At The White Coat Investor, we’re not completely against whole life insurance. In limited circumstances, it can serve a useful role when it's properly understood and appropriately used. The issue arises when a policy is sold, and the benefits are misunderstood or misrepresented.
There are still agents out there selling whole life insurance as an alternative way to save for retirement. Sometimes they try to run the numbers to “prove” that it is better than a more traditional way, such as using a portfolio of stock and bond index funds inside a retirement account.
Their arguments generally center on the fact that you can borrow tax-free (but not necessarily interest-free) against a whole life policy and that, because of its lower volatility, you can have a higher withdrawal rate from the whole life policy than a more typical 4%ish number. Naturally, they throw in some potential asset protection benefits (even though retirement accounts generally offer better asset protection than whole life) and the very real death benefit (which is particularly useful to your heirs should you die shortly after buying the policy but can be had dramatically cheaper with a term policy).
Garbage In, Garbage Out
Unfortunately, these agents usually make colossal errors in their analysis. A recent one I saw compared $1 million in a whole life policy against $1 million in a traditional IRA, ignoring the fact that it takes dramatically less money to build a $1 million IRA compared to $1 million in cash value in a whole life policy. How much less? It depends on your assumptions. Let's assume payments of 30 years, a return of 8% in the IRA, a return of 4% in the whole life policy, and a marginal tax rate of 40%.
The IRA is funded with pre-tax dollars, so
=PMT(8%,30,0,1000000) = $8,827.43 per year
The whole life policy is funded with post-tax dollars, so
=PMT(4%,30,0,1000000) = $17,830.10/(1-40%) = $29,716.83
You would have to put 3.4X as much money into the whole life policy over 30 years. No, that's not a reasonable assumption when making a comparison. Put $30,000 into that retirement account also, and you'll be amazed at the difference in retirement income provided.
More information here:
The 9 Pros and 7 Cons of Whole Life Insurance
A More Fair Comparison
A better way to compare is to equalize the amount of money going into both options over a typical accumulation period. Let's say 30 years. To make the analysis easier to do and understand, we'll use a Roth 401(k) as the comparison retirement account. Why not a tax-deferred account? A tax-deferred account is really just a combination account. It is a Roth account (your money) and a government account you're investing in on behalf of the government/IRS until the two accounts are later separated at the time of withdrawal. Both whole life policies and Roth accounts are funded with after-tax dollars.
Let's again use an 8% nominal rate of return for the investments (about what I'd expect long-term from something like an 80% stock/20% bond allocation) and a 4% nominal rate of return for the cash value of the life insurance (projections of good policies typically show a guaranteed rate of return of about 2% and a projected rate of return of about 5% on the cash value over a lifetime).
We'll ignore the value of the death benefit since, during the accumulation years, it can be obtained very cheaply with a term life policy, and, during the decumulation years, the cash value of the whole life policy or the remaining amount of the investments basically serves the same function. But even if you added in a small amount for the value of the death benefit, it wouldn't significantly affect the analysis.
Note that spending from both assets is tax-free. We'll assume the whole life policy offers wash loans and non-direct recognition (note that most policies are NOT structured this way), which allows us to ignore the interest on whole life policy loans.
After 30 Years
You go to work for 30 years, putting $10,000 a year into one of these “retirement savings vehicles,” and then you stop working and plan to live the rest of your life off the proceeds. How much is in each vehicle at the start of retirement?
Roth IRA
=FV(8%,30,-10000) = $1,132,832
Whole Life Policy
=FV(4%,30,-10000) = $560,849
So far, it seems obvious which “retirement savings vehicle” is better. You are starting retirement with twice as much money by saving in a retirement account vs. a whole life policy.
But can you withdraw more from a whole life policy? You can if you believe the illustrations. Many of them will show that you can take out 6% of the original value per year, and frankly, that's probably true.
So, $560,849 * 6% = $33,651 a year. Over 30 years of retirement, that adds up to a total of $1,009,528 in spendable retirement income. Plus, there's probably at least a little left over for your heirs to inherit. That doesn't seem terrible, right? You put $300,000 (nominal) in, and you pulled out more than $1 million. That's a win, right? Sure. Whole life isn't a scam. If you understand how it works, it is highly likely to do what it is designed to do. The problem is that the alternative is so much better.
Let's look at the Roth IRA.
