[Editor's Note: Regular readers know I'm not a huge fan of whole life as an investment and generally recommend against it in most situations. However, it is not without its benefits which make it suitable on rare occasions (although far less often than it is sold). Since nearly every physician will have whole life pitched to him at some point in his life, it is important to have at least a basic understanding of how it works.]
In my experience, there are a number of misperceptions surrounding participating Whole Life Insurance, including guaranteed rates of return, dividends, and the Internal Rate of Return. I would like to address these issues and, I hope, clarify this confusion.
What is Participating Whole Life Insurance?
First, what is participating Whole Life? It is a permanent life insurance policy issued by an insurance company to an individual where dividends may be payable. A mutual insurance company is owned by policyholders as opposed to a stock company which is owned by stockholders. The benefit of mutuality is that the company is operated solely for the benefit of participating policyholders who share in the better than guaranteed investment earnings and mortality experience in these policies through the payment of annual dividends. Dividends are not guaranteed, they are declared annually by the insurer’s board of directors.
A Whole Life policy is a unilateral contract between the policyholder and the insurance company. It promises that if the policyholder pays the specified premium, then a specified death benefit will be paid and that the cash value within the policy will equal the death benefit at a specified age (at which point the policy is said to “endow”). This age can be as late as 121, which is the age stipulated by the 2001 Commissioners Standard Ordinary (CSO) table.
Where Do Whole Life Insurance Dividends Come From?
The three variables in the dividend formula are: 1) actual mortality vs. guaranteed mortality; 2) actual investment returns vs. the guaranteed interest rate in the policy contract, and 3) expense charges. Expense charges are often negative as they reflect recovery of expenses in excess of what is covered in the guaranteed premium. The guarantee is that the policyholder will have his policy endow at the specified age regardless of these variables if he pays premiums through the length of the contract (WL99 refers to paying through age 99, for example).
The guaranteed cash values are based on a calculation involving mortality costs, expense charges, and interest. Guardian sets premiums at such a level that it can guarantee that they will be sufficient to ensure your policy will endow at the specified age. Two key assumptions backing this guarantee are the interest rate and mortality table. The interest rate is 4% and the mortality table is 2001 CSO, which has very conservative (high) mortality rates. This means that if interest rates fell below 4% or mortality experience was worse than 2001 CSO rates, Guardian cannot raise your premiums or lower your cash value. The interest rate guarantee, therefore, does not mean your cash values will increase 4% per year.
Thus, for the participating policyholder, the only non-guaranteed element is the annual dividend. As noted above, the annual dividend is determined by the actual mortality experience, expenses incurred, and investment returns. The dividend interest rate used in the dividend formula is declared annually and is stated as a percentage. The annual dividend payout is apportioned to each policyholder based on their policy values and the policy issue class. As the policy ages, the guaranteed cash value and the cash value created by prior dividends left with the policy to buy more insurance (referred to as “cash value of additions”), increase. The cash value of additions buys increased death benefit, referred to as “paid up additions.”
Offset and Overfunding
As the policy ages and its cash value increases, policy dividends during the premium paying period generally increase assuming the same dividend scale in all years. Eventually, the buildup of dividends may become sufficient to pay all future premiums, at which point a policy is said to “offset.” Every policy has a “base” premium which purchases a “base face amount” of death benefit. As noted, dividends purchase additional death benefit. The policyholder may also elect to “overfund” the policy and purchase additional death benefit through the use of “a Paid Up Additions rider,” (PUA Rider). Since PUAs are immediate, so are the cash values they generate. Typically, 95% of the PUA is added as cash value in the policy year the payment is made.
