the insurance company and call it good. Your premium is paid up for an entire year. I rarely advise people to pay this way (more on that later).
Otherwise, the insurer will charge a finance charge and let you pay your premiums throughout the year. Most people choose to pay their premiums monthly. What the insurer does is assume you've paid the full year's premium (even though you haven't) and then credits interest to your cash value and pays dividends as though you paid the entire premium in advance (even though you didn't).
Yeah, it's… all-the-way nice.
Meanwhile, you repay the insurer over 12 months (or 2 or 4 times per year depending on your payment frequency). At the end of the year, the financing arrangement restarts and the insurer "fronts" you more money and you repay them over 12 months.
The finance charge increases the premium a bit, of course, but insurance agents usually compensate for this by lowering the death benefit a little to keep the premium the same as if you paid annually. Usually, also makes the cash value appear lower than under an annual payment, but it's not. Ask your insurance agent to run a quote for $1 million under both annual and monthly premium modes. The cash value and death benefit will be the same, but the premium is a bit higher under the monthly payment mode.
Again, this is not necessarily a bad thing (and, in fact, can be a very good thing) as I'll show you later on.
Unscheduled premiums usually refers to paid-up additions premiums. Paid up additional insurance is optional insurance you can buy in addition to your normal (called "base") whole life insurance, up to a maximum annual threshold (maximum annual payment limit).
Why would you ever want to do this?
Because it increases your future potential dividend payments and your guaranteed cash value growth. It also gives you more ownership in the insurance company and with most companies this means… more votes.
For example, let's assume you make base whole life premiums of $1,000/yr and your paid-up additions maximum annual payment limit is $5,000/yr. This limit indicates that you can make excess premium payments in the amount of $5,000 per year without any medical underwriting or any other permission from the insurer.
This is super-nice if you ever become ill or can't qualify for insurance or… you just want to increase your cash value. You simply send in a check to the insurer and they must let you purchase more insurance - no questions asked.
But, you aren't required to make these premium payments or… you may be required to only make a minimum payment to keep the door open for future unscheduled paid-up additional insurance premiums (depending on the insurance company and the policy contract).
The annual payment limit is… annual. Meaning it resets every year so if you buy the maximum paid up additions this year, you can turn around and do the same thing next year and the year after that and so on.
These unscheduled and optional paid-up additional insurance premiums are the best way to increase your policy's cash value over and above the guaranteed growth rate.
Temporarily Stop Premiums
Dividends in a dividend-paying whole life policy (most whole life policies sold today are dividend-paying whole life) may be used to pay some or all of the premiums. Dividend payments are not guaranteed in any given year, so temporarily reducing premiums this way is a temporary and non-guaranteed way to reduce or stop premium payments.
Some insurance companies allow you to offset premium payments by surrendering ("cashing in") accumulated paid-up additional insurance and dividends to pay base whole life premiums, which is a more stable way to temporary reduce or eliminate premium payments.
Permanently Stop Premiums On A Guaranteed Basis
Almost every whole life policy has a "reduced paid-up" (RPU) option that lets you permanently stop paying premiums. The insurance company calculates how much insurance it can afford to give you based on your current cash value and what it is guaranteed to pay you through the guaranteed cash value growth function. As a result, RPU reduces your death benefit and guarantees no more premiums are due ever again. You also do not have the option of restarting premiums later.
In other words… you're done paying premiums. Your policy is paid-in-full.
This also tends to have the effect of slightly improving the rate of return on your cash value, though net cash value growth slows down because you're no longer adding premiums.
Important Whole Life Insurance Policy Riders And How To Use Them
Paid-Up Additional Insurance Rider (PUA Rider)
This nifty little rider gives you the ability to make additional payments on your life insurance policy (buying small "blocks" of paid-up additional life insurance), up to a maximum annual limit set by the insurance company.
Paid-up additional insurance is one of the best ways (perhaps the best) to increase your death benefit, future dividend payments, and cash value. Because this rider buys paid-in-full insurance, only one premium is required each time you elect to buy extra coverage.
As such, the cost per $1,000 of insurance is extremely high which results in most of the money being allocated to the cash value of the paid-up insurance to guarantee the future death benefit payout. This also means the return on paid-up additions cash value is high, since the premium cannot buy much pure insurance coverage so less of your premium (and interest earnings) goes toward the cost of insurance.
If you've ever read or heard an insurance agent or financial advisor tell you they will "overfund" your whole life policy, this is how they do it. They schedule at least some of your total premium as paid-up additional insurance rider premiums.
If a substantial amount of your premium dollars are diverted to paid-up additional insurance, you will have positive cash value in the first year of the policy and it will start growing at a faster rate than if you did not use the paid-up additions rider. Over the long-term, this rider also tends to produce a higher death benefit amount than without the rider.
Supplemental Term Insurance Rider
Supplemental term insurance riders allow you to blend term insurance into a whole life policy, so your policy is part term, part whole life. Sometimes, you'll hear this described as "term blending."
The term insurance portion of the policy starts out as pure insurance and is slowly converted into whole life over time. The conversion process is usually driven by non-guaranteed dividends but may also be influenced by other factors.
These policy designs require more effort on the part of the agent to set up and manage, but have become very popular in recent years because they lower the cost of insurance in the early years of the policy.
That lower initial cost can be exploited one of several ways.
Traditionally, the term blending option was used to lower the initial cost of whole life so whole life insurance sellers could better compete with universal life.
But, some savvy agents discovered that term blending also allowed more premium to be paid into the policy before hitting MEC limits, thus accelerating its cash value growth. Because the early year costs are low, more premium makes its way back into the policy's cash value and earns interest.
The net effect is rapid (and high) early year cash values. However, long-term cash values may or may not be higher than they otherwise would be and the long-term performance of the policy ultimately hinges on how the insurer prices the supplemental term rider and how that rider is paid for.
Overloan Protection Rider
There is exactly one company that offers this option with whole life insurance. Many companies offer this on universal life, but I thought I'd mention it here because it is both unique and serves a very important purpose.
There's no cost to have it or use it. What it does is… it prevents your whole life policy from lapsing due to policy loans. Instead of lapsing, your policy will stay in-force and automagically convert into a "reduced paid-up" (RPU) policy if you have any outstanding policy loans which exceed 99% of your policy's cash value.
The company also changes the dividend option to paid-up additions when the rider is triggered, unless you select the "dividends as cash" option. All other supplemental riders are terminated and no more premiums can be paid into the policy.
One last thing about this rider is… you must be at least 75 years old and the policy must have been in force for 15 years for it to take effect. So, basically, this is designed to prevent you from lapsing your policy in your old age and triggering a massive tax bill for any gains you realized in the policy. That's mucho important when using a whole life policy for supplemental retirement income.
Extended Coverage Rider
This rider option adds additional insurance coverage for a family member. It's kind of like getting 2 (or more) policies in 1. Most of the time, the coverage is extended to your spouse and children. The supplemental insurance death benefit has its own premium and terms and cannot be separated from the base whole life policy. Usually, the extended coverage is term insurance.
Terminal Illness Rider
Most whole life insurance comes with an accelerated death benefit rider of some sort. This means you get to spend your death benefit before you die.
There's a catch, of course (isn't there always?). For the terminal illness rider to kick in, you have to be expected to kick the bucket within 12 or 24 months. Still, it's a way for you to enjoy your death benefit while you're still alive and go make peace with the world before your time is up.
A few things about these riders. Normally, there is no cost to add this rider onto your policy but there is a cost if you ever decide to use it. Costs vary by insurer and death benefit amount being accelerated. It's usually very reasonable and worth having. Accelerated death benefit payments also reduce the death benefit and policy cash value, which should be obvious but I'm throwing it out there just in case it's not.
Insurance companies also tend to stipulate minimum acceleration amounts and allow you to take the acceleration as monthly payments or as a lump sum. Good news is… accelerated death benefits are usually tax-free.
Chronic Illness Rider
Similar to the terminal illness rider, this rider benefit lets you spend down some or all of your death benefit before you die. However, to exercise this rider, you have to suffer a heart attack, stroke, or have some other permanently disabling event and it has to be verified by a healthcare practitioner.
Some policies will also allow you to use the death benefit to pay for long-term care costs, but you must be expected to need care for the rest of your life to qualify for the death benefit acceleration. Some riders allow you to suffer non-permanent disabling events but this tends to be expensive for insurance companies to underwrite. So, most specify that your chronic illness be permanent.
On the upside, most insurance companies do not charge extra to have this rider. Some will, however, charge you if you decide to use it while others won't.
