This article is part 2 of 2, in the analysis of whole life versus term life insurance. Read the first article here.
It’s time to break out those costs and investment returns embedded in the whole life policy.
This is where most people fall down.
But, don’t worry. I’m going to walk you through the entire process, step-by-step, and I’ll simplify all of the complicated number crunching below.
When you buy a whole life policy, you receive a policy illustration, which explains how your policy works.
Unfortunately, whole life is considered a "bundled product," meaning the cash value and insurance components are bundled together, making it more difficult to compare it to other contracts without the help of a professional.
Popular methods of analyzing whole life involve calculating the cost surrender or net payment index, using the Linton yield method, or using a variety of other hypothetical financial models.
I don’t think any of those are good ways to analyze life insurance, so I decided to reverse-engineer my life insurance policy to see just what the insurer is assuming will happen with it.
Seeing those assumptions, along with the company’s financials, will give me some idea about whether the policy illustration makes sense.
Rather than build another hypothetical model on top of the insurance company’s hypothetical policy illustration, I decided to just disclose the cost and investment assumptions embedded in that illustration.
It’s easy if you know what you’re doing, and I think this method makes the most sense.
Anyway, here’s what I discovered about my whole life policy:
Here it is in graphical format:
As you can see, my policy’s costs (in yellow), relative to cash value (in green) and premium payments (in blue), aren’t excessive.
A lot of people will tell you that whole life is expensive, but those costs clearly don’t eat up the policy values, which is good, because I’ll need them later.
For this policy, I purchased $353,848 of death benefit, some of it being supplemental term insurance which converts to whole life every year automatically, along with a small amount of base whole life.
At no point during the contract is the policy scheduled to become a modified endowment contract (MEC).
If you don’t know what that means, hit me up in the comments section. I don’t have the space to go off on a tangent here.
Collectively, this is still called a whole life policy, so that’s how I’m going to refer to it.
The cost per $1,000 starts at just over $8. Then, it drops before it rises substantially in the older ages.
The 30 year average cost per $1,000 of whole life insurance is $7.19.
Think of the cost per $1,000 as the "unit cost" or "unit price" of insurance/savings.
Since whole life combines both insurance and savings, we’re measuring those combined costs.
You know when you go into a supermarket and you look at the price of something, and somewhere on the shelf is the "unit price?"
Usually, a product’s unit price is listed as so many dollars or cents per gallon, or per ounce, or per pound.
This is the cost that lets you make an "apples to apples" comparison between two similar or dissimilar products.
That’s exactly what I’ve done here, except I’ve done it for life insurance.
Since insurance is priced per "per $1,000" of insurance/savings, that’s what I used as the unit price here.
This is what I’ll compare to buying a 30-year term policy and investing the difference, because a 30-year term policy is very common.
But, I also wanted to know what the cost would be if I held the contract to the maximum age of 121.
The average cost per $1,000 over 86 years is $60.27 on a non-guaranteed basis.
This means that the insurance company assumes this is what the costs will be, but those costs could vary a bit over the years.
Next, let’s look at the costs and savings or cash value build-up if I were to buy term life insurance and some other savings product, like an investment of some kind or a hypothetical non-investment financial product:
And again in graphical format.
This illustration assumes the same 7.1 percent compounding rate as the whole life policy.
I think that’s a reasonable assumption because this is about what you’d average if you invested your money using the classic 60/40 split, and earned historical rates of return from the S&P 500 plus current bond rates (60 percent of your savings invested in the stock market, 40 percent of your savings invested in bonds).
The long-term average of the S&P500 stock market index is about 10-11 percent. Going forward, professional investors like Warren Buffett assume a 6-7 percent return, adjusted for inflation.
This comes out to about 8 to 9 percent, excluding inflation.
But, bond yields have been compressed. That means you’re lucky to get 3 percent from fixed-interest investments. This is unfortunate because bonds are a necessary safety net for the volatility of the stock market – they help preserve your savings and give you income from the interest they generate.
