There has always been this raging debate within the insurance world about which type of insurance is better, term or whole life? When it comes to talking with people, these can turn into emotional situations because they often involve how to best take care of young children and families after you are gone.
Typically, you would have wealth advisors on one side of the table likely advocating for term insurance, while on the other side you would have life insurance agents on the other advocating for whole life.
The underlying difference between the two types of insurance is that term is temporary while whole life is permanent. Think of term as your home or auto insurance; it is there when you need it. With term, there is a set amount of years and death benefit. Term life insurance is a “purer” type of life insurance, meaning it offers a death benefit and nothing more.
Permanent policies like whole life, on the other hand, cost more because they include an extra savings component, which is referred to as the “cash value.”
What is Whole Life Insurance?
Whole life insurance lasts for your whole life if you keep paying the insurance premiums. This means if you buy it when you’re 30 and keep paying your premiums until you die at 85, your family will receive the death benefit.
There are two components of whole life;
- Term Insurance (Death benefit) – is the tax-free amount of cash paid out by the life insurance company when you die. This is the same as for Term but recall that term is over a specific period and not your whole life.
- Cash value – is a savings account which is funded by a percentage of your premiums. Your life insurance company will then pay interest on the money in that savings account. The interest is a dividend from the insurance company’s annual profits, but most insurers guarantee a minimum yearly return.
The guaranteed minimum return is what whole life insurance agents focus on. These agents argue in favor of whole or other permanent policies, in part because they’re more profitable to sell, and in part, because they see them as relatively safe savings vehicles. This is especially true after a stock market crash as we had in 2008. However, don’t confuse insurance with investing!
How Does the Cash Value Account Work?
Every year, a certain percentage of your premiums goes into a savings account held by the life insurance company. This contributes to your policy’s “cash value.”
The cash value of your account earns interest. This interest is a dividend from the life insurance company’s yearly profits, and the growth rate is generally low compared to other investments. Life insurance companies have additional expenses (like policy administration expenses and underwriting costs) that a pure asset manager does not. Life insurance companies usually guarantee a certain amount of growth every year, which, again, is the featured selling point.
This cash value is a component of your death benefit. Your death benefit is made up of the term insurance policy described above and this cash value. As the cash value grows, the life insurance coverage provided by your term life policy gets smaller. Eventually, your cash value will cover the entirety of your death benefit, and your whole life insurance policy will no longer have a term component.
When the insured dies, the beneficiaries will NOT receive the death benefit provided by the term life insurance policy and the accrued cash value. Instead, the cash value replaces the term life component and represents the entirety of the death benefit.
You can withdraw the cash value out of your whole life insurance policy, and there are various strategies that you can use to do so. Usually, the only way to collect the full cash value before death is to surrender (a.k.a. cancel) your life insurance policy. Life insurance companies usually charge a surrender fee to do this. You may also pay taxes and other fees on your cash value.
You can surrender your policy at any time. However, most of the growth in your cash value doesn’t come until you’ve held the policy for two or three decades. If you surrender within the first ten years, it’s unlikely that your cash value will have grown significantly.
What Are the Beneficial Features of Whole Life Insurance?
- Whole life insurance lasts for your entire lifetime. If you keep making premium payments, your whole life insurance policy stays in force.
- Some of your premium goes into a tax-deferred savings account with interest. Like all insurance products, your premium goes to the insurance company to help spread out financial risk among a large group of people. However, what makes cash value life insurance products like whole life insurance unique is that some of your premium is being set aside into a savings account, which your life insurance company will deposit dividends into as an interest payment.
- You can potentially recapture some of the money you’ve spent on premiums. Because some of your premium is being put aside into a savings account, you have the potential to recapture that money. Note that this comes with many caveats. Often, if you attempt to make a withdrawal from your savings account in any way (such as a loan to yourself), the insurance company will charge you administrative fees, penalties, and other charges, and you’ll pay a tax penalty. These fees and penalties will eat into any earnings you’ve made on your savings.
- Your returns are usually guaranteed. Typically, your life insurance company will set a guaranteed minimum growth rate. Remember, however, that this “interest” is actually a dividend from your life insurance company’s profits, and the growth can vary wildly from year to year. If the stock market tanks, you don’t lose any of your cash value.
What Are the Negative Features of Whole Life Insurance?
- Whole life insurance is significantly more expensive. Premiums are often much higher than a term life insurance policy with the same amount of coverage because you’re paying for an insurance policy as well as putting money into the cash value portion of the policy. They can often cost six to 10 times as much as a comparable term policy. For a chart of rates broken down by age, see this full explainer on whole life insurance rates.
- Most policies are abandoned because they’re too expensive. Many people overestimate their ability to pay the large premiums year after year. Approximately 26% of whole life insurance policies are surrendered within the first three years, and 45% are surrendered within the first ten years.
- If you surrender your policy too early, your cash value will be very low. While your premium may be level, the percentage of it that goes into your savings account is not. In the first few years of your policy, a very small percentage of your premium goes into the savings account while the rest is used to pay for upfront costs like administrative fees and the agent’s commission. While this percentage increases over time, it’s often a bad deal for the 45% of policyholders who surrender the policy within the first ten years.
- Your returns are often low. Your returns from dividends that the life insurance will pay will not likely keep pace with the long-term returns of the stock market. Additionally, you will have the drag of the cost of the term portion of life insurance on your returns. This is one reason why I advocate for treating insurance as insurance and not as an investment.
The insurance company is expecting the premium you commit to each year, and they aren’t very flexible. Your policy could lapse if you lose your job and can’t make premium payments anymore. It is important to keep in mind that you are paying for life insurance, and the cost of insurance will be a drag on your overall performance.
Why Term Insurance is Likely Your Best Option?
For most people, and especially the 45% who surrender whole life insurance policies, a term life insurance policy is the better option. You’ll get more coverage at a cheaper rate than you would with whole life insurance, making it more affordable for the decades that you’ll be paying premiums.
The purpose of life insurance from my viewpoint is that it helps to cover a major need over a certain period. Therefore, Term insurance becomes an ideal and affordable avenue for families who if a parent passes away, has the financial resources to pay the mortgage, college tuition, and other life goals. Whole life is simply too expensive to cover this type of need.
It is a good idea to avoid combining insurance and investment or savings. Insurance is not an investment and shouldn’t be treated as an investment vehicle. Insurance should be a risk management tool within your wealth management plan.
There are far better-qualified tax vehicles to invest. I advise clients to take advantage of these investment vehicles which could help maximize your after-tax return options before considering whole life;
- 529 plan (if you have kids)
- Healthcare Savings Account (HSA, if you are able),
Whole life insurance products can be useful if you have;
- Maximized all your qualified tax vehicles that I previously identified,
- You have a need when it comes to managing your estate, or
- If you have a special needs dependent who will need care after you are gone, whole life may be a good option.
If you’re trying to put together a wealth management plan, insurance should definitely be a component that needs to be a part of your plan. Understanding the differences between the various types of insurance products will help align your needs to the right policy for you.
Working with a professional such as a Certified Financial Planner®, who puts your best interests first and not commissions, should be able to guide you to make the right decision for you and your family.
For questions about any wealth planning, portfolio management, or tax topics, do not hesitate to contact me to find out what options may be best for your own personal situation.