Investment grade life insurance is commonly sold as a solution to avoid the non-diversifiable market risk associated with investing in the market. The problem is that investment grade life insurance is basically a marketing gimmick which should alert every suspicion nerve in your body to its highest level. Here are the reasons why:
Plain and simple, according to the legal definition, life insurance cannot and should not be categorized as an investment.
Does a Life Insurance Policy Provide a Rate of Return on the Annual Premium Paid?
Some life insurance contracts do provide a rate of return, or at least, a return of premiums paid. For example:
Is Whole Life Insurance a Rip-Off?
It has been said that Term life insurance is better than Whole Life insurance because you can buy Term and invest the difference between the cost of Term insurance and Whole Life insurance. Interestingly enough, insurance companies have capitalized on this typical financial advice of, buy term insurance and invest the difference, by developing Universal Life insurance policies. Universal Life insurance is a type of life insurance that buys Term insurance and invests the difference. Typically, many advisors call Universal Life insurance investment grade insurance without the risk because the main purpose of Universal Life insurance is to overcome the risk(s) associated with investing.[iv] That is because a Universal Life policy does have an investment component to it. The money spent on the base term insurance of a Universal policy is greater than the cost of purchasing Term insurance outright, leaving a portion of the premiums paid to accumulate. This accumulated cash value (extra money paid, not needed for the cost of insurance) earns a rate of return that mirrors an interest rate such as the Libor (London Interbank Offered Rate), or an index such at the S&P 500 or is actually invested in stock and securities. This investment component of Universal Life insurance is a speculation attempt to overcome the ever-increasing cost of the term insurance in Universal Life policies.
Unfortunately, most Universal Life insurance contracts fail to overcome the cost of the term insurance. Candidly, this is the very reason the concept of buying Term insurance and investing the difference fails those who attempt it. You can read more about how Universal Life Insurance Works in this in depth article
In fact, “Lawsuits filed against insurers in recent years for their practices around universal life insurance policies highlight the risks these products can pose to unwary financial advisers and clients.”[vi] One insurer paid out over $2.25 billion, and other $195 million, to settle lawsuits over their Universal Life insurance products. Remarkably, insurance industry observers believe this is just the beginning of problems for Universal Life insurance and the companies that issue these contracts.[vii] [viii]
But permanent participating Whole Life insurance is different than Universal Life insurance. Participating Whole Life insurance is built upon a level annual premium, instead of ever-increasing annual premium like Term and Universal Life insurance policies. This level annual premium allows for Whole Life insurance to develop equity, which is a cash equivalent that overcomes the cost of the total annual premiums paid for the life insurance policy. This is a marked difference than merely having access to overpaid premiums that may, or may not, have earned a rate of return in Universal Life insurance contracts. And it certainly beats the zero percent rate of return promised in all premium recovery Term life insurance policies and the zero return of premiums in typical Term life insurance contracts. Read more about how whole life insurance works in this in depth article
Knowing that there is a legally binding contract that guarantees all the premiums paid for a Whole Life insurance policy, plus any and all dividends earned, will be accessible to the Whole Life insurance policy holder before the policy is mature, or paid-up, means that the cost of Whole Life insurance is essentially zero. Why anybody would promote the idea that Whole Life insurance is a rip-off[ix] is unfathomable as Whole Life insurance is the only type of life insurance that guarantees that the policy owner will have access to the money paid for the life insurance policy, plus any dividends paid by the insurance company to the policyholder, and that the policyholder can use, spend, leverage, save or invest this cash value in any fashion the policyholder wishes while the policy remains in force and continues to grow. In other words, a Whole Life policy becomes an asset rather than an expense, a financial tool instead of a financial liability, a guarantee versus a risk, and all that means a better deal for the policy holder.
If Whole Life Insurance is Not an Investment How Can It Earn a Rate of Return?
