Please pardon our appearance as we complete the final development phase

Introduction

Formulate a Financial Plan

Know Your Net Worth

Manage & Minimize Debt

Accumulate Assets

Budget to Live Within Your Means

Understand Investing Basics

Plan for Retirement

Insure People & Property

Deal with Financial Advisors

Review Your Employment Contract

Make Plans for Your Estate

Make Good Decisions

Conclusion

Permanent insurance remains in force as long as you continue to pay your premiums. Thus, properly maintained permanent insurance will pay death benefits when you die.[1] Coupled with the ability to accumulate cash value in a permanent policy, these two features explain why, for a given death benefit amount, permanent insurance costs much more than term insurance.

Insurance agents often use a renting vs. buying a home analogy, where the purchase of term insurance is equivalent to “renting” insurance coverage for a limited period of time, whereas purchasing of permanent insurance is “buying” coverage for your lifetime. In the case of the latter, you build up equity in the policy in the form of cash value. The analogy is repeated here to help explain the differences. It’s not meant to encourage you to rush out and buy a permanent policy. The odds are low that a permanent policy is the best choice for you. In fact, many permanent policies lapse or are cancelled before the death of the insured.

Permanent policies are complex instruments with lots of moving parts. Each insurer has its own preferred bells and whistles, which makes it very difficult to create true apples-to-apples policy comparisons.

The main features of permanent life insurance usually include:

  • Some fraction of each of your premium payments is saved or invested on your behalf. Over time, you’re creating cash value, or in our context, a pillar of wealth. But in many policies (especially Whole Life) it may take a decade or more to accumulate a meaningful amount of cash value
  • The estimated annual return on a Whole Life policy, especially assuming you attain your life expectancy, is low
  • You may be eligible for dividends. Insurers strive to offer a fairly stable stream of dividend payments. But such payments are not guaranteed
  • Cash value accumulates tax deferred—you don’t have to pay taxes on the gains in the policy cash value—unless and until you elect to withdraw them 
  • You can surrender the policy for its cash value, pay off the relevant taxes, and keep the rest
  • There’s an alternative way to access your cash value without surrendering the policy, by taking out a loan from the insurance company against the cash value you’ve accumulated. It should be possible to borrow this money without triggering taxes, but you must pay interest to the insurance company on those loans. And the amount lent to you is no longer accumulating interest in the cash value account. Taking out a loan can seriously throw off your illustrated returns
  • You may be able to add riders to your policy. Some examples include: (1) Disability Income Rider providing monthly payments to replace income in the event of disability, and (2) Acceleration of Death Benefit Rider allowing you to receive some cash prior to death in the event of a terminal illness diagnosis. Generally, you pay extra for riders. Always be wary of such added features as they may not be worth the cost. Some riders are touted as free but insurers don’t really give anything of value away

 

Reduced Paid-Up Policy

A permanent life insurance policy may be convertible into a fully paid-up policy, i.e., no more premiums need to be paid, with a lower death benefit. Generally, this is only possible after an extended period of time, during which the cash value of the policy has grown sufficiently. That cash value is used to buy a fully paid-up policy.

  There are several categories of permanent insurance, including Whole Life, Universal Life, and Variable Life. Some of these have their own variants (e.g., Indexed Universal Life, Variable Universal Life, No-Lapse Universal Life, etc.)

 

Whole Life Insurance

Whole Life (WL) policies are generally characterized by guarantees and stability. Premiums are fixed—they don’t change over time, you’re guaranteed a specified death benefit, and a minimum rate of return on your cash value in the form of interest paid by the insurer. In addition to the guaranteed interest rate, you may receive dividends. Retaining the dividends within the policy provides an opportunity for greater cash value growth and enhanced death benefit. For a Whole Life policy, the insurer is obligated to invest your cash value in high quality bonds.

The annual return on investment in a Whole Life policy is low, especially assuming you attain your life expectancy. Thus, from an isolated, pure math perspective, Whole Life is "not a good deal." However, those who die prior to reaching their previously determined life expectancy, realize a higher return. In a morbid sense—the sooner a person dies, "the better the deal" in terms of the return realized by the beneficiary.

Due to the guarantees in a Whole Life policy the premiums are large and commissions are hefty. This makes the sale of such policies very appealing to agents and raises the question of whether a policy is being sold for the right reasons: to address the true needs of the consumer or to enrich the agent.

The very rigid terms of WL policies can become a constraint for the policy owner. Cash value takes a long time to build, and large premiums must be paid consistently—over decades. To keep the policy in force until death, the owner must pay premiums until death.

Finally, the cash value of a Whole Life policy can be undermined in a highly inflationary environment, especially if the guaranteed interest rate is low.

