Why Whole Life Insurance Is A Bad Investment

Whole Life Insurance vs. Term Life InsuranceWhen you have children, many people tell you it’s important to buy life insurance to protect your family.

You’ll have two options:

Term Life Insurance. Term life is a life insurance product that covers a limited term in return for a constant monthly premium over the covered term. For someone who is 30 years old, premiums can be less than $75 per month.

Whole Life Insurance. Whole life is a hybrid investment and insurance product that covers you until death. For someone who is 30 years old,  the premiums can be less than $800 per month, and they don’t change over the life of the policy.[1]

Whole life insurance is a more complicated product than term life insurance. Like universal life or variable universal life insurance, whole life offers an insurance payout and, over time, the policies accrue a cash value that can be withdrawn.

Typically, a whole life policy’s cash value increases by a guaranteed minimum per year and by a larger, “expected” amount that varies each year with changes in the financial markets. Term life insurance does not offer a cash value. It only serves to insure you against death during the policy’s term.

The cash value helps financial advisors and insurance agents position whole life insurance as a type of investment product. We believe whole life does not make sense as an investment product.

How the math works: whole life vs. term life

To understand why, consider the analysis in Table 1. The analysis shows what would happen if you took the difference in premiums between a whole life insurance policy and a term life insurance policy and invested it, with the return you could expect from a diversified investment portfolio like those Wealthfront offers. We then compared the ultimate value of the saved premiums, including those expected returns, with the cash value of the whole life product over the same period of time.

Table 1.

Difference Between Whole Life & Term Life Insurance

Whole Life Term Life Difference
Annual Premium $8,230 $672 $7,558
Expected Value after 20 years $236,679 $313,939

In this example – which we developed using a term life quote and a whole life illustration, or policy explanation, from MetLife, a high-quality insurance company – a 30-year-old male has a choice between whole life insurance and term life insurance for a period of 20 years. The whole life insurance has an annual premium of $8,230 per year (you can pay monthly but it costs slightly more). The 20-year term life insurance costs $672 per year.

After 20 years the expected cash value of the whole life policy (the amount you could withdraw) is $236,679.

If you invested the difference between the two premiums in a Wealthfront account using an allocation based on our clients’ average risk tolerance, you would expect the difference in premiums to grow to $313,939 over 20 years[2], which represents an additional $77,260 or 33% over the expected cash value at the same point in time for your whole life insurance policy.

The shorter the term you want to insure, the greater the difference in value. After 10 years, the expected cash value of the whole life insurance policy is $70,871, while the expected outcome from term life plus an investment portfolio would be $108,355 – 52% more.

The difference in the ultimate value of the two approaches is due to the high fees insurance companies pay to distributors (which is why these policies are pushed so hard by financial advisors and insurance agents) and the extra profits to the insurer.

To be fair to the insurance companies, whole life insurance covers you until you die.  Therefore, if you think there is a reasonable chance you could die in your 50s (i.e. more than 20 years after you buy the policy), whole life insurance could be a better bet.

Whole life insurance also offers a guaranteed minimum cash reserve value. In the case portrayed in Table 1, the guaranteed minimum cash value is $190,000. If you think the markets are not likely to appreciate over the next 20 years then whole life insurance is a better deal. If you think you’re likely to live into your 60s or that capital markets are likely to appreciate, even modestly, term life insurance is a much better deal.

Why buy insurance?

Life insurance financially protects your loved ones in the unlikely event you or your spouse dies before your family builds a significant net worth. You want to have enough in assets, so that your family could pay off the mortgage and maintain your standard of living, even if one or both parents dies.

You want to buy the most cost effective bridge from your current state until the point at which it’s likely your family would have enough in assets to cope with that kind of change. If you work in Silicon Valley, chances are you’ll need a policy for no more than 20 years, because you should be able to develop an equity stake worth at least $1-$2 million in that time span if you follow our career advice and earn an equity stake consistent with the industry standards we show in our startup compensation tool.