Whole Life Investment Returns
The actual cash value of the policy—determined by the combination of guaranteed basic cash value, policy dividends, and rider additions—can be compared to the premiums paid and expressed as the Internal Rate of Return (IRR). While the IRR may be negative in early years due to the amortization of sales and issuing expenses, over time it may exhibit a positive return. [Editor's Note: The IRR will certainly be negative in the early years but will almost certainly be positive, at least on a nominal basis, eventually.] For example, in a WL99 policy based on the 2013 Scale in all years, the IRR over a 25 year period is illustrated to be 4.22% for a Male 35 Preferred NT $1M face amount with dividends used to purchase paid up additions.* “Overfunding” a policy is the practice of adding PUAs with the intent of increasing cash value, increasing the IRR, and/or early offset. Overfunding is subject to IRS limitations that, if exceeded, can result in a policy becoming a “Modified Endowment Contract” (MEC) with negative tax consequences.
Death Benefit IRR
When considering the IRR, the policyholder should also consider the IRR of the death benefit. If a policyholder were to make a single monthly payment and then die, the IRR of the death benefit would be astronomical. Over time, the IRR of the cash value and the death benefit converge so that towards the end of the policy period, they are nearly the same. The flexible nature of participating WL insurance allows the policyholder to choose their desired balance (within ranges) of death benefit and cash values (should supplemental income be desired).
*A hypothetical illustration of a policy issued in 1986 with gross premium, net single premiums and guaranteed cash values taken from published rate manuals, shows an IRR of 4.83% for the 25 year-period ending in 2011. Dividends up to and including 2011 are actual historical dividends that would have been credited to this policy assuming that dividends were applied to purchase paid-up additions in all years, and that no loans or withdrawals of policy values were taken. Dividends are not guaranteed; they are declared annually by Guardian’s Board of Directors.
[Editor's Note: For whatever reason, discussions about whole life insurance tend to generate more heat than light. Let's keep comments on this post restricted to a discussion of the mechanics of whole life insurance- i.e. how it works. Ad hominem attacks will be deleted. If you wish to talk about how bad (or good) whole life insurance or those who sell it are, save it for tomorrow's post.]
Looking forward to this week. I too am not a big whole life fan, but I do see a place for it if one could afford it.
I just met with a NW Mutual guy this week in order to transfer a policy my dad had on me since age 5. Big whopping $6000 policy! Current cash value was about $2800. I had a few choices:
1) Cash out
2) Continue $6.62 a month until age 65 (projected death benefit of about 23K and a cash value of about 14K)
3) Continue monthly for about 5 years to break point. At age 65 it would have death benefit of around 16.5K and cash value of 10K.
At this time I am going with option 2 with plan to keep until death since I have no life insurance beyond age 63 as its all in term. With life expectancy into the 80’s it should have value over 35K for total cost to me of about $2400
I did appreciate that NW Mutual bases projections on the last 5-8 years rather than 30 year history and that salesman was very honest about expected future returns and had built these into projections (probably because he is young). For info, 10K yearly policy costs lead to a guaranteed value equal to cost at 20 years and an expected cash value equal to cost around 10 years. At 30 years values were 1.2mil/6.5/3.5 for death benefit/expected/guaranteed.
So question to WCI, maybe a future post idea.. 1) What do you think of purchasing a minimal whole life policy on your children to be passed down later? Would it be better to just open them up an investment account even if the contribution is so low?
No, I don’t think purchasing a minimal whole life policy is a good idea. You’ll recall that I had a minimal whole life policy ($20K face value) with a decidedly negative return after 7 years when I surrendered it. One problem with tiny policies is that the annual policy fee eats more into the return. Calculate the return on your tiny policy up until this point. I’ll bet it is terrible. If you’re going to have a tiny investment account for children, I’d go with a 529. The best book I’ve seen on this subject is “make your kid a millionaire.” It goes through UGMA accounts, 529s, variable annuities etc. Imagine if my parents had put $10K into Vanguard’s S&P 500 fund for me when I was 1 year old. Average annual returns have been 10.99% since then. Tax drag would be minimal. The annualized return would be slightly lower, so let’s use 10%. It would now be worth $340K. Why someone would lock in low returns for money that has decades to compound is beyond me.
Generally, the only reason to consider insurance on children is to protect their future insurability. Remember, your children depend on you and not the reverse. Also keep in mind that until they are older (around age 20), they cannot even qualify for the best underwriting classification that the carriers offer.
