December 13, 2024

Analytical Business Tactics

Long Term Benefits of Investment

Whole Life Insurance: A Misguided Investment?

Whole Life Insurance: A Misguided Investment?

Zachary Brody, CFP® is the Founder of Lumiere Financial, a registered investment adviser.

Consider the case of John Doe, a well-to-do dentist who was advised to invest in a whole life insurance policy instead of paying down his high-interest student loans, contributing to an employer-sponsored 401(k) or investing in a low-cost index fund. His returns? Nonexistent.

Jane Smith, another investor, was sold on the “tax benefits” of whole life insurance and told that there was no other vehicle that can provide her with such. Little did she know, these benefits were also available with indexed universal and variable universal life policies.

Take the example of the Johnson family. After a life insurance agent with a fancy title approached them, they were sold a whole life policy with high commissions, only to discover later that their agent was prioritizing his own profit over their financial well-being.

The stories mentioned above represent just some of the clients I’ve seen over the past year, clients who thought they were bolstering their savings with access to tax benefits that the rich use, only to discover that their investment will not yield any returns for over 20 years.

In this article, I hope to shed some light on what whole life insurance is, its pros and cons, what questions you should ask before making a purchase, who the ideal client is for this policy type and recent “hype” videos that may not portray whole life accurately.

What Is Whole Life Insurance?

Whole life is a type of insurance that covers a person for their entire life. It “guarantees payment of a death benefit to beneficiaries in exchange for level, regularly-due premium payments. The policy includes a savings portion, called the ‘cash value,’ alongside the death benefit. In the savings component, interest may accumulate on a tax-deferred basis. Growing cash value is an essential component of whole life insurance.” Whole life may offer you the flexibility to pay for a certain period of time, referred to as limited pay whole life.

The Pros And Cons Of Whole Life

As with all financial products, whole life insurance has its advantages along with downsides and risks.

Pros

• This is a more conservative investment.

• It will provide you with a death benefit.

• There may be some riders you can add to enhance the policy (e.g., a rider that allows you to utilize some of the death benefit for the cost of chronic illness or long-term care).

• You may be able to “overfund” this policy (i.e., pay additional premiums to purchase paid-up insurance), thus creating additional cash value and increasing your cash-value-to-death-benefit ratio.

Cons

• The insurance company does not need to pay you a dividend.

• The internal fees and expenses can increase.

• There is a lack of investment control, as the cash value is invested in the insurance company’s general account.

• There is typically a long break-even period, meaning your cash value to equal the cumulative premiums you paid could take 10 or more years.

• Your agent is typically compensated more on this product in comparison to similar cash-building products, which may put your agent’s interests at odds with yours.

What You Should Ask

Before buying a whole life policy, ask the issuer:

• How long do I have to pay premiums for this policy?

• What is the historic dividend rate?

• What is the worst-case scenario? On the sales illustration, carefully review the guaranteed returns column. This shows the worst-case scenario of the policy and is required by law.

• What is the credit rating of the issuer? You want to know if the insurance carrier has the financial strength to remain solvent.

• What are the fees and expenses associated with this policy? Specifically, you want to understand what the cost of insurance is each year, as this can erode your cash value.

• Can you show me a limited-pay whole life compared to a policy that I will pay until death?

• What are the current and maximum loan interest rates?

Who Is The Ideal Client For This Product?

This product might be a fit for you if you want steady fixed returns or a non-correlated asset class for your portfolio. It also could be an option if you like the tax benefits of the FIFO (first-in-first-out) approach, which allows you to withdraw the basis or the (after-tax) premiums you paid into the policy and then take a loan against any of the gains. This allows you to have a “Roth-like” vehicle. Whole life might also work for you if you are OK with not having control of the investment options and you believe that the insurance carrier will continue to pay you dividends based on their prior dividend scale.

Sometimes whole life is marketed to clients as a Roth-like asset because if structured correctly, you will not need to pay taxes on the gains. Be careful, though, because if your policy lapses when you have an outstanding loan that is greater than your basis, this will generate a taxable consequence.

Don’t Get Caught Up In The Hype

Recently, whole life insurance has made a debut on social media platforms such as Instagram, TikTok and YouTube. Content creators, some of whom are insurance agents, push the “be your own bank” concept. Oftentimes, these videos fail to discuss the risks and overly inflate the benefits of purchasing a policy, which they portray as an “investment” that is suitable for everyone. However, the reality is that whole life is suitable for a limited subset of the population.

In summary, you should pause before purchasing a whole life policy. Although it can be a valuable financial instrument for investors with conservative risk tolerances seeking guarantees, that is a small subset of the population. Be wary of influencers on social media platforms portraying whole life as a product with just benefits and no drawbacks. Consider alternatives, such as traditional investments (e.g., exchange-traded funds, money markets and savings accounts), which offer more liquidity. Consult with a qualified financial professional, usually someone who is fee-only and is held to a fiduciary standard.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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