Whole life is the most basic form of permanent life insurance, sometimes called “cash value life insurance”. Premiums are collected and invested in the insurer’s general investment account. In exchange for paying these premiums, the policyholder gets a promise of future insurance benefits.
Specifically, the policyholders receives a guaranteed death benefit, guaranteed cash values, and a guarantee that the premiums will remain level for the rest of the insured’s life.
The guaranteed death benefit is exactly what it sounds like. The benefit pays when the insured person in the contract dies. The death benefit is paid to the named beneficiaries.
The guaranteed cash value is the savings portion of the policy. Each year, the cash value increases at a guaranteed rate. In addition to the guaranteed rate, many whole life policies also earn dividends, which are normally reinvested into the policy to buy more life insurance. The additional life insurance (called “paid-up additions”) further increases the guaranteed cash value and earns its own dividends, which can then be used to buy more paid -up additions. Over time, the cash value and death benefit of a dividend-paying whole life policy can become substantial.
How Can The Insurance Company Make These Promises?
The insurance company can make these promises because they use a very precise mix of bond investments and alternative investments. They also generate consistent cash flow through regular business operations and ancillary lines of business. All this adds up to a lot of money. W does it go? Insurance companies have a reputation for being greedy, but also very profitable. When a policyholder owns a whole life insurance policy, they become part owner of the insurer, and thus are entitled to the profits of those insurers. This is what the whole life dividend represents — the accumulated profits and performance of the life insurance company.
Once again, not all of the investments in the general account are bonds, but many of them are. Insurers attempt to diversify investment holdings so that you can be guaranteed a minimum interest rate on policy cash values. Insurers spend a lot of time and resources matching cash flows to liabilities, which is how they meet their long-term death benefit guarantees.
But, life insurers know that they must remain competitive in the marketplace. So, they invest surplus funds into more speculative investments to earn a higher rate of return. This “excess return” helps generate generous dividend payments to policyholders without risking the guarantees inherent in the policy.
Should You Buy Whole Life Insurance?
The Good: It’s a relatively simple contract, mechanically speaking. You pay the premium and the insurance company gives you guaranteed cash value growth, a guaranteed death benefit, and guaranteed policy loan access. In most whole life policies, the premium is even guaranteed never to increase. So many guarantees. That’s why people love it.
Whole life insurance reduces, and in many cases it eliminates, the risk of you not saving enough money for your future financial goals because the cash value is guaranteed to grow by a certain amount each and every year. If the policy earns dividends, you can potentially realize your financial goals more quickly or save less money to realize your goals.
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The main benefit of whole life insurance is predictability. You can match known future expenses to known future savings inside your whole life insurance policy. If you fail to save enough before you die, your whole life death benefit makes up the difference.
You can use the policy’s cash values while you’re alive, through partial surrender of paid-up life insurance or through policy loans. If you use policy loans for major purchases, and you repay those loan at a market rate of interest, there’s also the potential to increase your cash values and death benefit over and above what you otherwise would have had.
Whole life is essentially a “forced savings.” You have to make those premiums every month, which makes it easy to “stay on track” with your insurance and savings plan. According to some research, it’s very difficult for the average investor to beat the net, after-tax, returns of a well-designed whole life insurance policy over the long-term, which makes the life insurance policy a simple method of saving up money without the risk of investing.
The Bad: The life insurance business is like any other business — there are poor, average, and excellent companies selling poor, average, and excellent policies. In the whole life space, it’s sometimes difficult to tell which is which.
Some of the problem stems from poor product design in the industry, while other problems are administrative ones.
A poorly designed whole life policy typically indicates a company’s lack of focus on their core product line. This can happen when life insurance companies get too involved in ancillary lines of business and neglect their core line of business. The result is, the product (and company) suffers.
Some product design problems stem from the life insurance agent, not the company. A life insurance company may provide a good, overall, life insurance policy. It’s up to the life insurance agent to further customize and design the policy to suit the policyholder’s needs. However, some agents spend very little time on policy and case design and focus more on sales and marketing. When this happens, policyholders don’t receive maximum value out of their whole life policies. Instead, they receive an “off the shelf” product that feels “clunky” or “unfinished” and often performs poorly — even over the long-term.
Another risk policyholders face is administrative risk. Some life insurance companies spend a lot of time on product design, but neglect policy servicing. When this happens, policyholders are unable to get the amount and type of after-the-sale policy servicing necessary to make their life insurance policy work the way it was designed to work.
For example, a life insurer may not process policy change forms in a timely manner, or may neglect to provide policyholders with timely inforce policy illustrations and reports. A life insurer may drag their feet when processing policy loan requests or have difficult-to-understand or inconsistent policy loan repayment procedures.
All of this can cost policyholders a lot of time, money, and it can make it feel like buying the policy was a bad idea. This is why choosing a good life insurance agent, and a good life insurance company, is very important.
With whole life, you also have to think long-term. Premiums go on theoretically forever, so you have to have the mindset of a perpetual saver. Not everyone likes that idea. Be willing to save money consistently each and every month and put that savings toward your premiums.
Even with a good policy design, expect the first few years (e.g. 3-5 years) of the policy to have negative annual returns. Also, in general, your total net cash value is unlikely to equal your total premiums paid for up to 8 or 9 years, though in some cases, net cash value may exceed total premiums paid in 6 or 7 years.
Every whole life policy is built on the assumption that you will hold the contract for at least 10 years, and probably 20 or even 30 years. Thus, even though you may have substantial cash value available in the first year of the policy, the return on that cash value is guaranteed to be negative.
Policy loans are an attractive feature of whole life, and they can help you grow a sizable savings. But… they can also get you into trouble if you’re not financially responsible. If you fail to repay your policy loans, or if you are using policy loans for retirement income and do not have a professionally-designed income plan from your insurance agent or broker, excessive policy loans can cause the policy to lapse. If this happens, you lose your life insurance and may be taxed on all the gains you experienced in the policy.
Verdict: Buy it if you are committed to saving money for the long-term, have a low risk tolerance, cannot afford to lose any of the money you’ve saved, and if you have an agent or broker willing to explain the ins and outs to you.
Insist on a fully custom policy design, which will incorporate your own personal financial goals. Ask for anti-lapse provisions to prevent your whole life policy from lapsing due to policy loans. Most policy designs should have a high early cash surrender value without compromising latter-year cash value growth.
Some high cash value whole life policies sacrifice long-term policy performance for high early year cash values or early access to cash values so ask your insurance agent or broker for a detailed analysis of both short-term and long-term expected performance of your policy. In most cases, you shouldn’t be sacrificing long-term cash value growth for early access to your cash values.
In general, the best policy designs will incorporate some form of term life insurance (called “blending”) which will lower the overall cost of the policy and allow you to build up cash value very quickly. However, it is possible to design non-blended whole life which performs just as well as blended whole life — it all depends on the issuing insurance company, the flexibility in design options given to the agent, and the skill level of the agent designing your policy.
While it does take time to see net positive returns in a whole life policy, your patience will be rewarded. Most people who buy whole life insurance (and keep it for 20 years) are happy with their purchase — they often see benefits that were not immediately apparent in the early years of the policy.
David C Lewis, RFC is an independent life insurance agent, a Registered Financial Consultant, and the founder of Monegenix®. For more information about his unique approach to life insurance and financial planning, go to www.monegenix.com.