If you look to join a company with momentum, you have a very good chance of garnering a 0.1% stake in a business that could be worth at least $1 billion if it goes public (i.e. $1 million to you). It will also put you into position to later earn a much larger equity position at a hot startup that could earn you well more than that.

Over 20 years you should have at least five shots at a big outcome. Managed well, your equity stakes should be able to supply your required reserve. When you feel comfortable with your reserve, you can cancel your term life insurance policy without a penalty.

This analysis shows you why whole life insurance doesn’t generally make sense as an investment product, especially for families in Silicon Valley. Brokers and advisors who are paid high commissions on whole life insurance policies try to take advantage of your desire to protect your family in order to sell you whole life insurance. But, you don’t have to fall for their pitch.


[1]We’re basing our estimates of prices on quotes from several major life insurance companies.

[2]This assumes a base annual return of 5.72% (please see the Projected Performance chart with a risk level of 7) and an additional 1.4% per year after-tax return from continuous tax loss harvesting. That translates to a total annual return of 7.12% (5.72% + 1.40%). These expected Wealthfront returns are net of all fees.

 

Disclosure

Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security or insurance product. Wealthfront is not a licensed insurance agent.

Past performance is no guarantee of future results, and any hypothetical returns, expected returns, or probability projections may not reflect actual future performance. There is a potential for loss as well as gain that is not reflected in the hypothetical information portrayed. Actual investors on Wealthfront may experience different results from the results shown.

 

 

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23 Responses to “Why Whole Life Insurance Is A Bad Investment”

  1. Klep April 25, 2013 at 8:51 pm #

    Totally agree that, by itself, whole life policies are unattractive. Any thoughts on whether an ILIT, used for estate planning purposes, makes life insurance more compelling? You’d have the same mediocre returns, but theoretically a huge tax benefit…

    • Andy Rachleff April 26, 2013 at 3:50 pm #

      1. life insurance proceeds are not subject to income tax
      2. life insurance (proceeds) which is not in an ILIT is part of your estate so may be subject to estate taxes if you have a taxable estate
      3. life insurance (proceeds) in an ILIT is not subject to estate taxes, so it can make life insurance more compelling than assets that are subject to estate tax
      4. downside to ILIT is it is irrevocable, so if you life situation changes (divorce, screwed up kid) after it is established there may be undesirable results unrelated to taxes

  2. Mike Simmons April 29, 2013 at 2:29 pm #

    Andy,
    Thanks this is a great post and very timely for me.
    I am already and investor with WF and I’m interested in whole life to round out my investment portfolio for 2 reasons:
    1) I have the option of a constant rate of return (not too bad) that has NO exposure to the market. Almost all of my net worth is currently exposed to the market and some to real estate holdings. can you describe why it does not make sense to have a third bucket of investment that is guaranteed and constant with 0 beta to financial markets?
    2) As the post above mentions there are tax advantages in that the cash value of the policy is one of the FEW avenues of tax free money post-retirement and you have total flexibility on how you can spend it.

    Is there a time/place for whole life if you’ve already got a solid foundation on well-balanced market-based investments?

    • Andy Rachleff April 29, 2013 at 5:19 pm #

      I think the premium you earn over the guaranteed payout from whole life is well justified by the modest additional risk over 20 years. As we explained in Couples Investing: How to determine risk tolerance, over a long time horizon you actually lower your probability of capital loss if you increase your risk tolerance. I know that sounds counterintuitive, but we explain the math in the aforementioned post.

      We assumed you took advantage of tax loss harvesting which negates any tax advantage the whole life policy might have.

      As we explained in the article, whole life makes more sense if you

      1. are unlikely to generate enough wealth from equity to cover your family’s needs over the next 20 years
      2. think the market is unlikely to appreciate over the next 20 years (which is highly unlikely)

      I hope that helps

      andy

  3. Tom Stanley April 30, 2013 at 7:17 am #

    Thanks for the article. As a professor in finance I’ve read many papers and blogs similar to your nice piece. Your target market is clearly young professionals and so it is tailored to highlight the power of investment in indexed solutions. When I was younger I believed strongly that your approach was correct. Age brings a different perspective and often a more balanced approach to all of life’s challenges.