At 30 years, it is worth $1,132,832. Most financial planners and investment authorities think you can safely withdraw about 4% a year, adjusted upward with inflation each year, from a typical portfolio and expect it to last 30 years. After 30 years on a nominal basis, the amount left in the portfolio on average is 2.7X the original amount. You just have to limit withdrawals to 4%ish in case you hit a bad sequence of returns. While 4% seems like less than 6%, that 6% projection from the whole life policy is actually less money for two reasons:
- You start out retirement with so much less and
- It isn't adjusted to inflation
In Year 1, the whole life policy “pays” you $33,651, and the retirement account pays you $1,132,832*4%= $45,313. You're already ahead with the traditional method. But the difference becomes greater each year. If we assume 3% per year inflation, by Year 30, you're withdrawing $106,783 a year, nearly three times as much as you'd be pulling out of that whole life policy. If you chart it out with a spreadsheet, you'll learn that the traditional method totals $2,155,798, more than twice as much as you could have spent using a whole life policy as your retirement savings vehicle.
How much will you have left for your heirs? There's plenty of variation. But a likely outcome is that you'll still leave about $1 million to your heirs with the whole life policy, and you'll leave about $3 million to your heirs with the traditional method. In total, you and your family get $5 million vs. $2 million.
There's really no comparison here. You can tweak the assumptions a little here and there, but it just isn't going to come close to narrowing that gap.
What About Risk?
One criticism that is fair to point out is that investing involves risk, and there isn't a ton of risk involved in buying the whole life policy. Yes, the company could fail, but that's not likely—and there are state guaranty associations that would lessen the consequences of company failure. Yes, the insurance company could dramatically cut dividends, but they're already so low that they are unlikely to be cut to zero. Meanwhile, it is probably more possible (although still a low risk) that stocks and/or bonds could have a lousy 30 years either during your accumulation years or your decumulation years. But I think you're being paid more than adequately for taking on the small amount of risk that exists there in the long term.
You could lessen the risk in the decumulation years by simply swapping your larger lump sum in the retirement account for a Single Premium Immediate Annuity (SPIA). While you'd be giving up the death benefit, you'd be guaranteeing a significantly higher (twice as high) retirement spending income than the whole life policy could provide.
More information here:
Should I Invest in Real Estate or Whole Life Insurance?
What About Tax-Deferred Accounts?
Insurance agents love to talk about that bogeyman known as the IRS. In reality, for most retirement investors, they have a higher marginal tax rate during their accumulation years than during their decumulation years. If you run the numbers for a typical retiree, they look EVEN BETTER if you use a tax-deferred account than the tax-free Roth account. Just remember to adjust for the fact that you are now saving pre-tax dollars instead of post-tax dollars. Saving taxes at 40% and paying them at 25% is a winning proposition for most.
How Can I Sell Whole Life to My Clients?
If you're an honest agent and you are just now realizing that selling whole life as a way to save for retirement is basically financial malpractice, how can you still feed your family? You have two options.
The first, which I hope you take, is to simply sell your clients the products they need and want. Those include things like disability insurance and term life insurance. For a very small group of people who need or want a permanent death benefit (perhaps an ILIT if they have an estate tax problem or key man insurance for a business) or want to “bank on themselves,” it can include a few whole life policies.
The second is not to make the comparison to a traditional portfolio of stock and bond index funds invested in a retirement account, but instead, make the comparison to a portfolio invested entirely in bonds and/or certificates of deposit outside of a retirement account. The lower rates of return available after-tax from these investments (whether taxable or municipal bonds are used) will compare more favorably. At that point, the value of the death benefit and some additional asset protection might tip the scale to where a client might choose to buy some whole life AFTER maxing out retirement accounts. You'll still have to get over the fact, though, that the client and their family are highly likely to leave their heirs dramatically more money by investing in stock index funds or real estate than through the purchase of whole life insurance with those taxable dollars. This approach is for very risk-averse clients who can brook no volatility with their investments. Even then, you still might not be doing them a favor, as author and investment advisor Phil Demuth explained:
“Even if risk tolerance existed and could be measured accurately, why would it be an important factor to consult when considering how to invest? You should invest in the way that has the greatest prospect to fulfill your investment goals. That might mean taking more or less risk than you would prefer. If you are a sensitive soul who can brook no paper losses, the solution is to get a grip, not to invest ‘safely’ if that locks in running out of money when you are old.”
The main issue with “investing” in whole life insurance is simply that the returns are low, and over 30-60 years, the effect of compound interest on those low returns makes it a pretty lousy investment vehicle, no matter the use for the money.
What do you think? If you were approached to buy whole life insurance, was it pushed as a source of retirement funds? Did the agent tell you that it would do even better than retirement accounts?