Disability Waiver of Premium Rider
If you become disabled, the insurance company will waive the premium payments until you are back on your feet (up to the maximum payment allowance). Normally, this rider option is good for either a 3-year disability or a 6-year disability, with some companies offering a 2-year benefit or grade benefits depending on your age.
Most insurers also require you to be disabled for at least 6 months before they will waive the premium payments.
If you're concerned about disability, look for a company that offers "own occupation" definition of disability. Most companies only offer "any occupation" definition of disability.
The difference is… huge.
With an "any occupation" definition of disability, the company will only waive premiums on your policy if you are unable to do any work at all. Meaning, if you can still pump gas at a gas station, you can still work or… if you can still sweep floors or work for minimum wage, you won't qualify for disability coverage.
"Own occupation" means you cannot work in your primary occupation or line of work doing the exact same job you were doing before you became disabled. If you do some kind of skilled labor job, or own a business, or you're a high-level executive, this is usually the definition of disability you want to have from your insurance company. It's more favorable to you and thus easier to get approved for the disability benefit if you ever need it.
Guaranteed Purchase Option Rider
Handy if you know you'll be purchasing more life insurance in the future. Otherwise, not worth the extra cost. This rider lets you buy more life insurance at specified ages without going through medical underwriting to prove your insurability. That means, if you get sick later on in life, you can still get life insurance.
There's usually a hefty fee for this option as you're basically putting the life insurance company on the hook for potentially high-risk coverage (high risk for them). In most cases, I recommend folks buy a separate convertible term policy but in unusual circumstances, this rider can make sense.
Cash Value Growth And Modified Endowment Contract (MEC) Limits
The cash value of whole life insurance is a mystery to some. It's growth rates are weird, don't follow the usual linear growth pattern found in other assets, and… it's not known for being an exciting, high-yielding, risky, investment.
So… what's the deal?
Occasionally, someone will look at an illustration I put together and ask, "Why would anyone buy this?"
It's an understandable confusion.
At one time, whole life insurance was "common sense," just like - once upon a time - teaching and learning standards for English (grammar), arithmetic, and science were common sense.
Unfortunately, today, instead of "common sense," we have "common core."
But, I digress.
Cash Value Growth And Modified Endowment Contract Limits
Before I dive into the meat and potatoes of whole life cash values, a public service announcement brought to you by the Internal Revenue Service (no, I'm kidding, this is my professional warning to you):
Most of the time, it makes sense to avoid transforming your whole life insurance policy into a modified endowment contract.
What's a modified endowment contract, you ask?
Why Not A Modified Endowment Contract?
A modified endowment contract (MEC) is a special tax qualification for all cash value life insurance policies which arises when the cumulative premiums paid to the insurer exceeds the federal (IRS) tax law limits for that policy. Every whole life policy, universal life policy, and variable life policy is subject to these limits.
Specifically, certain aspects of the modified endowment contract become taxable whereas they were not taxable under the whole life insurance policy arrangement. For example, any gains in the policy (money in excess of the premiums you paid) are taxable at ordinary income tax rates when you withdraw them or take on policy loans. This money is assumed to be withdrawn or borrowed first, meaning there is no way to avoid taxation on gains if you tap your policy cash values.
Any withdrawals prior to age of 59 1/2 are assessed an early withdrawal penalty of 10% (similar to the penalty applied to retirement accounts for early withdrawal).
This MEC classification is permanent and cannot be undone (not even by skipping premiums in later years).
In other words, once you go tax, you can never go back.
There is a bright side to all this, however. If you leave the cash value alone in the MEC, it is not taxed. And, like traditional whole life insurance policies, MEC death benefits aren't subject to income tax. Incidentally, people who buy these policies intend to use them as endowments and do not plan on using the cash values while they are alive so the taxation of the cash values is a non-issue for them.
How Policies Become A MEC
The IRS is very clear on how life insurance policies can become modified endowment contracts. First, the policy issue date is checked to be on or after June 20, 1988. Second, the policy must meet the statutory definition of a life insurance policy under section 7702 of the Internal Revenue Code. Third, the life insurance policy must fail the Technical Miscellaneous Revenue Act (TAMRA) 7-pay test.
Whole life policies issued and kept in force prior to June 20, 1988 are immune from MEC testing and will never be taxed as modified endowment contracts. However, any lapse and subsequent renewal becomes a new policy and is then subject to the 7-pay test.
The 7-pay test determines whether total premiums paid on a whole life policy within the first 7 years of the policy are more than what was required to keep the policy in-force. In other words, the MEC limit is equal to the annual premium that would pay the policy in full after the payment of seven level annual premiums.
One more thing: the MEC testing resets if any material changes are made to the policy (this includes a material change to a previously "grandfathered", MEC-immune, policy). An example of a material change would be increasing or decreasing the face amount of insurance through withdrawals or surrenders or underwriting to expand the existing policy to include additional insurance. This can be especially awful for older policies which were previously immune to MEC testing and which would be classified as MECs under current tax law.
For example, let's say you own a whole life policy worth $100,000. The MEC limit for that policy was calculated to be $2,000 per year for the first 7 years. That means you can pay up to $2,000 in premium every year without the policy becoming a modified endowment contract.
If, however, you pay $3,000 in year 3, you cannot fix the error by paying $1,000 in year 4. The excess premium causes the total cumulative premium payments ($7,000) to exceed the cumulative MEC premium limit of $6,000 by year 3.
If that sounds a little confusing, don't sweat it. It's pretty simple, since the calculations are done for you by the insurance company before your policy is even issued and… MEC testing and status is carefully monitored every year by the insurance company.
Life insurance companies understand that most clients want to avoid their whole life policy becoming a MEC and will warn you when your premiums are about to exceed the limits. They will also advise you to redirect premium and may have policies and procedures in place to automatically put any excess premium into a premium holding account until or unless you approve the MEC status for your policy in writing or via verbal confirmation over the phone.
So, to recap, most clients, most of the time, are better off avoiding Modified Endowment Contract (MEC) limits because it will make it much harder to effectively use the policy's cash value while they're alive.
Cash Value Growth Factors And Historical Performance Of Whole Life Insurance
Cash value build-up inside of whole life insurance usually sparks an interesting question and an unending debate: "What is the return on cash value and death benefit in whole life insurance?"
Simple question, difficult answer.
The return on your whole life cash value and death benefit is driven primarily by several factors.
First, your age and health status. If you're young and healthy, your return on cash value will be higher because your cost of insurance is lower and you have a long time to grow the cash value in your policy.
The older you are, the lower your return on cash value will be, all other things being equal.
However, there are exceptions to this, too because…
Policy design and premium payment schedules can dramatically affect the long-term performance of cash values.
In general, the faster you put money into a policy, the higher your long-term return on cash value will be. This means shorter-pay whole life policies may be better than long-pay policies for older folks.
Finally, policy design has a direct impact on long-term performance. In general, the lower the (net total) internal costs of the policy are, the higher your return on cash value.
Historical Performance Of Whole Life Insurance
One of the best ways to understand how whole life insurance works and performs is to look at its historical performance.
The risk here, of course, is getting trapped by "historical determinism." Historical performance numbers are a cool way to learn about how whole life works, and… they help you better understand how whole life insurance has done in the past but… past performance is in no way predictive.
In other words, looking at a life insurance company's past performance can't tell you anything about how well it will do in the future. It just can't.
What it can give you is insight as to how it might perform in specific economic climates.
Here are a few examples from a well-run, large mutual life insurance company:
Whole life does have amazing potential for both males and females (even males in their 50s!), as you can see.
The 35 year old female earned a return on cash value of 5.86% per year and a return on death benefit of 6.86%. The 45 year old male earned a return on cash value of 4.80% per year and a return on death benefit of 5.55%. The 55 year old male earned a return on cash value of 5.89% and a return on death benefit of 6.23%.
In all 3 cases, the policyholder earned far more than was originally illustrated.
These returns are annual compound returns (actual growth rates experienced by the policyholder), net of all fees, commissions, and taxes (cash values are generally not subject to taxation).
Few financial products, and even many investments, struggle to give individuals this type of return on their savings. Return isn't everything, of course, but it is something.
With that said, some whole life products haven't returned anywhere near this return. Many whole life policies tend to return between 2% and 3% per year, compounded. Well-designed whole life policies from major mutual life insurers (i.e. policies designed specifically for cash accumulation) can potentially return between 4% and 6% per year, compounded.
Owner, Client, And Customer: It's Your Money, Right?
Whole life insurance that's purchased from a mutual life insurance company gives the policyholder ownership (or "membership", depending on the exact nature of the corporate structure) in the insurance company. The policyholder can vote on who is elected to the board of directors and thus has some say in the general direction of the company.
Policyholders also have incredible control over policy options and functions, and are able to change many provisions of their contract.
