Is whole life insurance right for you?

Follow our advice to assess this most misunderstood coverage

Published: April 06, 2015 03:45 PM

We’ve long advised younger, budget-conscious families to buy term life insurance. The main reason—it offers bargain-price protection that pays a large benefit to your survivors if you die during the typical 20- to 30-year term of the contract. Consequently, we’ve tended to short-shrift whole life insurance because it’s a murky mix of life insurance and savings or investment vehicle that builds cash value after several years and into the ­future—again, as long as you pay the premiums, which can be 10 times as high as those on a same-sized term policy.

Our advice—that term life is a better deal for most families—hasn’t changed. But because bigger annual premiums result in larger commissions for insurance sales­people, sooner or later an agent may try to sell you a whole life insurance policy, also known as “cash-value” and “permanent life.” But whole life is a lot more complicated than term, and you should understand how both types work.

The confusion starts with the fact that whole life insurance combines two financial products—life insurance and an investment—into one that is supposed to serve your needs over your entire lifetime. But life is unpredictable, and the circumstances that drove your initial purchase can be very different a decade later. A period of financial stress, say, may prompt you to eliminate the high annual payment and surrender the policy for its cash value.

Running the numbers

Click on the image to expand it.

To grasp the value of whole life insurance, you need to see how it and term life insurance operate in practical terms. We got term and whole life quotes from AccuQuote, an online broker that sells policies from about 100 insurers nationwide, for a 40-year-old Illinois man in perfect health who wants a $500,000 policy with level annual premium payments (click to enlarge the chart, right).

When you’re young and have a family, term life insurance (dotted-red, then solid red line) provides a big death benefit for a bargain price (turquoise line). But at age 70, in our example, the 30-year term protection ends. That’s also when the term life starts becoming prohibitively expensive because of the insured’s age and declining health, and the increasing probability of death.

A traditional whole life insurance policy purchased at 40, keeps the death benefit in force beyond age 70, as long as premiums are paid (dashed-blue, then solid-blue line). Whole life premiums are steep, though: $6,760 per year vs. $660 annually for the term policy. But the “excess premium” goes to guaranteed savings, which build cash value over time (light-gray line).

Alternatively, you could buy the 30-year term policy and each year invest the difference between the whole- and term-life premiums in conservative 10-year Treasury notes. (T-notes are a comparable alternative to investing in whole life, in terms of liquidity, risk, and resulting returns; a stock mutual fund would not be comparable.) In this illustration, which assumes that the current 2.17 percent 10-year T-note rate remains level, the T-notes can provide a higher return on your money (dark-gray line) vs. the guaranteed return (light-gray line)—but no death benefit past age 69.

So one value of whole life is the continuing death benefit (dark-blue line) for your heirs while you continue to build cash value.

But some whole life policies also pay dividends based on the insurer’s financial performance. Those returns, not guaranteed but likely, can be reasonably estimated. When the dividends are used to buy additional “paid-up insurance,” that can add an estimated $500,000 to cash value by age 90 (light-blue line) and boost the death benefit to $1.1 million (gold line).

However, the average annual rate of ­return—1.5 percent for the whole life guaranteed cash value, 2.2 percent for the Treasuries, and 3.5 percent for the whole life possible cash value—is undercut by inflation, currently about 2.2 percent per year.

So your savings tread water while providing lifelong life insurance, and you can pass on the assets tax-free to your heirs.

Whole life insurance can provide benefits while you're still alive. Check out the worthwhile long-term care rider

Timing is everything

The name of the game is to hold on to your policy until you die. About 4 percent of whole life policies per year lapse, according to a study of 47 million policies issued by 20 insurers over more than two decades, by LIMRA, an industry research company. That means the value of a whole life policy depends on how long you own it. Here's what to look for:

Less than five years

If a reversal of fortune causes you to quit the policy in less than five years, whole life is a lousy investment. Huge front-end sales commissions and policy-surrender charges eat up the cash value, and you’ll probably lose all or most of your investment. You will have received the value of the life insurance protection for that period, but that will be wildly overpriced because you could have paid significantly less for a simple term policy.

Our advice: If you worry that you won’t be able to maintain those high whole life premium payments for even a few years, buy term insurance instead.

Sixteen years

If you dump your policy around the 16th year, your cash surrender value plus the value of the insurance you received will be about what you put in. So that’s the earliest you can drop the policy without losing your shirt.

Our advice: If you’re wealthy, you can probably gamble on whole life over that long period. If you’re struggling, go with term.

Two decades and beyond

As our chart shows, if you steadily maintain your payments for two decades, the returns on whole life, including dividends, start significantly pulling away from the term plus Treasuries alternative. Meanwhile, surrender charges have usually disappeared, if you want to cash out. “If you hold a cash-value policy long enough, it can compete with alternative investments of comparable risk,” says Glenn Daily, a New York City fee-only life-­insurance consultant.

Our advice: Higher-income folks in the 20+ years club have options: If you’re building a legacy for your heirs and have the money to keep going, the rising return trajectory and insurance coverage should give peace of mind. If you need to leave whole life, you can.

Whole life provides a death benefit until age 100 to 121, depending on the policy, but you have to keep paying the premium as long as you live. However, for an additional premium, if you become disabled before age 65, the insurance company pays the premiums for the rest of your life.

Hidden truths

This mixed bag of potential benefits and costs is complicated enough for consumers to navigate, but poor disclosure robs consumers of the information they need to comparison shop.

Although most states have adopted model disclosure regulations promoted by the National Association of Insurance Commissioners, no state or federal agency requires them to mention such basics as investment-­management fees, rate of return, and (with the exception of New York) sales commissions.

Insurers also don’t disclose what part of the annual premium goes to pay the life insurance vs. savings components of the policy. If you don’t know how much is going to your cash account, you can’t accurately calculate your rate of return on that asset.

That makes it difficult to compare one policy with others. And yet there are large differences in prices among companies for essentially the same coverage, industry experts say. Brian Fechtel, a chartered financial analyst and 27-year life-insurance agent, says commissions on whole life can be 130 to 150 percent of the first-year premium.

“If the industry disclosed the commissions, whole life sales costs would have to come down to be competitive,” Fechtel says.

—Jeff Blyskal (@JeffBlyskal on Twitter)

Editor's Note:

This article also appeared in the February 2015 issue of the Consumer Reports Money Adviser.

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