When an annual premium is paid (this annual premium can be paid monthly, quarterly or semi-annually) for a Whole Life insurance policy, the insurance company takes a flat fee from the premium for administrative costs, but the rest of the annual premium is invested in the portfolio of the insurance company and managed by the CFO of the company. In doing so, life insurance companies have historically:
This means that whatever portion of this 4% that is remaining after all the operational costs, commissions, and mortality costs (claims paid), is guaranteed to be credited back to the policyholders as a cash value increase. Any rate of return which the life insurance company earns above and beyond this 4% is used to pay policyholders, who have purchased participating Whole Life insurance, a dividend. These dividends can be used by the policyholder(s) to purchase more Whole Life insurance which is classified as paid-up life insurance. This paid-up insurance is subject to earning its very own dividends for the rest of the policy’s lifetime. This compounding effect of participating whole life insurance is why many mistakenly refer to Whole Life insurance as earning a rate of return. This is a misnomer, as Whole Life insurance only provides a guaranteed cash value based on the 4% mentioned above, and if it is a participating policy, it can also earn dividends. But Whole Life insurance, by definition, never earns a rate of return and isn’t exposed to risk. And so, it can’t be classified as an investment, or an investment grade life insurance policy.
What a Whole Life policy does generate is an internal rate of return, or a discount rate, which makes the premiums and underwriting cost of the policy become equal to zero at some point in the life of the contract. When this occurs, in a Whole Life policy, the life insurance policy has effectively cost the owner nothing, zero, zilch, making it a great retirement savings strategy and a valuable income replacement option. Many have even reported that participating Whole Life insurance is like a Roth IRA with a death benefit. And yet, this too is misleading in that a Roth IRA could still face tax liabilities if inherited while a life insurance policy provides tax-free income to loved ones.
But once this discount rate, or internal rate of return, of the policy reaches zero, from this point forward the annual guaranteed cash value increase on each annual premium paid becomes immense. For example, a 35- year-old male in standard health can pay a total of $53,068 in premiums by year 8 for a $475,000 life insurance policy. But in year 8 the insurance company guarantees that this policy will generate cash value that is 1.17% greater than premiums paid for that year. By age 65, 30 years after this Whole Life policy was initiated, the life insurance contract guarantees that the annual premium of $4,267 will produce $7,970 of increased cash value, which is an 86.78% return on the annual premium payment for year 30.
Of course, the guaranteed cash values will have already exceeded the total premiums paid and therefore this Whole Life policy will have cost the policyholder zero while they continue profiting from these crazy high returns on annual premiums paid for the rest of their life. This never happens with a Term policy as there is no equity that is created in Term life insurance, nor in term-based life insurance policy such as Universal Life insurance. In fact, there is no other known place where a guaranteed annual return of this magnitude can be found in the financial world today.
Permanent Whole Life Insurance is Part of a Sound Investment Portfolio:
Even though Whole Life insurance is not an investment, nor is it an investment grade life insurance contract, it still remains part of a sound investment portfolio. Not only does participating Whole Life insurance provide returns, both guaranteed and additionally through dividends while the insured in living, it also provides tax-free cash upon the death of the insured.
The cash value and equity that develop in participating Whole Life insurance can be leveraged or withdrawn while the insured is still living and can be used to invest, refinance, create cash flow, and take advantage of opportunities so that opportunity costs are not lost. When a Whole Life insurance policy is leveraged to access cash, the policy itself continues to grow and benefit from all the features of a policy that has not been leveraged or borrowed against. This adds additional value to participating Whole Life insurance about which most financial advisors and policyholders are unaware or misinformed. Unbelievably,
To protect against loss of income, disability, interest costs, taxes owed on qualified retirement accounts, estate taxes, market risk, and even outliving one’s retirement savings, life insurance contracts provide a guaranteed solution.[xii] That is why calling our office today so that you can get a participating Whole Life insurance policy designed and prepared just for you and your needs, is paramount for your financial well-being. Not because life insurance is such a good investment but because it is a great asset which continues to work and grow for you as long as you live and then blesses your loved ones after you are gone. Again, tax-free.
Dr. Tomas P. McFie
Most Americans depend on Social Security for retirement income. Even when people think they’re saving money, taxes, fees, investment losses and market volatility take most of their money away. Tom McFie is the founder of Life Benefits which helps people keep more of the money they make, so they can have financial peace of mind. His latest book, How to Build Sustainable Wealth, can be purchased here.
[xi] A Plain English Explanation to Help You Pass the Series 65 Exam, Robert M. Walker: January, 2019, pg 45
[xii] Ibid pg 55