All the money in the company, of course, belongs to the owners of the company - the policyholders. So, from that perspective, the cash value of the policyholder's whole life policy does in fact belong to you as a policyholder. It really is your money.
And… because it's your money… you have a great degree of control over how that money is invested.
You can either let the company invest your premiums into the general investment account of the insurer or… you can withdraw or borrow money from your insurance company and you become the investment. More on that in a moment.
Back to company ownership. Why make the distinction between the insurance company and you?
It's a technicality, really.
Corporations are their own entities - they are formed by groups of people coming together for a common purpose. Mutually-owned life insurance companies are no different.
As a client making premium payments, borrowing money through policy loans, and making loan repayments to the insurer (including interest payments), the money being paid to the insurer belongs to the insurer. The insurance company's management is authorized to manage that money in whatever way they deem best for the benefit of its owners - the policyholders.
But… who owns the insurance company?
As a policyholder, you do.
Here's how it works: A whole life policy requires you to wear multiple hats because you are simultaneously the owner of the insurance company, a client and customer, and (if you take on policy loans) a borrower (debtor) to the insurer.
This is why you are entitled to both the interest and profits of the life insurance company, even when you are also borrowing money from them and paying interest on policy loans which is… profit to the insurer which then… belongs to you as the owner of the company. Confusing? You're not alone. Many people find this arrangement unusual simply because they are not used to this sort of business relationship. Usually, in most business relationships, the company's owners are the company's owners and the customer is the customer and the two aren't the same. But, in this instance, they are the same - the owners of the company (the policyholders) just so happen to also be its customers.
Yes... you really are simultaneously a client and customer. You must pay your premiums to get the benefits of the policy. And, any policy loans you take on must be repaid either out of pocket or when you die (you can choose to defer any and all policy loans until you die, at which point, the balance will be repaid from the death benefit).
It's very much like owning a business.
If you are buying the goods and services, you are the customer and owe the business for any debts you incur or purchases you make. When you cash your paycheck, you are the owner and are entitled to its profits. This has very important and profound implications when you use the cash values of your policy. Generally, people dislike insurance companies and try to find ways to "get at them"… reduce their premiums, reduce interest payments on loans, and so on.
Obviously, because you are part owner of the life insurance company, this strategy would be a very bad idea. As part owner of the insurer, it's in your best interest to help your insurance company succeed. Because, if you do, you are rewarded with increasing dividend payments over time.
In the next couple of sections, I'll explain how to access your cash values and how a general approach of helping your insurance company succeed ultimately helps you build up your own savings within the policy.
How To Access Your Cash Values
As owner (or member) of a mutual life insurance company, you have indirect control over how your premium dollars are invested - you can either let the insurer invest your premiums for you in the general investment account or… you can remove them from the policy and invest them elsewhere. This is accomplished through either partial surrenders or policy loans.
In the case of policy loans, your premium dollars remain invested in the general account, while you use borrowed funds for some other purpose. More on that in a moment.
Partial and Full Surrenders
A surrender or withdrawal is nothing more than you selling your insurance policy back to the insurance company for its cash value (which is the cash surrender value of the policy). There is no discount or negative value applied to this sale.
The insurer gives you the full market value and, in some cases, a "terminal dividend" (final dividend payment) plus a premium refund credit. And, the sale is guaranteed.
They cannot turn you down.
In rare and unusual circumstances, an insurer might delay paying you for up to 6 months but nothing like this has happened in the industry since the Great Depression in the 1930s when the government forced banks and insurance companies to declare a bank and insurance company holiday (today's insurance companies have much more control over whether an insurance company holiday happens, however).
Moving right along…
You can cash in part of your policy (called a "partial surrender") or all of your policy (called a "full surrender"). Surrenders reduce the cash value and death benefit in the reverse order that they were added to the policy. A reduction of $1 in death benefit does not necessarily result in a reduction of $1 in cash value. It all depends on your individual cost of insurance (which is determined by your age, health status, and when you purchased the policy) and when you surrender it.
Surrenders are considered permanent withdrawals (resulting in permanent reductions to the death benefit) and you generally cannot put the money back into the policy. Because of this, most policyholders opt for policy loans unless they are winding down their policy and using the cash values for supplemental retirement income.
Surrenders are usually processed within 3-5 days and checks or direct deposits made within 5 to 10 days of the initial surrender request. Meaning, if you make a surrender request on the 1st of the month, you will probably have your money sometime between the 5th and the 10th of that month. Of course, this depends on the insurer and their internal procedures for processing requests. Some are a little faster, some a little slower.
Because surrenders or withdrawals are permanent changes to the policy, most policyholders use policy loans prior to retirement. Policy loans are tax-free as long as the policy remains in-force and it does not result in a permanent reduction in the death benefit or cash values.
What is a policy loan?
Good question, buckshot.
In order to answer it, I'm going to have to geek out again.
Let's dive in and explain some basic financial concepts and how they apply here in the context of policy loans.
A policy loan is a secured or collateralized loan against the value of the life insurance policy. You may take as many loans as you want, up to the full loan value of your cash value, which is usually between 80% and 90% of the net cash surrender value (the value you would get if you completely surrendered your policy for cash).
Each loan is automatically consolidated with previous loans, making policy loans -in effect - one single loan. You can, of course, keep each loan segregated in your own personal accounting or budgeting system but the insurance company will not do this for you. The loans are considered "non-amortizing loans", meaning there is no set repayment schedule. Instead, the insurer charges interest on the loan and bills you for that interest annually.
The interest method used, however, differs from what conventional lenders use. Instead of a daily compounding interest calculation, interest merely accrues daily against the outstanding principal of the loan. You may choose to pay some of the interest, all of the interest, or none of the interest. If you do not pay all of the interest when billed, the insurance company adds it to the principal of the loan and it will start to accrue interest.
But... you may also set up your own custom repayment schedule to repay policy loans. If you do, the insurance company will allow you to pay down the principal of the loan during the year before paying any interest. This effectively reduces the total interest you pay over the course of the loan and lowers your net effective APR.
For example, if you take out a $10,000 policy loan at an APR of 5%, but repay the loan over 60 months (5 years), the interest charged on the loan may be slightly cheaper than a conventional loan or it may potentially be substantially lower than if you took on a conventional loan.