    I’d like to see you update your article with several new considerations.

    First, that financial solutions are not black and white, meaning that a hybrid solution may exist where your indexed investments coupled with life insurance (whole life or other) might be optimal. Yes, you might give up a bit in investment performance, but you hedge your bets.

    Second, it would be interesting to see you use a real whole life product from an industry leader like a Guardian or Northwestern Mutual Life rather than Met Life which is a stock company that frankly has awful whole life products. Yes they sell cheap term insurance, but the financial performance is terrible in comparison to the long term financial results of the industry leaders. While choosing a poor company makes your illustration striking, it reveals that you are more interested in capturing every potential investment dollar instead of revealing potential benefits to your very unique clients.

    Finally, as an older person in my 60′s I’ve found that my need for life insurance has changed. Early in life, I felt I only needed term insurance because I would have a limited need to cover living expenses for my wife and children. Now that my children are grown, I find that I still need life insurance to ensure my spouse continues in the same life style, but also I need life insurance to provide liquidity to cover significant estate tax obligations. It would be beneficial for you to quote that same $1 million dollar term life policy for a 60 year old and begin to run the calculations on the over/under performance compared to a whole life policy bought in the mid thirties.

    My point in this challenge is that I’m very impressed with your firm and its approach to managing money by attacking a bloated and inefficient investment management industry. The purchase of life insurance is not a simple problem that can be distilled down to a few equations and calculations as there is no way you can quantify the changing perspectives that a life insurance buyer might undergo over time.

    Best of luck.
    Tom

    • Andrew August 13, 2013 at 2:24 am #

      Love this. Northwestern Mutual returns on whole life would have a different flavor to this article.

    • Falk September 18, 2013 at 6:14 am #

      Thank you, finally somebody who looks beyond the simple and unqualified ‘SuzyOrman’ opinion…

  4. Bryan Haas April 30, 2013 at 12:21 pm #

    Andy,

    I enjoy your blogs, but I respectfully disagree with you on this one. Whole life insurance is certainly not appropriate for everyone, but it is absolutely more relevant than what you describe. Within a well-diversified plan, the goal for every dollar is not simply rate of return. If it were, then no one would have a traditional savings or money-market account, not to mention bonds and other low-risk investments. When looking at someone’s holistic plan, other factors come into play, such as liquidity, tax-efficiency, and diversification in terms of offensive planning, and insurance needs when it comes to defensive planning. For some individuals, there are insurance needs that will never be out-lived, such as estate planning and funding a special-needs trust for a child with special needs. On the offensive side, yes, you absolutely have the potential to have higher returns in other higher-risk investments. But with the right company, whole life insurance can have excellent returns in terms of being a low-risk investment vehicle. Everyone uses the same concept in their 401(k). Within a 401(k), it’s not a question of should you allocate into stocks or bonds. Rather, it’s a question of how much should you be allocated in stocks, and how much should you be allocated in bonds.

    Additionally, the concept of buying term and investing the difference looks logical on paper. However, how many people are actually implementing the second half of that equation? For most people, “buy term and invest the difference” practically turns into “buy term and spend the difference.” How many people, when shopping for term insurance, actually take the time to also ask for a quote on a whole life policy, calculate the difference in premiums, budget that amount towards strategically-planned investments, and implement that consistently month-in and month-out for 10-30 years in order to realize the returns of the plan? It’s the same reason why most people are encouraged to tackle their debt by starting with the smallest amount as opposed to the highest interest rate. Logic on paper would suggest starting with the higher interest rate, but behavioral studies show more practical success when starting with the smallest amount.

    Lastly, term vs. whole life is not an all-or-nothing debate. I would submit most people should start with 90% of their life insurance portfolio in term insurance, and 10% in whole life. Over the course of the term, the insurance need for most people will likely decrease, but not down to $0. At least have a portion of your insurance locked in at reasonable rates while you are younger and healthy that won’t die off when the term is up. Additionally, put your term insurance with a strong company with solid conversion options. Evaluate your insurance needs annually, and over time as your needs toward the end of the term become more clear, at least you will have positioned yourself with some good options on converting more to whole life if you need to, while hedging against the possibility of becoming uninsurable due to changes in your health.

