Buy Term and Invest the Rest: Why Whole Life Probably Isn't For You
We have discussed in an earlier video why life insurance is important to single income families. Life insurance tends to break into two categories: term and whole life insurance. Term life insurance is insurance for a set amount of time. Whole life insurance is an insurance plan that combines both insurance and investment in one package. Due to its large commissions many insurance salesmen would be more than willing to sell you whole life insurance. Today we will show why whole life insurance would not be beneficial to most people.
Whole life insurance policies generally have much higher premiums than term life for the same coverage amount. With the investment aspect of a typical whole life policy, the policy is expected to accumulate cash value as the years go by. This may prove a tempting incentive until we show you why you may want to keep your insurance and investments separate from each other.
Investments under whole life may grow, but the rate at which whole life policy grows is usually slower than the rate of inflation. Returns for whole life are usually negative for at least a decade. The reason why returns are negative for so long is that the premiums in whole life policies have to account for overhead, commissions, fees, and the cash portion of your policy. After adjusting for inflation, you are actually losing money in the long run and any positive returns are small. You can be much better off investing in low cost-index funds or (for the more risk-adverse) bonds and T-bills. Another cause for concern of whole life insurance policies is that your holdings are not diversified and held in one company. What will happen in the chance that the insurance company holding your policy just happens to go bankrupt? Let’s not forget how close AIG came to collapsing in the 2008 financial crisis. Remember, you can find great diversification in an index fund with less than 0.10% a year in expenses.
For every alternate use of whole life insurance, there exist better (and cheaper) options. We already discussed why whole life insurance is a poor investment choice alone in the above paragraph. One reason why people get whole life insurance is the fact that they are able to take out loans anytime during the policy. Basically, you're paying interest on money you already own. You’re probably better off not buying the whole life insurance policy and taking a regular loan when needed. Not to mention that any expected future expenses, such as a college fund for your children, could probably be better off by investing in a different plan completely. An enthusiastic salesman may tout the tax-saving benefits of whole life insurance. To begin with, this benefit would only hold in jurisdictions offering such tax benefits, like the US and parts of Europe. Even in these cases, there are better options. Richer individuals who maxed out their tax-deferred savings or businesses will find this feature useful. However, most people that are sold whole life insurance do not fit these categories and can therefore find better options elsewhere. Annuitizing assets, setting up a retirement account, using tax-deferred pension plans are the best way for most people looking to set-up a good retirement account.
So why are overly enthusiastic insurance salesmen continuing to offer us such a bad deal? The answer is that whole life policies tend to pay out the largest commissions. Insurance companies know that whole life insurance policies are the best way to separate you from your money. This blatant conflict of interest comes at the fact that your salesman and insurance company are trying to maximize profits. Remember, when you are buying a whole life insurance policy, you are also paying for the overhead of the parent company, commission of the salesman, and various other factors before adding cash value to your own policy. Your returns in a whole life policy are usually negative for at least the first decade or so and will not beat inflation. Not to mention the surrender fee you will have if you decide to cancel your policy early, which over 80% of people do. After reading this, there is little wonder why most insurance companies would be more than willing to sell us these plans.
Surprisingly, there are some situations in which whole life insurance could make sense. Usually if you have already maxed out your tax-deferred pension savings and still have a large amount of money, don’t mind low to negative returns in the first decade of the plans existence, maxed out all retirement accounts, have a serious need for permanent death benefit, and are willing to hold on to the policy until death, then whole life insurance may be for you. The sad fact is that only a fraction of a minority of people fit all of these criteria concurrently. So you are most likely better off not buying whole life insurance that you don’t need. The fact of the matter remains that whole life presents itself as a product that is designed to be sold, but never bought.