With a long-term rate of return on stocks of 8-9 percent, and a long-term return from bonds of 3 percent, your weighted average return from a 60/40 split would be about 7 percent.
I also assumed an average 1.44 percent total fee for investing with mutual funds inside a qualified investment account (based on the 401(k) Averages Book, 14th edition).
Finally, I assumed a term policy premium of $359 on $350,000 of death benefit for the next 30 years.
Oh, and I bumped up the annual contribution amount to just over $15,000 to account for the tax benefit I would get from setting aside money on a pretax basis in a 401(k).
My average (after tax) annual premium payment for life insurance was only $12,037.
The 30-year average cost per $1,000 for this BTID strategy: $7.86.
Not bad, but my custom whole life policy is a little bit cheaper.
Where I might save money is after 86 years (at age 121), where the average cost per $1,000 of insurance and savings is just $12.26.
One thing to note with the BTID strategy is that the death benefit stays level for those 30 years. If I needed more insurance over time, I would have had to purchase more which would have affected the cost per $1,000.
Here’s What The Cost Analysis Doesn’t Tell You
If you just look at the costs, you’re not going to get a very clear picture of how good the product is, because you’re only looking at how bad something is.
Let’s go back to the supermarket example for a minute. The unit price of a single bag of Ramen noodles, for example, is important because it tells us the relative cost for what we’re buying.
But, it doesn’t tell us anything about the benefit of the noodles, such as the nutritional value we get for that cost.
And, the benefit of something is at least as important as its cost.
Think of it this way:
Ramen noodles have a lower unit cost than a bushel of apples – but apples are far healthier. They’re much more nutritious, which brings us to the next step in the process:
Here’s What You Really Want To Know About Your Savings Strategy
If the only thing that mattered was the cost of insurance, we would give up investing and just buy a 30 year term policy.
That’s not going to work because you need savings, I need savings – everyone needs savings.
So, what you really care about is what you’re getting for your money – how much money you have to spend now and later.
With most retirement plans, you put away a lot of money in savings and that’s it – you can’t really spend much, if any, of it until you retire. When you do, you’re on your own to figure out how much money you can safely withdraw for retirement income.
The maximum amount of money you’ll ever get from your savings is called "terminal income value."
To figure out that maximum income amount, we use an annuity. An annuity is an insurance product that converts your savings into a guaranteed monthly income.
Here’s what that looks like for the whole life insurance policy at age 65, 70, and age 75:
@ Age 65: $5,032/month
@ Age 70: $8,033/month
@ Age 75: $13,085/month
If the transfer of money from the insurance policy to the annuity is structured properly, all or nearly all of this income is tax-free due to the exclusion ratio of annuities and the higher standard deductions we all receive once we hit age 65.
Now for the BTID (BTSD) strategy:
@ Age 65: $5,155/month
@ Age 70: $7,861/month
@ Age 75: $10,179/month
There are a few things to note here with these numbers.
First, the maximum income from the whole life policy and BTID/BTSD strategy is about the same at age 65, but the whole life plan absolutely crushes the amount I could have withdrawn from a qualified retirement plan, like a 401(k) or IRA at age 70 and beyond.
Part of the reason for this is taxes.
Delaying taxes inside of a 401(k) for all those years only racked up a bigger tax bill later.
Secondly, because the IRS forces you to take income from IRAs and 401(k)s at age 70 1/2, you’re eating into your savings before age 75 whether you want to or not.
This results in a lower net income (and I adjusted the "@ age 75" income to account for the withdrawals made between 70 and 75).
So, from an income standpoint, it doesn’t help you to wait until later in a retirement account.
At the same time, taking income at age 70 means that you have a smaller account balance to work with.
Finally, I did not figure in Social Security Income. I honestly don’t know what’s happening with that program. You might want to ask your Congressman.
Many people don’t believe it will be around by the time they’re ready to retire. Some do.