In the following example, let's compare a conventional loan at 5% APR and repayment rate to a life insurance policy loan at a 5% APR and repayment rate:
Conventional Loan @ 5% APR/Repayment Rate
|Payment Date||Payment||Principal||Interest||Total Interest||Balance|
Policy Loan @ 5%APR/Repayment Rate
|SCHEDULED PAYMENT DATE||RECOMMENDED LOAN PAYMENT DUE||ACCRUED INTEREST PER PERIOD||ACCRUED INTEREST ADDED TO LOAN PRINCIPAL||POLICY LOAN PAYOFF AMOUNT||AMOUNT SAVED|
|2/1/19||$188.71||$42.47|| ||$9,853.75|| |
|3/1/19||$188.71||$37.53|| ||$9,702.57|| |
|4/1/19||$188.71||$40.75|| ||$9,554.61|| |
|5/1/19||$188.71||$38.66|| ||$9,404.56|| |
|6/1/19||$188.71||$39.15|| ||$9,255.00|| |
|7/1/19||$188.71||$37.12|| ||$9,103.41|| |
|8/1/19||$188.71||$37.55|| ||$8,952.25|| |
|9/1/19||$188.71||$36.76|| ||$8,800.29|| |
|10/1/19||$188.71||$34.80|| ||$8,646.37|| |
|11/1/19||$188.71||$35.16|| ||$8,492.82|| |
|12/1/19||$188.71||$33.25|| ||$8,337.36|| |
|2/1/20||$188.71||$34.65|| ||$8,028.14|| |
|3/1/20||$188.71||$31.75|| ||$7,871.18|| |
|4/1/20||$188.71||$33.14|| ||$7,715.62|| |
|5/1/20||$188.71||$31.30|| ||$7,558.20|| |
|6/1/20||$188.71||$31.54|| ||$7,401.03|| |
|7/1/20||$188.71||$29.75|| ||$7,242.07|| |
|8/1/20||$188.71||$29.94|| ||$7,083.29|| |
|9/1/20||$188.71||$29.14|| ||$6,923.72|| |
|10/1/20||$188.71||$27.42|| ||$6,762.43|| |
|11/1/20||$188.71||$27.53|| ||$6,601.25|| |
|12/1/20||$188.71||$25.87|| ||$6,438.40|| |
|2/1/21||$188.71||$26.65|| ||$6,113.56|| |
|3/1/21||$188.71||$23.35|| ||$5,948.20|| |
|4/1/21||$188.71||$25.05|| ||$5,784.53|| |
|5/1/21||$188.71||$23.46|| ||$5,619.28|| |
|6/1/21||$188.71||$23.44|| ||$5,454.01|| |
|7/1/21||$188.71||$21.91|| ||$5,287.21|| |
|8/1/21||$188.71||$21.84|| ||$5,120.34|| |
|9/1/21||$188.71||$21.04|| ||$4,952.67|| |
|10/1/21||$188.71||$19.59|| ||$4,783.55|| |
|11/1/21||$188.71||$19.44|| ||$4,614.27|| |
|12/1/21||$188.71||$18.03|| ||$4,443.59|| |
|2/1/22||$188.71||$18.14|| ||$4,102.15|| |
|3/1/22||$188.71||$15.66|| ||$3,929.10|| |
|4/1/22||$188.71||$16.54|| ||$3,756.93|| |
|5/1/22||$188.71||$15.23|| ||$3,583.45|| |
|6/1/22||$188.71||$14.94|| ||$3,409.68|| |
|7/1/22||$188.71||$13.68|| ||$3,234.64|| |
|8/1/22||$188.71||$13.34|| ||$3,059.27|| |
|9/1/22||$188.71||$12.53|| ||$2,883.09|| |
|10/1/22||$188.71||$11.35|| ||$2,705.73|| |
|11/1/22||$188.71||$10.93|| ||$2,527.95|| |
|12/1/22||$188.71||$9.80|| ||$2,349.04|| |
|2/1/23||$188.71||$9.21|| ||$1,990.16|| |
|3/1/23||$188.71||$7.58|| ||$1,809.03|| |
|4/1/23||$188.71||$7.59|| ||$1,627.91|| |
|5/1/23||$188.71||$6.57|| ||$1,445.77|| |
|6/1/23||$188.71||$5.99|| ||$1,263.04|| |
|7/1/23||$188.71||$5.02|| ||$1,079.36|| |
|8/1/23||$188.71||$4.39|| ||$895.04|| |
|9/1/23||$188.71||$3.59|| ||$709.92|| |
|10/1/23||$188.71||$2.70|| ||$523.91|| |
|11/1/23||$188.71||$2.00|| ||$337.20|| |
|12/1/23||$188.71||$1.16|| ||$149.64|| |
The savings seems small in this example. By taking on a policy loan, you save $38.67 over a conventional loan. If you make weekly loan payments, you accelerate the payoff, saving even more money. With the conventional loan, this is not possible unless you make extra payments over and above the scheduled monthly payment. With a policy loan, you simply change the payment frequency to realize additional savings.
At higher interest rates, the savings can be substantial. Here is the same loan at an 8% APR:
Conventional Loan @ 8% APR/Repayment Rate
|Payment Date||Payment||Principal||Interest||Total Interest||Balance|
Policy Loan @ 8% APR/Repayment Rate
|SCHEDULED PAYMENT DATE||RECOMMENDED LOAN PAYMENT DUE||ACCRUED INTEREST PER PERIOD||ACCRUED INTEREST ADDED TO LOAN PRINCIPAL||POLICY LOAN PAYOFF AMOUNT||AMOUNT SAVED|
|2/1/19||$202.76||$42.47|| ||$9,839.70|| |
|3/1/19||$202.76||$37.48|| ||$9,674.41|| |
|4/1/19||$202.76||$40.63|| ||$9,512.28|| |
|5/1/19||$202.76||$38.49|| ||$9,348.01|| |
|6/1/19||$202.76||$38.91|| ||$9,184.16|| |
|7/1/19||$202.76||$36.83|| ||$9,018.22|| |
|8/1/19||$202.76||$37.20|| ||$8,852.66|| |
|9/1/19||$202.76||$36.34|| ||$8,686.23|| |
|10/1/19||$202.76||$34.34|| ||$8,517.80|| |
|11/1/19||$202.76||$34.62|| ||$8,349.66|| |
|12/1/19||$202.76||$32.67|| ||$8,179.57|| |
|2/1/20||$202.76||$33.92|| ||$7,840.87|| |
|3/1/20||$202.76||$31.01|| ||$7,669.12|| |
|4/1/20||$202.76||$32.29|| ||$7,498.65|| |
|5/1/20||$202.76||$30.42|| ||$7,326.30|| |
|6/1/20||$202.76||$30.57|| ||$7,154.10|| |
|7/1/20||$202.76||$28.75|| ||$6,980.09|| |
|8/1/20||$202.76||$28.85|| ||$6,806.17|| |
|9/1/20||$202.76||$27.99|| ||$6,631.40|| |
|10/1/20||$202.76||$26.25|| ||$6,454.88|| |
|11/1/20||$202.76||$26.26|| ||$6,278.38|| |
|12/1/20||$202.76||$24.58|| ||$6,100.20|| |
|2/1/21||$202.76||$25.15|| ||$5,744.37|| |
|3/1/21||$202.76||$21.94|| ||$5,563.54|| |
|4/1/21||$202.76||$23.43|| ||$5,384.20|| |
|5/1/21||$202.76||$21.84|| ||$5,203.27|| |
|6/1/21||$202.76||$21.70|| ||$5,022.21|| |
|7/1/21||$202.76||$20.17|| ||$4,839.62|| |
|8/1/21||$202.76||$19.98|| ||$4,656.84|| |
|9/1/21||$202.76||$19.12|| ||$4,473.20|| |
|10/1/21||$202.76||$17.67|| ||$4,288.10|| |
|11/1/21||$202.76||$17.40|| ||$4,102.74|| |
|12/1/21||$202.76||$16.00|| ||$3,915.98|| |
|2/1/22||$202.76||$15.84|| ||$3,541.96|| |
|3/1/22||$202.76||$13.52|| ||$3,352.72|| |
|4/1/22||$202.76||$14.11|| ||$3,164.07|| |
|5/1/22||$202.76||$12.82|| ||$2,974.13|| |
|6/1/22||$202.76||$12.39|| ||$2,783.76|| |
|7/1/22||$202.76||$11.16|| ||$2,592.15|| |
|8/1/22||$202.76||$10.67|| ||$2,400.06|| |
|9/1/22||$202.76||$9.81|| ||$2,207.10|| |
|10/1/22||$202.76||$8.66|| ||$2,013.00|| |
|11/1/22||$202.76||$8.09|| ||$1,818.32|| |
|12/1/22||$202.76||$6.99|| ||$1,622.54|| |
|2/1/23||$202.76||$6.06|| ||$1,229.44|| |
|3/1/23||$202.76||$4.68|| ||$1,031.35|| |
|4/1/23||$202.76||$4.32|| ||$832.91|| |
|5/1/23||$202.76||$3.35|| ||$633.50|| |
|6/1/23||$202.76||$2.60|| ||$433.34|| |
|7/1/23||$202.76||$1.69|| ||$232.26|| |
|8/1/23||$202.76||$0.89|| ||$30.39|| |
|9/1/23||$202.76||$0.03|| || ||$172.35|
|10/1/23||$202.76|| || || ||$202.76|
|11/1/23||$202.76|| || || ||$202.76|
|12/1/23||$202.76|| || || ||$202.76|
|1/1/24||$202.76|| || || ||$202.76|
This time, the savings is $983.40 over the conventional loan - a substantial savings.
... savings which can be put directly back into your life insurance policy to increase your own savings (cash value) and death benefit, instead of going to a bank, credit union, credit card company, or some other lender.
The unique nature of the policy loan increases borrowing efficiency, making it difficult to get a better deal elsewhere. Generally speaking, the higher the APR on the conventional loan, the more savings a policyholder can realize by using policy loans instead of the conventional loan.
The idea is to pay market rates of interest on the policy loan, adding the savings to your policy. This improves cash surrender values, death benefits, and allows for more borrowing in the future when needed.
Interest rates on policy loans vary, but are usually well below market rates. Policies with preferred loan options typically have a gross loan interest rate of between 5% and 8% but there is more to a policy loan than just its loan rate. Since policy loans are secured against the policy's value, and cash values are never removed from the policy, the insurance company continues to credit interest to those cash values and usually tries to match the loan rate (APR) to the dividend interest rate (or partially offset the policy loan rate with the dividend interest rate), either through direct or non-direct recognition of policy loans, thus creating a net loan cost which is less than 2% and sometimes 0%.
This additional interest crediting to policy cash values can make the net cost of a policy loan even lower.
