The truth is life insurance is almost always a bad investment, unless you die before your expected mortality. You should keep your investments separate from your insurance. Here's why.
A good friend recently called me. He was excited.
“I just bought a fantastic whole life policy from a guy I know,” he said. “I can’t believe the benefits. I don’t know why everyone doesn’t do this.”
“Really?” I said.
“Yes,” he went on, “unlike an IRA, you can invest unlimited amounts and still get tax-free compounding. You can borrow against the policy if you need to. And no matter how bad the financial markets get in the future, your principal is 100% guaranteed. I don’t know why everyone doesn’t do this.”
“What are you paying in commissions?” I asked.
“Commissions? Nobody mentioned those.”
“And what are your annual expenses?”
“I don’t know,” he said. “But with all the great benefits, does it really matter?”
Do sky-high investment costs matter? Whoa. This was clearly someone who drank the Kool-Aid. Or, more specifically, someone who’d sat down with a salesman who played up the “benefits” of whole life while glossing over, downplaying or omitting the considerable drawbacks.
Life or death: You lose either way
The truth is life insurance is almost always a bad investment. If you need coverage, buy a low-cost term policy and keep your investments separate. Otherwise, you will pay through the nose.
A term policy is life insurance only. On the death of the insured, it pays the face amount of the policy to the beneficiary. You can buy term for almost any period of time up to 30 years.
Whole life insurance combines a term policy with an investment component. And since there is tax-exempt compounding, a lot of insurance salesmen call these policies “retirement plans” and emphasize the “forced savings.” In other words, you are required to keep forking over those monthly premiums.
But whole life is a terrible “retirement plan.”
Why? Let’s start with the fact that it is wildly expensive. For instance, if you buy a $500,000 Met Life policy with an annual premium of $700 a month, how much of this $8,400 over the first 12 months would you guess goes to the agent who sold it to you?
Five percent of it? A tenth, maybe? Nope. Try all of it.
That’s right, the entire $8,400… or $15,000… or whatever you pay in first-year premiums is the industry-standard, first-year commission.
In addition, your agent will get paid roughly 7% of your annual premiums over the next decade.
And this is just the beginning. There are other annual costs as well.
A good rule of thumb is that mortality expenses, investment fees and commissions will lop off as much as three percentage points from your annual return. To say this will reduce your long-term returns is an understatement. It’s like dragging an anchor behind your portfolio.
One of the reasons for the newfound popularity of index funds — which offer much of the tax efficiency whole life buyers seek — is that investors have smartened up to the fact that these funds have low annual expenses. A typical index fund charges approximately 0.2%.
Someone holding a whole life policy, on the other hand, will generally pay 15 times that much … every year. And often more.
Don’t be fooled
Worse still, it is virtually impossible to tell what your returns might reasonably be. That’s because you don’t know how much of what you pay in goes toward the insurance and how much toward the investment.
James Hunt, actuary for the Consumer Federation of America, who has analyzed thousands of policies, notes that whole life insurance policies hardly ever yield a reasonable return unless held for 20 years or more.
And if you bail out sooner? For starters you can kiss that principal protection goodbye. After all, your first-year premium went to the agent, so there is a lengthy lock-up period with hefty surrender penalties.
And how about that principal protection? What’s that cost? Everything comes with a price and this is especially true of investment products that offer principal protection. It severely reduces the future value of your policy.
In truth, the only way to turn life insurance into a good investment is to die before your expected mortality. And that isn’t exactly the kind of win we’re aiming for.
So don’t be fooled by big claims, promises of security or an insurance agent’s bravado.
Every whole life plan comes with a big honkin’ price tag attached. So buy a low-cost term policy to satisfy your insurance needs — and forget about “permanent insurance.”
When it comes to investing, simpler is better.
Fancy investment products exist to benefit the salesman and the company he represents … not you.