If you’re relying on it in your old age, the BTID/BTSD numbers will be lower, because between 50 percent and 85 percent of your benefits may be taxed, depending on your income, increasing your tax liability.
Whole life insurance does not cause your Social Security benefits to become taxable. So, the benefit would simply increase your income.
There’s One More Thing You Need To Know
It’s called "income volatility"
Income volatility is the effect of the natural "ups and downs" of the stock market while you’re trying to draw an income.
Up until this point, I’ve assumed that my savings would grow at 7.1 percent, compounded annually. It’s called the "compound annual growth rate" or CAGR.
The benefit of calculating investment returns this way is that it smooths out that volatility in any given year and tells you what you would have to earn to get the dollar amount calculated in that year.
The problem with using the CAGR is that it hides the natural volatility of the stock market, which is OK if you’re just buying and holding investments. You don’t really worry about losing money in any given year.
All you care about is the value of the savings in year 30 (or whatever year you happen to be retiring).
The problem starts when you want to draw an income. Now we have to account for that volatility because drawing an income and losing money in the stock market could really screw us up.
What happens if I draw an income and lose 38 percent in the market (this actually happened to some people in 2008)?
How long would my savings last if that happened once or twice during my lifetime?
Probably not as long.
Yes, there are ways to try to guess what a "safe withdrawal rate" would be, but they all suffer from the same problem: no one can really predict the future.
So, unless you have a crystal ball, predicting your future savings is a lot of guesswork.
When you buy whole life insurance, you completely insulate yourself from the risks of the stock market.
The insurance company manages that risk for you, guarantees your cash value each year, offers you the possibility of dividends to increase that cash value savings beyond the basic guarantee, and then offers you a guaranteed income when you retire.
That’s a lot of guarantees.
And, if you noticed, I actually did better than investing in the stock market.
Now, I want to make something very clear about comparing whole life to the stock market:
Normally, you shouldn’t do it.
In this example, I used a hypothetical return so that you had a reference point to compare whole life against.
Whole life insurance doesn’t always outperform a good investment strategy, but it did this time – that’s something that almost no one admits to (that whole life insurance can beat the stock market net of taxes and fees).
And, I can use that cash value savings throughout my life for any reason, and with no restrictions or penalties.
No roller coaster ride.
No sleepless nights.
No wondering whether I should take out a loan to fix up the house, buy a car, go on vacation, buy a new Mac, pay my kid’s college tuition, or pay my health insurance deductible.
If I need the money, it’s there. If I don’t, it keeps working for me.
If I want to invest in stocks, I can. If I don’t want to, I don’t have to.
Choice. Control. Peace of mind.
That’s what I have that I don’t have with other strategies.
So, should You Buy Whole Life Insurance?
I know, I know. I can hear you saying "but, you just showed me how awesome this whole life thing is. Why shouldn’t I buy a policy right now?"
The reason you shouldn’t do this is because you don’t have a high savings rate and you have to be willing to change your financial habits and behaviors.
And, that’s nearly impossible to do because it’s hard. H-A-R-D. Hard.
So hard that most people fail.
Unless you’re willing and able to save more than 20 percent of your income, forget about it. You need cashflow to support a whole life policy in the early years.
Piddly amounts of $50 or $100 a month just won’t cut it.
Now, if you’re willing to get over that hump and start saving more money, it might be a good idea for you. But, you have to work with someone who knows how to structure a life insurance policy for high cash value accumulation.
So, to recap:
- Whole life insurance and buying term and investing the difference produce almost the same results, net of taxes and fees. Almost.
- Whole life gives you more control and access to your money throughout your life compared to a BTID/BTSD strategy, which can be a curse or a blessing depending on your relationship with money.
- Choose whole life when you have a need for insurance and savings that you think will last for your entire life.
- If you decide to do this, work with a financial planner or insurance agent that knows how to design custom high cash value whole life policies and can reverse-engineer them to guarantee you a low-fee, high-value policy.
Would you ever buy whole life as a way to save money? Why or why not?