 

Universal Life Insurance

Unlike Whole Life’s fixed premiums, Universal Life (UL) policies offer adjustable premiums, allowing you to pay more into the policy when you have extra cash, or to pay less when cash is scarce. There’s also greater flexibility in increasing or decreasing the death benefit.

Some Universal Life policies allow you to choose between guaranteed cash value returns (unlike Whole Life, you may not be eligible for dividends) or indexing returns to stock market performance (Indexed Universal Life or IUL). You may be allowed to switch between these alternatives once a year. If you opt to invest cash value in stock indexes, cash value accumulation may be disappointing when equity markets decline.

A UL policy may lapse under certain conditions, including: changes in the insurer’s mortality assumptions, increases in administrative expenses, underperformance of the underlying investment portfolio, or insufficient premium payments. With the exception of the latter, these factors are not under your control.

Due to the flexibility of Universal Life policies, they are often used in estate planning.

 

Variable Life Insurance

Unlike the conservative nature of Whole Life cash value investments (primarily in high quality bonds), variable life cash value may be invested in a wide range of securities, often stocks and bonds, exhibiting a wide range of risk and return characteristics.

Insurance companies began to offer variable policies decades ago in an effort to compete with stock market returns. This was at a time when consumers increasingly questioned the point of purchasing relatively low-return Whole Life policies when they thought they could double or triple their returns by investing in stock markets.

Insurers wanted to attract these consumers, but they didn’t want to have to guarantee higher returns, so they created the glamorous seeming VL product, touting its market return potential. The downside was, and remains, that consumers shoulder all the investment risk.   

With Whole Life policies, your cash value is invested in the insurer’s General Account, and the insurer is responsible for managing those investments on your behalf. The insurer guarantees you some minimal performance through fixed promised interest rates (and usually fairly stable dividends). In contrast, Variable Life contributions are managed in a Separate Account. You get to choose the underlying investments, and you may be able to change them over time. But as noted above, you bear full responsibility for the investment performance.

To sell Variable Life policies, an agent must have an insurance license and a securities license.

Variable Universal Life (VUL) allows you to choose from a broad set of risky investment alternatives and flexibility to alter your premiums.

Whole Life is positioned on the most conservative end of the permanent policy spectrum, while Variable Life is at the opposite—most speculative end. Universal Life lands between these two extremes.

 

Variable Insurance Products

Insurance products such as variable life and variable annuities are pitched to consumers who desire investments with higher returns. But such products require consumers to take on more risk. This defeats the purpose of insurance, which is to reduce risk and uncertainty.

The whole point of insurance is that you pay for the peace of mind of reducing household risk. Why on earth would you purposely add more uncertainty through speculative investing risk?

At a very basic level, using insurance products as investments doesn’t make sense, because they tend to involve too many middlemen and too many fees. The fees undermine returns, making them inferior investments. Variable products magnify policyholder risks and offer inferior (after-fee) returns. They can’t be an efficient investment choice.

Stay away from variable products. There’s no compelling reason for such products to be offered to the retail public—certainly not in their current opaque, high-fee formats. If you want to chase risky returns, you can do so more directly and efficiently in investment accounts.

 

General Criticisms of Permanent Policies

Permanent life insurance policies have been heavily criticized over the years. Much of this criticism is well founded:

  1. High commissions motivate agents to push permanent policies aggressively
  2. Policies may not yield promised cash values and long–term returns
  3. Policies may self-destruct due to reasons that are hidden in small print, and
  4. Unnecessary bells and whistles pushed by shady agents cost more than they are worth

As a result, we must be very careful before committing to such policies. Having said that, and in the interest of intellectual honesty, I’m compelled to point out that several criticisms of permanent life insurance products are not completely accurate.

Here are some observations:

  1. Despite assertions to the contrary, the cash value of permanent life insurance policies is an asset. I don’t, however, consider permanent insurance to be an asset class. Agents may position it as an asset class in an effort to convince you it’s a necessary component of your overall nest egg. It isn’t!
  2. Since it is an asset, the cash value of permanent life insurance can be considered a Pillar of Wealth, although your particular circumstances determine whether it’s a pillar you should own. Odds are you shouldn’t!
  3. Permanent life insurance cash value can provide some diversification to a household’s portfolio. This is more of a mathematical assertion. As long as the cash value asset is not perfectly correlated with any other assets the household owns, it does provide some diversification. Having said that, it’s legitimate to question how much diversification benefit is provided and whether that justifies holding such an asset. That, of course, depends on specific circumstances and preferences

Insurance companies have made it easy to criticize permanent policies. But doing so reflexively, without conscious thought, deprives us of having deeper conversations about such financial tools and their potential future role for more households. Misunderstandings of permanent policies are most apparent in the Term vs. Permanent debate, which we address next.

 


[1] In contrast, statistically speaking, the vast majority of term policies don’t end in death benefit payments as most people outlive their term limits.

 


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