    At the end of the day, whole life insurance isn’t the silver bullet of financial planning as some agents try to position it, but it’s not the smoke and mirrors of financial planning either.

    • Andy Rachleff April 30, 2013 at 2:17 pm #

      Thank you for your comments. We clearly explained that our advice was for young people who work in tech, not the general populace. Once you build a large enough net worth, there is very little value to having insurance as it is not cost effective.

      We also assume that our audience is intelligent and will do the right thing. Arguing that you shouldn’t use term because you will spend the savings and not invest it shows a lack of respect that is typical for your industry. Young informed investors have deep mistrust for life insurance companies because of attitudes like this.

      Burt Malkiel and I as well as most sophisticated investors do not believe Life insurance should be considered as an asset class in a diversified portfolio. Its return, cost, variance and covariance do not make it a compelling component to be added to a portfolio. In the form of term insurance it can provide compelling protection to younger people. Having a mix of term and life insurance makes no sense to us.

    • Karin December 30, 2013 at 11:53 am #

      Very well stated. Thank you.

  5. Matthew Ranalli April 30, 2013 at 2:45 pm #

    There frankly is no better financial vehicle than an indexed universal life policy with zero spread loans. It protects your heirs, you can borrow from it tax free in retirement without ever having to repay, and it’s not nearly as expensive as whole life. If you have to drop the face value on a whole life policy, two things bad can happen, the cash value bucket can be reduced and expense charges per thousand are on the original face amount. IUL’s are clearly the best financial vehicle to date. You can’t lose with one, because the negative years in the market are zero gain/loss, your average rate of return is around 8%, check any 15 year period in the S&P 500, any period.

  6. M Duran May 2, 2013 at 12:01 pm #

    I agree with the general assessment and understand that the advice is targeted at a certain consumer/investor. In my case I chose to get a whole-life insurance policy for two reasons. I am a small business owner and we don’t offer 401s or other retirement vehicles. The company is able to pay my whole-life premium and because it is something I cannot touch until much later it can be reported as deferred salary, which does not affect my current tax bracket as the money does not show up in my income statement. On the negative the company cannot claim the premium as a deduction. If I had more traditional retirement vehicles (the IRA max is not enough) I would probably not invest in Whole Life.

  7. Matt June 25, 2013 at 7:08 pm #

    I appreciate your thoughtful article. I think I agree that whole life and other similar products do not make sense but mostly because of the signficant costs of insurance and management. These fees and expenses are extremely opaque…in fact, it would be nice to see a clear description of the fees, along with an example showing the compounding effect of these fees over time. It also seems to me that, at some point, a whole life product could make sense if the imbedded costs were low enough. However, such a product may not be available in the market place. Since withdrawals are taken as loans there is not a taxable event (and there may be caveats to this). As a result, the tax deferrals have value and need to be compared against the after tax returns of an index fund, target fund, etc. I’m not sure how the math ultimately works out (i.e., the tax benefit could be eroded by the high costs) but I would assume that at a low enough price, this product could have some utility. But given the other drawbacks, including the relatively high percentage of people who ultimately do not fund the insurance product fully, I think the index approach discussed here is better.

  8. Brooke July 31, 2013 at 6:54 am #

    I totally disagree with you. I locked in a $100,000 whole life insurance policy at 20 years old for $298 a year. The rate never goes up. This is not an investment. This is a guarantee that when I die, my family won’t have to pay for my funeral or debt obligations. Now that I’m 27, the same policy will cost me $900 a year until I’m 65 and I will be taking out that policy later this month (with a different company so that I can mitigate for risk) I invested money in a Roth IRA from 18 and that money has been on a roller coaster much more than I would have ever liked. Maybe in a former lifetime, earnings were continuously good but in this day an age, I believe that I’ll be lucky to average 6 or 7% a year in the stock market over the course of my lifetime. And that is no guarantee. If you ask me, the stock market is about to nose dive anyways. I’ll take my slow returns and stupid whole life insurance policy any day over having to stomach 2008 again. 20% of every dollar I earn goes to retirement anyways. I’ll take lower returns for the guarantee that I won’t be in a situation like my father in law who lost 1/3 of his retirement at the age of 57 in 2008. No thank you. Way to go America, greed has scared the crap out of the younger generations.