Policy loans are guaranteed issue loans, meaning you cannot be turned down so long as you have cash value available to secure the loan. Unlike conventional loans, there is no credit check (and no "dinging" of your credit) with a life insurance policy loan. It will not show up on your credit report and does not affect any other credit-based or credit-dependent product or service, like auto insurance or credit card APRs. Funds are typically released from the insurer and deposited into your bank account within 5 business days, though some insurance companies can take up to 10 business days to deliver a paper check. Direct deposit of loan funds is generally quicker than check delivery. Some insurers also allow expedited loan processing, allowing policyholders to receive the loan money in as little as one or two days.
Policy Loan Rates And Interest Due On Loans
Policy loan rates are annual percentage rates (APR), which does not take into account the effect of compounding interest. In that sense, policy loan interest is non-compounding.
However, unpaid loan interest at the end of the year does get added to the policy loan principal. If you do not pay this interest, it will start to compound. If you repay your policy loans, the net effect is not harmful to you. Even if you don't repay your loans, the cash surrender value is used as collateral for the loan and is compounding against the loan. Interest is only assessed on outstanding principal balances and life insurance companies always allow you to repay loan principal before applying any money to interest. This can help you pay off the loan faster than if you had used a traditional loan (which requires interest be repaid before principal).
You can choose at the end of the year to pay either interest, principal, or both.
You can also make policy loan repayments monthly, weekly, bi-weekly, semi-annual, quarterly, or some other repayment frequency. It's totally up to you and the insurer will not hassle you for money or a specific payment schedule.
If you need to temporarily stop repayments, you can.
If you want to defer payments for a year, you can.
If you only want to pay the interest on the loan, you can.
If you want to accelerate payments, you can.
If you don't want to repay your policy loans, you can do that too.
This gives you an amazing amount of control over how much interest you pay, your repayment schedule and, ultimately, your long-term cash value accumulation as a result of continuous policy loans. More on that in a moment.
Direct Recognition Versus Non-Direct Recognition
Since policy loans are secured by your insurance policy, the insurance company must figure out how best to make good on its promises to pay the guaranteed interest plus any excess profits back to policyholders. They do this by setting both contractual promises and internal protocols for how they will recognize any loans taken out against life insurance policies.
They use either the "direct recognition" method or the "non-direct recognition" method.
"Recognition" refers to how the company will recognize the policy loan when paying dividends on loaned policy values.
In the direct recognition method, life insurers "recognize" the loan for purposes of paying dividends. This means the insurance company matches the dividend rate to the APR of the policy loan.
This might mean raising or lowering the dividend interest rate on loaned policy values (while leaving the dividend interest rate unchanged on unborrowed policy values).
Since all policy loans come from the insurance company's general investment account, the insurer cannot pay back more in dividends (investment gain or profits) than what it charges you in loan interest (which, from the perspective of the insurer, is investment profit).
In other words, if the insurance company lends you money at 5% APR, it can afford to pay you a maximum of 5% on the money it lent you when it pays dividends at the end of the year.
In essence, a policy loan diverts money away from the general investment account and puts it into the policyholder's hands so he or she can use it for something else (a new car, start a business, or an investment of some kind).
The insurance company thus "recognizes" this against the dividend payment. For example, if the normal dividend interest rate on unborrowed policy values is 6%, and the APR on policy loans is 5%, then the insurance company will change the dividend rate paid on borrowed policy values to 5% to match what the insurer is now being paid on that money. All unborrowed funds keep getting the normal 6%.
So, for example, if you have $100,000 in cash value earning the normal dividend interest rate of 6%, and you borrow $10,000 at 5%, at the end of the year the insurer can afford to pay you 6% on the remaining unborrowed $90,000 and 5% on the $10,000 you borrowed.
This means the net cost of the loan is 1% (6% normal dividend rate - 5% matched dividend rate = 1%).
This might seem like a drag at first, but it can also become a benefit when insurers use this direct recognition method to boost the dividend interest rate. When interest rates are rising (and when conventional loans from a bank or credit union would otherwise be unattractive), the insurance company can create a negative spread to the insurer and a positive spread directly to the policyholder.
For example, suppose interest rates rise and the new APR on policy loans becomes 8%. The normal dividend rate is still 6%. All borrowed policy values now have a 8% dividend interest rate instead of 6%, making policy loans very attractive for the policyholder and for the life insurance company.
If you have $100,000 in cash value earning the normal dividend interest rate of 6%, and you borrow $10,000 at 8%, at the end of the year the insurer can afford to pay you 6% on the remaining unborrowed $90,000 and 8% on the $10,000 you borrowed.
Even though there is an interest cost, the difference between the dividend rate on unborrowed funds and borrowed funds is -2%, meaning your policy cash values grow at a faster rate when you take on policy loans.
In addition to the direct recognition, a spread is sometimes charged on these policy loans to control arbitrage and to pay for policy loan servicing, but these spreads are typically very small, between 0.10% and 0.70%.
Some insurers may charge a 0.10% spread on policy loans for the life of the policy while others will charge a higher spread, say 0.70% for the first 10 years of the policy and then eliminate the spread in years 11+.
A spread effectively reduces the dividend rate on borrowed funds by the amount of the spread. So, if the policy loan rate is 5% APR, this makes the dividend rate on those borrowed funds 5%, but a spread of 0.70% will adjust the dividend rate on borrowed funds down to 4.3%:
Another example of direct recognition with a high loan rate:
The margin obviously increases the cost of the loan but it also makes it more fair for policyholders by accounting for the full cost of servicing the loan (instead of subsidizing it with other parts of the business or by other policyholders without policy loans).
Direct recognition can encourage policyholders to be judicious in borrowing, only taking policy loans when it really and truly makes sense and to also repay those policy loans at a higher rate of interest than what the insurer is charging.
From the point of view of the policyholder, paying more interest than what is required makes perfect sense since he or she is owner of the insurance company, and paying more premium generally improves policy performance while increasing cash values. At first, this seems counterintuitive, since we've always been taught that paying less interest is the goal. Normally, that's wise advice because you normally don't have any ownership stake in the financial institution issuing the loan.
But, with a whole life policy, you do have ownership stake in the financial institution issuing the loan. So, any additional funds paid to said institution are ultimately a net gain to you. The excess interest payments can be added to the cash value through a paid-up additions rider and by directing the insurer to purchase paid-up additional insurance with all excess monies they receive. More on that in a moment.
Non-direct recognition means the insurance company does not "recognize" the policy loan when determining dividend payments to policyholders with outstanding policy loans.
For example, if an insurance company's normal dividend interest rate is 6%, it will continue to pay dividends based on that dividend interest rate regardless of policy loan activity.
You could borrow substantially all of your cash value and your dividend payments will not change.
What is this magic and how does it work?
Non-direct recognition makes it appear as though you're getting a "free lunch," but you're smarter than that. The insurance company is not doing this service for free. In order to maintain the dividend rate regardless of policy loans, it has to increase its operating costs to offset the higher dividend it's paying. Some companies accomplish tying dividend payments to net death benefit values.
As policyholders take on policy loans, the net death benefit drops (due to the fact that policy loans are secured against the death benefit). Since dividends are based on net death benefit, the actual dividends paid are lower than what they otherwise would be, despite the fact that the dividend interest rate did not change.
Other companies choose to lower all policyholder dividends all the time, regardless of policy loan activity. This way, they can maintain the same dividend regardless of policy loan activity.
In this scenario, policyholders who do not take policy loans are subsidizing those who do.
Still other insurers choose to subsidize dividends on loaned policy values with other lines of business, which generally increase the cost of operating the business and thus… the cost the insurance policy, effectively reducing the net amount credited to cash values.
How much is the reduction? That varies from insurer to insurer. It can be an effective adjustment of 0.50% or 1%.
But… the insurance company won't tell you up front exactly how they calculate their dividends and what the adjustment is on non-direct recognition loans. That's proprietary information they don't want leaking out into the public because they don't want their competitors to know how they calculate dividends. It's a competitive advantage thing.
But, from my experience and running thousands of life insurance policy illustrations and talking to financial analysts at some of the major mutual insurers, I've figured out that… at the end of the day… non-direct recognition is no better or worse than direct recognition in most cases.
It's just different.
Yes, it's true there can be an advantage to loans under a direct recognition scheme when loan rates exceed the general account portfolio rate (and when borrowing accelerates cash value growth), but… most of the time, either direct or non-direct recognition will work just fine.
While non-direct-recognition does not explicitly encourage excess payments to the insurance company, most policyholders benefit by paying more back to the insurer than what the insurer is charging them for the policy loan.
Control Of Repayment Schedules
One of the nice things about policy loans is you have complete control over the loan repayment schedule.
You can pay nothing, just the interest on the loan at the end of the year, $50 per month, $72 per month, some other arbitrary dollar amount per month toward just the loan principal, or create a fully amortized repayment schedule similar to what you'd get from a bank or credit union with the difference being your insurer will prioritize repayment of the loan principal over the interest payments.
