Whole Life Insurance: The Basics

What is Whole Life?

Whole life insurance is the most basic form of permanent life insurance. It is basically a term life insurance policy combined with a fixed-yield savings account. This savings account usually yields an interest rate around 2-5%, but grows tax-deferred, similar to your IRA. When the proceeds are withdrawn, they are taxed, but they are not taxed year to year. The premium of a whole life policy has essentially two parts: one part covers the cost of the insurance, the other goes into your cash value account tied to the life insurance policy. I am not going to go into extensive detail as to how these policies work, as there are better resources for that. Rather, I will focus my attention on specific benefits and drawbacks of whole life policies.

Benefits

  • Flexibility. It can be difficult to talk broadly about whole life policies because there are so many riders and options you can take to truly customize a whole life policy to your needs. These riders and options are a plus, though, because they allow you to cusomize your insurance coverage and cash value account as you progress through your life.
  • Permanence. Because whole life policies are a form of permanent insurance, they do not expire after a given time frame. This means that you will have coverage over the course of your entire life, so long as you continue to make payments on the policy. The cash value of the policy also helps provide a degree of stability to the policy; as long as your cash value is sufficient to pay the premium, the policy will not lapse. If you fail to make a premium payment, then the payment is simply withdrawn from your cash value.
  • Forced Savings. If you struggle to set aside funds for the future, then a whole life policy can help force you to save. Because a portion of each premium payment goes into your cash value account, you are essentially getting a bill each month from the insurance company demanding that you make a certain deposit to your cash account. This can make it easier for some people to set aside the funds that they will need to save. These savings also grow tax-deferred, which is an excellent bonus.

Drawbacks

  • Low Return. While the interest earned on the cash account is guaranteed and tax-deferred, the actual rate of return tends to be disappointingly low.
  • Expensive. As we just saw in the Dave Ramsey quote above, there are high costs to permanent insurance of any kind, whole life included. The expenses of managing and maintaining these accounts, paying (large) commissions to the sales agents, etc make these policies very inefficient. Whole life policies can be double or even thrice as expensive as an equivalent term insurance policy. You get way more bang for your buck from a term insurance policy.
  • Permanence. While permanence can be considered a benefit of whole life policies, it’s also a double edged sword. One of the great lies of the life insurance industry is that after “some point” in the future, you can stop paying premiums on your policy. This, the customer interprets to mean that the policy is free after that point because the cash value grows faster than the premiums come out. That’s true, but highly deceptive in nature. You see, when you sign up for a whole life policy, you agree to pay premiums on that policy for the rest of your life. Just because you reach a point where you need not write a check for the premium does not mean that you are not charged for the policy. So, if you are planning on using your cash value to live off in retirement, you had better plan on continuing to pay your premium out of that fund, because it’s automatically set to auto-pay the insurance company. And you wondered why insurance companies LOVE espousing these policies….

All of the $93 per month disappears in commissions and expenses for the first 3 years. After that, the return will average 2.6% per year for whole life, 4.2% for universal life, and 7.4% for the new-and-improved variable life policy that includes mutual funds, according to Consumer Federation of America, Kiplinger’s Personal Finance, and Fortune magazines. The same mutual funds outside of the policy average 12%.

Dave Ramsey

My Recommendation

In my opinion, whole life policies are among the worst life insurance policies that a person could get. If you want permanent life insurance and the benefit of forces savings and tax-deferred growth, then there are better forms of insurance out there for you. Whole life policies can be good for the very wealthy (who are unlikely to be reading this blog) to protect their vast estates when they die, but for most people, they are not a great option.

Posted on 25 Jan 2009