    • Mike August 19, 2013 at 6:34 am #

      Term life over that same time period would have been much less and it pays out the same when you die – whatever the policy is taken out for. In addition, you would (your heirs) get to keep whatever would’ve been invested outside of the policy. As opposed to a whole life policy where they keep your investment (anything outside of the face value of the policy). As far as your father in law, whatever he lost would’ve been gained plus some – the market has increased passed it’s 2008 high.

  9. YOGENDRA SOLANKI August 17, 2013 at 7:00 am #

    If you look at only cash value in a whole life policy, it is a bad investment and most articles do that. But, if you look at death proceeds at the end of the day, is it a bad investment?

    • Andy Rachleff August 17, 2013 at 2:08 pm #

      Term life insurance is a much cheaper way to insure your life than whole life. Our analysis assumes you still insure with term life.

  10. Thomas Rockford January 21, 2014 at 8:24 pm #

    Term life is cheap and it works to fill the temporary need of family protection. If you have children it should be mandatory to have some term insurance. A 10,20,30 year term is good enough to get your kids through school and the difference saved from whole life could be used to fund a retirement account or placed in an annuity.

  11. Ausin Regas February 1, 2014 at 7:47 am #

    Hi Andy,
    Excellent article. There are two additional points that I would like clarity on:
    a) The article assumes zero dividend payout. This dividend net future value is usually quite high. b) Can you elaborate on tax-efficiency – I keep hearing that whole life is tax advantage, thought it isnt clear to me. The dividends are clearly tax-free. The death benefits are tax free (assuming no estate tax). But is the surrender value (minus premium) tax-free if you are still alive? Can you hand over the surrender value to the beneficiary without taxation issues?

    • Andy Rachleff February 5, 2014 at 5:09 pm #

      I’m not sure I understand what you mean by we assume no dividend payout. Wealthfront assumes dividends are reinvested in the portfolio. We actually use dividends to rebalance your portfolio which is more tax efficient than buying sand selling ETFs.

      Whole Life Policies seldom if ever pay dividends

      The cash value of your portfolio accumulates tax free, but you need to pay taxes on the gain if you ever choose to withdraw it. The tax benefit of that accumulation is relatively minor and doesn’t affect our conclusion. Death benefits are not relevant to this discussion because they are not part of the investment decision. Term Life death benefits are tax free as well.

      I’m confused re you question re surrender value. Why would you pas son the surrender value if the death benefit is far greater, which should be the case?

  12. Adam Schwartz February 2, 2014 at 3:26 pm #

    In the table in this article you show that investing the savings in premium results in $313,939 after 20 years compared to the cash value of the whole life insurance of $236,679. If I understand correctly, the $236,679 can be withdrawn tax-free. If you’re tax rate at the time you use the investment gains is 25%, won’t your after-tax gains be the same in both cases. And if your tax bracket is higher, won’t you be better off with the whole life insurance?

    • Andy Rachleff February 5, 2014 at 5:11 pm #

      Unfortunately your understanding is not correct. You need to pay taxes on the appreciation of your cash value when you withdraw it. That’s why it’s not nearly as attractive as many agent represent.

  13. Lindsey March 16, 2014 at 1:31 am #

    I definitely feel like I got ripped off on my whole life insurance policy. I bought one from my advisor at Northwestern and owned it for 4 years, and didnt even get my money back when I surrendered it.
    I found a really cheap policy at LifeAnt and pay like 1/10 of the cost. Its term so I’m not getting completely ripped off anymore, and I can still sleep at night knowing the kids and wife are safe.
    I like the Suzy Orman approach of investing the difference. I dont do the whole amount but a part of it. Definitely its adding up to more already.

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