You can schedule repayments similar to a fixed payment loan, a credit card, or some other revolving line of credit.
At the end of the year, you will be billed for any interest. You can add it to your current policy loan and not pay it, add it to the current outstanding loan and pay it off, or pay the loan interest out of pocket. Most people choose to add the loan interest to their existing loan principal and then continue making payments until the loan is repaid in full. Because payments are applied to principal first, the amount of interest charged (on a loan that is being repaid) is constantly decreasing, so - in most cases - there is no serious disadvantage to adding loan interest to an existing outstanding loan.
Growing Cash Values While Using Policy Loans
How interest rates work and a demonstration of the whole life insurance borrowing strategy…
Twenty years ago I had a capital of about a half million dollars. I then realized that a business man with a half million of capital and a million and a half of insurance on his life would have better credit than one with a half million of capital and no insurance - so I took the insurance. I now find that trading on the credit it created I made more profit than if the money which went into insurance had gone directly into my business.
- John Wanamaker
John Wanamaker made whole life insurance famous by being the most-insured man in America in the 1800s. He also spoke publicly on numerous occasions about whole life insurance and endowments, which he used to build a $100 million business empire before his death in the early 1900s ($100 million in the 1900s would be worth well over $1 billion today).
That empire still exists.
Back then, it was Wanamaker's Department Store. Today, we all know it as Macy's Department Store. His method is very similar to more modern strategies which advocate using a whole life insurance policy to fund major purchases and investments.
This is precisely what Wanamaker did.
He plowed a substantial amount of money into whole life insurance and then… used his policies as collateral for loans to build his business. Sometimes, he would borrow from his insurance company. Other times, he used commercial paper (for very short-term loans). He rarely took on bank loans or mortgages (he didn't like them).
At that time, that sort of thing was unheard of. Most businessmen financed businesses through a bank.
Wanamaker decided to self-finance and… his strategy (coupled with his brilliant business ideas) paid off. He became one of the richest men in America at that time. He was outdone only by his son, who did the same thing.
Could he have done it without using whole life insurance?
Anything is possible if you're dedicated enough to your ideas.
But, in Wanamaker's own words:
I simply worked out five conclusions as the result of my own thinking, without any moving cause except my own judgment:First: that at the time I knew I was insurable and I could not be sure of immunity from accident or ill-health and it might be that at some future time I would not be insurable. This was the first step to the building up of my 62 policies.Second: that life insurance was one of the best forms of investment because from the moment it was made it was good for all it cost and carried with it a guarantee and there was protection in that investment that I could not get in any other.Third: that life insurance in the long run was a saving fund that not only saved but took care of my deposits and gave the opportunity for the possible profits that not infrequently returned principal and interest and profit.Fourth: that life insurance, regarded from the standpoint of quick determination, was more profitable than any other investment I could make.Fifth: that it enabled a man to give away all he wished during his lifetime and still make such an estate as he cared to leave.… I did not know what life insurance really meant to me, until my policies were falling due and I had a large sum of money with which I began to build my Philadelphia Store. I would not have been prepared to start my building when I did if I had not saved $2,500,000 little by little.
Anyway, here's how Wanamaker did it (and, oh by the way… here's also how whole life insurance policy loans work)…
Let's start with a basic whole life policy which has been "juiced up" with paid up additions.
Let's also assume insurance needs are $1 million. $1 million is a nice round number.
I like round numbers:
|YR||AGE||PREM||CASH VALUE||DEATH BENEFIT||ANNUAL RETURN ON CASH VALUE|
| || || || || || |
This policy is illustrated for a 35 year old, male, non-smoker, but the basic principle of whole life insurance is the same at all ages, gender, and risk classes.
For $1 million of insurance, the annual premium is $11,346.00.
In the first year, this generates $5,947.00 of cash value. That doesn't look too impressive and that's because whole life insurance is a front-loaded contract, meaning a substantial portion of the expenses and costs of doing business are in the first couple of years of the contract.
In the first three years, the annual return on cash value is negative. In the fourth year, the cash value grows at a faster rate than the premium being paid, generating a positive annual return. And… it remains that way forever.
But because of the costs in the first 3 years, it takes 8 years before the net cash value of the policy exceeds the total premiums paid into the policy (called "total return" or "internal rate of return").
This is the primary disadvantage of whole life insurance.
It is a long-term contract that always pays off but… it requires patience to see it through. Most people who do not like whole life insurance don't like this aspect of it, are "natural risk-takers," and are emotionally or psychologically more satisfied with short-term or high-risk investment strategies with short potential time horizons and quick payoffs.
Individuals who prefer whole life insurance are somewhat patient, they think long-term and long-range, they are more risk averse (they feel somewhat uncomfortable taking excessive investment risks), they have a low risk capacity (i.e. objectively, they cannot afford to lose their savings or income), and they have a psychological need for financial security and stability.
By age 70, that patience has paid off and the policyholder has become a millionaire, accumulating a savings of $1,062,868.00. In addition to the cash value, they have a little over $700,000 of insurance (insurance is total death benefit - net cash value) and a total death benefit of $1,777,092.00.
If you smoothed out the annual returns earned over 35 years for this individual, you'd find they made a compound annual return of 4.94% so far. This return is net of taxes since whole life insurance cash values can generally be used tax-free as long as the policy remains in force.
But, active policyholders don't sit on their cash values for 35 years.
They typically use their cash value while they're alive for various purchases. The next illustration shows how policy cash values can be used to purchase multiple vehicles over time.
In this example, assume the policyholder stops financing his or her automobile purchases through the bank or credit union and instead finances them through his or her own life insurance policy.
The policyholder buys a $20,000 automobile every 5 years:
LOAN PRINCIPAL (END OF YEAR)
Instead of paying interest and principal to a bank or credit union, this individual repays his life insurance company with the same payments he or she would make to a traditional lender.
The insurance company collects interest payments, just like a bank would. But, it counts these interest payments as profits, which it then distributes to all policyholders through the annual dividend (non-direct recognition) or to the borrowing policyholder directly through direct recognition of the policy loan (switching the dividend rate on the secured cash value to match the loan rate). Eventually, the policyholder recoups the interest cost of the loan through the dividend payment.
Once the loan is fully repaid to the insurer, the policyholder can continue payments through the paid-up additions rider, enhancing the cash value of the policy and the long-term cash value and death benefit growth.
In this example, financing one car every 5 years pushed the cash value at age 70 up from $1,062,868.00 to $1,103,115.00… a net increase of $40,247. The excess payments made to the paid-up additions rider are equal to the interest that would have gone to a bank for the privilege of automobile loans for 35 years but instead went to the policyholder. As soon as cash value is available, the policyholder can borrow to pay for anything he or she wishes - automobiles, computers, vacations, even homes or… investments in other businesses outside of the insurance policy. Some policyholders use their cash values to purchase valuable art, precious metals, to start their own business, or to make investments in common stocks.
As the policyholder repays policy loans, cash value is restored and is immediately available for borrowing again.
In essence, the borrowing and repayment process can be done an infinite number of times, with each repayment growing cash values higher than they were before so long as all loan payments are made, and excess payments are made to the paid-up additions rider. Payments into the policy can be made up to the policy's annual payment limit. Once a policy's annual premium limit has been reached, the policyholder starts another policy and repeats the process.
Occasionally, a client will ask me if they can add bonuses they receive from their employer to their insurance policy or… tax refunds.
Here's how that might look:
"ADDITIONAL PREMIUM (TAX REFUND PAID IN AS ADD'L PREM)"
An annual $3,000 tax refund that's put into the life insurance policy first, before it's spent on something else, goes to work earning interest for the policyholder… forever. It can then be borrowed against for major purchases. It also generates $244,283 more cash value than the previous example, pushing the non-guaranteed illustrated cash value from $1,103,115.00 to $1,347,398.00 at age 70:
By this time, the compound annual return on the non-guaranteed cash value has gone from 4.94% at age 70 in the original scenario to 5.11% at age 70 and continues to rise to 5.15% well into retirement. The policy is also able to generate a non-guaranteed tax-free income via policy loans of $51,162 per year, adjusted for inflation every year, for the rest of the policyholder's life. I also ran an alternate income scenario showing income running out to age 121. Few people want to see this because no one believes they'll live that long. However, the policy can potentially support you for that long, if need be:
INCOME FROM POLICY TO AGE 100
"ALT INCOME FROM POLICY TO AGE 121 (NOT REFLECTED IN CASH VALUE OR DEATH BENEFIT)"
***Note: "Income from policy" denotes withdrawals from the policy up to the policy's basis (total premiums paid into the contract), and then switching to policy loans with policy income creating loan principal and interest. The loan interest generated is partially or fully offset by interest credits to the policy's cash value.
Alternatively, a policyholder could annuitize their policy, and convert it into guaranteed lifetime income if they want or need more certainty about their retirement income.
Some policyholders take it one step further by financing their own life insurance premiums. When they do this, they receive an effective discount on their whole life premiums and repay their insurance company with the same monthly premium they were making before.
The end result is usually a dramatic and permanent increase in the compound annual growth rate of the policy which results in even stronger cash value growth.
Stopping Premiums While Repaying Loans
Something else to note: In the previous examples, I assumed you pay premiums the entire time you are also borrowing and repaying loans. In reality, you may not be able to do this or you may not want to do this.
That's fine. Whole life policies generally have the option of going on "alternate payment option" or "premium offset" where premiums can be temporarily stopped while making loan repayments. The insurance company will use dividends, paid up additions, or a combination of both to continue making premiums while you repay your policy loan.
The Risk Of Policy Loans
During this process of paying premiums, financing major purchases and investments, and accumulating cash values, the policyholder risks very little since those cash values are guaranteed against loss.
Technically, it is possible to lapse a policy by borrowing too much against the cash value or by not repaying the loan or neglecting the policy in some other way, but… it's rare and 100% preventable.
The loans are all secured against the cash value but are never taken out of the cash value so the policy's growth rate continues regardless of loan activity. This is why cash values grow to substantial amounts over time when using the whole life insurance borrowing strategy.
This is true for both direct and non-direct recognition insurance companies. Even though the direct recognition method does alter the dividend to match policy loan rates, it does not affect the guaranteed growth rate and there is always dividend payable whenever dividends are declared by the company.
So, even if direct recognition results in a reduction in dividends paid on loaned amounts, this is made up for through the loan repayments and subsequent dividends paid in the future so long as the policyholder is smart about repaying those policy loans.
When the policyholder is ready to take income from the policy, the insurance policy can be kept in-force (thus keeping the life insurance component of the policy) or converted to an income annuity (giving up the insurance component and receiving income only).
In some cases, the insurance company will offer a higher income payout if the policyholder converts the policy to an income annuity. But if the policyholder elects this option, a portion of the income will be subject to income tax.
Finally, to prevent a policy from lapsing due to excessive policy loan activity, the policyholder could elect a reduced, paid-up option which will eliminate outstanding policy loan debt, prevent the policy from lapsing due to over-loaning, and end the required premium payments on the policy.
Alternatives To The Life Insurance Method
Some people believe they can save themselves the cost of insurance and do it better without the insurer. Most people, most of the time, however, find alternatives to whole life produce worse results and are harder to manage.
For example, suppose you tried the same thing with a savings account or bank CD paying 2% interest on your savings:
Bank CD Paying 2% Annually
|Year||Beg. of Year Account Balance||Beginning Of Year Payment||Annual Earnings Rate||BOY Value||Annual Earnings On Acct.||End of Year Account Balance|
The bank CD produces inferior growth on savings, before accounting for taxes. In this case, the cost of insurance is a moot point. The growth of the savings is just not there.
But, let's assume this person persists and does the borrowing strategy through their bank, instead of an insurance company:
Using A Bank CD To Finance Purchases
Beginning Of Year Payment
Annual Earnings Rate
BOY Account Value
Annual Account Earnings
Annual Tax Payments
Annual Cash Withdrawal
End Of Year Account Repayment
Annual "Interest" Cost
End of Year Account Balance
After adjusting for taxes, the ending account value here is just $591,665 - which is good, but not anywhere near as good as the whole life insurance option.
A few things are hurting you here.
The most obvious is the low interest rate. Whole life pays a guaranteed interest rate plus annual dividends (interest and profits of the insurer), which is difficult to compete against.
You pay taxes on any gains from CDs.
You also have to withdraw money from savings each time you "borrow" because you're not actually borrowing money… you're withdrawing it, which slows down the growth of said savings.
If you did borrow money against your bank CDs, the picture looks even more bleak.
Banks are in business to make a profit, just like life insurance companies. So, they are going to charge you more interest than what they're paying to your CDs. The difference is, with a life insurance company, you get a share of those profits. You don't get the same deal from a bank or other lender.
There's also the awkward rollover and repurchase risk with bank CDs.
A CD is a "certificate of deposit," and typically does not allow for systematic contributions or withdrawals. So… you can't just "throw money at it" randomly whenever you want. Nor can you withdraw money whenever you want without losing some interest earnings (clawback provisions for early withdrawals on CDs are usually 3 months of interest payments). Meaning, you're not going to be earning a consistent rate from the CD plan. I did not show it here, but the extra drag of CD redemptions would lower your net savings.
You could hypothetically increase the return and eliminate some of the tax burden by assuming you make better returns inside a qualified retirement plan, like a 401(k).
A few people have asked me about this in the past.
Most people aren't serious about actually doing it with their retirement account (more on that in a moment). But… aside from that, let's say someone did want to legit try this.
Could they do it?
Yeah, of course they could.
But… there are a few not-insignificant hurdles to overcome.
First, the IRS prohibits 401(k) plan loans in excess of the lesser of 50% of the account value or $50,000. So, at some point, you're capped out at $50,000 of total loanable funds which… limits the amount you can borrow and repay to your savings which… slows down the growth of your savings considerably.
Like the savings account option, you have to cash in your investments, and withdraw funds from the account, which also slows down the growth of your savings since you're no longer earning any interest on the borrowed money.
But, unlike the bank CD option, any volatility in the marketplace could cause you to lose a significant portion of your savings.
As you "borrow" from your 401(k) plan, you end up doing the same thing as with the bank CD - you're withdrawing money from your 401(k). It's not a true collateralized loan.
As such, you run a serious risk of withdrawing money during micro (small) or major market corrections - essentially, you're unintentionally timing the market while financing your major purchases.
If you sell your investments during a correction, you compound your losses. As you repay your 401(k) loan and buy back in at higher and higher asset level, you systematically erase any of the benefit you had by simply buying and holding for the long-term.
To throw some salt in the wounds, you pay tax twice on the interest you pay back to the 401(k) plan since those interest payments are made with after tax dollars and yet the entire 401(k) balance (including after-tax interest payments) are taxed at retirement when you take income from the plan.
Borrowing from retirement plans also comes with increased risk if you lose your job because plan loans must be repaid in full immediately or the entire amount is taxed as a distribution and subject to a 10% penalty if you're younger than age 59 1/2.
Finally, your administrator has the final say as to whether you can take out a loan. This means you might be arbitrarily turned down for a 401(k) loan if your plan administrator wants substantial proof of your need for the money. Remember, your 401(k) is a trust account and the administrator has final say over what happens to the funds.
You might not be able to take out a loan at all.
With some of the more popular low-cost 401(k) options on the market today, plan administrators simply do not allow plan loans because they're too costly to administer.
Again, it's not to say these alternatives can't work. It's just that they tend not to work as well as whole life and are more difficult to manage. And, for most people, they find it's simply not worth the risk because investments work best when you buy them and hold them (basically) forever.
What good is cash-money-bling if you can't spend it, amirite?
Once you've built up substantial cash values in a whole life policy, you have a few decisions to make. Either you:
1) Don't spend a dime,
2) Spend some of the money or;
3) Spend it all and let the good times roll, baby!
Assuming you want to spend at least some of the cash value at some point in the future (whether for retirement or some other ongoing income need), you have several options.
Dividends can be withdrawn from the policy by surrendering paid-up insurance and taking dividends back as cash.
This can be done at any time and without receiving those dividends at a discount to their original value. In other words, if you originally received $1 in dividend from the insurer and used it to buy paid up additional insurance, then you can withdraw that $1.
You won't receive any less than what's in your cash value (which is why it's called "net cash value"). In fact, you'll receive more because dividends used to purchase paid-up additional insurance go on to earn guaranteed interest plus their own dividends (it's like dividends having little dividend babies).
Any dividends you withdraw permanently reduce the net death benefit payable when you die and also reduce your net cash value by the amount of the withdrawal. So, if you withdraw $1, your cash value is reduced by $1 and your death benefit is reduced by whatever amount of death benefit that $1 of dividend purchased.
Withdrawals, Switch To Loans At Basis
Once you've withdrawn enough dividends from your policy to recover your cost basis (an amount equal to your total premiums paid into the policy), the IRS says you have a "gain" in the policy.
I thought dividends were a "return of premium"?
Lots of financial blogs have exaggerated this idea that dividends are a return of premium, which is… sort of true but not really. Dividends are considered a perpetual return of premium by the IRS but only if they're used to buy paid-up additional insurance (which excludes them from being taxed), but… once you start withdrawing dividends, all the sudden… the rules… they change.
Withdrawn dividends represent a gain if you withdraw more money than you paid into the contract.
So, if you paid $20,000 in premiums over the course of 10 years, and then withdraw $30,000 in dividends, $10,000 of that money will be taxable at ordinary income tax rates.
It's like this:
$30,000 total withdrawal - $20,000 of cost basis/total premium paid into the policy = $10,000 gain
But, instead of being taxed on this money, you can switch from "withdrawals" to "policy loans" at your cost basis, and avoid paying taxes on all that income (called "phantom income").
It's true you will pay interest on these loans and, over time, it could be substantial. But, it may be less than the amount you'd pay in taxes. The best income scenario ultimately depends on your future tax bracket and the tax rates and rules in the future when you draw income from your policy.
Policy Loans Only
In lieu of withdrawing money from the policy, you can take policy loans only.
Instead of withdrawing money from the policy or borrowing against the cash value, you can convert the policy to an annuity. An annuity is a special type of insurance policy that guarantees you an income either now or later.
The downside here is you will lose your life insurance policy and access to your cash value. You will also be taxed on the gain you realized in the policy when you receive it as income. The upside is the insurance company will convert your cash value to a guaranteed income for the rest of your life with optional payments to your beneficiaries after you die.
Depending on your age and income needs, this might be a good option as it can generate a high income in the latter years of your life, even after accounting for taxes.
Non-Forfeiture Options For Whole Life Policies
There is this weird, persistent, myth out there that if you if you change your mind, and don't want your whole life policy anymore, you lose everything.
Enter non-forfeiture options - provisions embedded in every whole life insurance policy sold today which prevent this from ever happening.
Worst-case scenario, you can always surrender the whole contract for its net cash surrender value, but… you don't have to take this option.
Instead, you may elect one of several non-forfeiture options.
A non-forfeiture option means you are not losing the benefits of your life insurance policy. Instead, you are converting them to something else or getting some other benefit from the insurance company.
For example, most whole life policies offer the option of conversion to extended term life insurance. Under this option, the cash value is used to pay for the term premiums for however long the cash value will support a term life policy at the age the non-forfeiture extended term insurance option is elected.
Another non-forfeiture option is called "reduced paid-up," meaning the insurance company will reduce the face amount of insurance to a death benefit amount which can be supported for the rest of your life given the current cash surrender value of the policy.
This is very similar to the extended term insurance option except that it's an "extended whole life option." Under this option, your current policy becomes paid-in-full and no further premiums can be paid into the policy.
An annuity is the other option for non-forfeiture. An annuity is an insurance policy which guarantees an income to you either now or sometime into the future. As I noted above, some insurers will offer an annuity payout as an income option for retirement.
Under this option, your whole life policy cash value is moved to an annuity and your life insurance policy is canceled. The annuity may be deferred (meaning, you defer income payments and instead earn interest on your savings) or immediate (meaning, you take income immediately from the annuity).
How Can Insurance Companies Offer These Guarantees And Potential Dividends?
The answer is: It's magic.
No, no, I'm kidding of course.
The cash value of whole life is actuarially (mathematically) designed to grow in value over time and equal the death benefit at either age 100 or age 121. The cash value is also used to replace the insurance component of the policy (called the "net amount at risk" or "at risk amount") and provide money to help pay for the death benefit when you die.
The way they're able to do this is by matching their investment cash flows and assets to liabilities. They also maintain a healthy surplus (cash reserve) to protect policyholders and are very conservative with how they manage policyholder funds.
At the end of the day, the cash value of whole life is guaranteed against loss and also grows at a guaranteed rate each and every year. This requires expert-level money management which, quite frankly, doesn't exist outside the insurance sector.
It just doesn't.
While not all of the insurance company's investments in the general investment account are bonds, many of them are. Insurers attempt to diversify investment holdings so that you can be guaranteed a minimum interest rate on policy cash values. Insurance companies are one of the few financial institutions that matches its assets to liabilities, which is how they meet their long-term death benefit guarantees.
As mentioned before, it also ensures that the insurer meets its contractual obligation to provide a guaranteed cash value that equals the death benefit amount at your age 100 or age 121.
Over and above the guarantees, a life insurance company selling whole life wants to be competitive by offering an attractive dividend to its owners (policyholders). Because mutual life insurers' primary source of income is policyholder (owner) premium payments, it has a strong incentive to grow the mutuality and keep its policyholders happy. To this end, it engages in highly profitable lines of business (e.g. life insurance, disability insurance, mutual fund management, etc.) to earn enough to pay dividends to its policyholders. It also generates substantial investment earnings from its bond and fixed-income holdings. Excess interest not needed to secure the policy's guarantees is included in the year-end dividend payment.
These dividend payments tend to be massive for what should be obvious reasons. And, the longer a policyholder owns a whole life policy, the more substantial the potential dividend payment is.
Clarification On The Cost Of Whole Life Insurance
A major misconception about whole life insurance is that it is more expensive than term insurance. By "expensive," most people mean that you pay more in out-of-pocket premium than for term insurance.
In fact, it's near-impossible to find an online source that doesn't describe whole life insurance as being more "expensive" than term.
However, the high expense of whole life is grade-A nonsense. Every life insurance agent knows this because we all take the same basic Life and Health 101 courses before being licensed to sell insurance.
Our introduction to life insurance course material explicitly states that:
"In essence, the level premiums collected under a permanent policy are actuarially (i .e. mathematically) equivalent to the sum of the increasing annual renewable term rates for the same insured risk and for the same period of time. Because of the time value of money (i.e., the influence of interest), the actual sum of out-of-pocket premiums paid under a permanent policy (or a term policy that extends for a number of years) will be significantly less than those paid under an ART policy, all other factors (e.g., age and policy face amount) being equal." - Life And Health Insurance License Exam Manual, 6th Edition.
ART refers to "annually-renewable term" insurance, which is the basic chassis that all term (and whole life, for that matter) insurance is built on.
In other words, premiums for whole life are not "excessive" and, in fact, are very similar to a basic term insurance policy if you were to strip out the interest earnings and cash value from the policy.
As time goes on, however, the out of pocket premiums for all forms of level term insurance (which, again, are all based on a one-year annually-renewable term policy) are substantially higher than for whole life.
Even if you were to calculate the internal costs for whole life, they are generally lower than for an equivalent term insurance policy, over time. Again, this is due to the fact that the cash value of whole life insurance is slowly replacing the pure insurance component of the policy, lessening the total cost for the policy over time.
A Word On "Self-Insurance"
Technically speaking, there is no such thing as "self-insurance." Black's Law dictionary defines "self-insurance" as:
An approach in risk management where a sum is set aside to protect against the possibility of a loss. No insurance policy is involved and should be called risk retention.
And, in fact, this is what it is called in all insurance courses: risk retention.
This is perfectly fine as long as you understand what this means.
Using your own savings as pseudo-insurance (AKA "self-insurance") means segregating these funds from your other savings, reducing the total usable savings available to you while you're alive.
This is a "soft cost" of so-called "self-insurance" plans - $1 of income or savings is needed to "insure" $1 of liability. This makes self-insurance very expensive, since the unit cost or "cost per $1,000" of "self-insurance" is $1,000. ($1,000 of savings is required to "buy" $1,000 of "self-insurance").
If you purchase life insurance, then $1 of income or savings may buy $500 or $1,000 or perhaps more of insurance. Not only is the cost per $1,000 of insurance much, much, lower than the risk retention strategy, the life insurance policy also (as an effect) allows you to keep more of your savings free for other investments or expenses that might come up.
In other words, combining life insurance with a savings (i.e. whole life) allows you to have access to most or all of your savings while simultaneously maintaining insurance at a reasonable cost.
This is true whether you're 20 years old or 80.
Is Whole Life Insurance Right For You?
Hopefully this guide has helped you make a decision about whether whole life insurance is right for you. Most policyholders view their whole life policy as a long-term asset, and never surrender it unless they need to convert their cash value into retirement income. If the idea of owning a guaranteed lifetime asset is exciting to you, then whole life insurance might be just what you need.
However, if you're still not sure, keep reading the guide.
Learn More About Life Insurance
Protect yourself, your loved ones, and build real lifelong financial security. Learn (almost) everything you need to know about life insurance by reading The Rogue Agent's Guide To Life Insurance.
About The Author
David C. Lewis, AKA The Rogue Agent, is a licensed independent life insurance agent (License No./NPN: 8462895), specializing in life insurance planning and The Perfect Policy™ design concept. He is also the owner of Monegenix®. To learn more about him and his work, read his full bio.