Unfortunately, all too often, I see parents that don’t have enough insurance on their own lives considering or asking about the purchase of insurance on their children becasue the premiums are lower and they feel they are gettting a “good deal”.
Right, but you cannot “lock in” insurability by buying a tiny policy now in hopes that they can somehow lock in the ability to buy a $2M term policy later.
True. I asked about my “tiny” policy and it could only expand to twice its size, $12K. A pittance.
Even after a pretty thorough explanation, I still don’t know why a person would not just buy term life and some other instrument that pays dividends.
1.What makes whole life uniquely attractive?
2. How is whole life different than universal life?
We’ll be getting to a lot of those things in the coming days. It is difficult to generalize about universal life policies because they vary so much. The key benefit of universal life over whole life is flexibility of premium. Whole life premiums are not flexible (at least until the point where the dividends can pay them.)
I agree that most people are generally better off with term life plus “another instrument that pays dividends” such as a rental property. You can borrow against that tax-free too! But rental properties don’t provide a death benefit, other than the step up in basis.
Thank you for sharing this post, Bob. Like where your head is at Jim to designate a full week to share your experience and perspective on whole life insurance. You are absolutely correct to note that at some point during most physician’s professional careers they will be pitched on the value of participating whole life insurance.
Why ‘rent with term insurance when you can own it with whole life insurance’? This pitch is not something I preach, but know it is prevalent in the sales tactics that some agents use.
Generally speaking a standard (no paid up addition riders, etc) whole life insurance policy will equal a nice ‘payday’ in the form of a commission check to the selling agent and decreased value to the client. It would not necessarily be a problem if consumers held these contracts for very long, long periods of time 20 or 30 years. The fact is many do not hold these contracts for the duration and end up losing hundreds, if not thousands of dollars.
Blended contracts with, in some cases (depending on carrier) with riders tend to greatly reduce sales loads and increases the cash value accumulation amounts significantly. Blended policies generally are designed with a mix of whole life insurance and term life insurance. Here is great article to reference.
http://www.lifeinsuranceadvisorsinc.com/articles/individuals/MakingLifeInsuranceGood.pdf
Yes, there are ways to improve the return on whole life on the margin, such as paying annually, using paid up riders, blending it with term life you may need etc. But in many ways it is putting lipstick on a pig. It might look a little better, but it is basically the same underneath- an investment that must be held for life in order to provide a relatively low rate of return.
So in the first one or two years there may be a negative IRR, but subsequent years the IRR on cash
value 1-2%. A little later, say in the 10th or 15th year the IRR on cash value can be close to 4%….And this factors having to pay for the cost of insurance, policy charges, etc. That is not a bad deal at all.
Whether it is a good deal or a bad deal is in the eye of the beholder. Personally, I think a 4% return on a multi-decade investment is pretty poor. But if someone actually understands what he is getting and still wants it, then I have no objection. My problem is too many people are buying whole life insurance under the misconception that they’ll be getting 6, 7, 8%+ returns guaranteed, along with a lot of other benefits that may or may not be there. That, of course, isn’t true.
Okay, you are correct with the eyes of the beholder.
As you, whole life is a bundled product comprising of term insurance and an investment account. I would not argue with your thoughts on expected return for a multi-decade investment. There are definitely better investments out there, depending on risk profile. If insurers buy high quality bonds with yields of 4.5-5% how can one expect a return of 6, 7, or 8% guaranteed? That is wrong. Without knowing what they individual tax bracket is we cannot assume anything. On a pre-tax assumption I have seen policies that were bought in the late 80’s performing well, with IRR’s in the high 3’s…..they have low policy charges too, which is extremely important. So whatever that
individuals marginal tax bracket will determine after tax return.
In my opinion max blended cash value policies, with a little piece of whole life and the majority in term insurance can be an cost effective savings vehicle for the long term. Unfortunately that is not how permanent life insurance is sold, 70% of the time.
Happy Holidays to you and yours, Jim. Keep up the great work with your blog. Thank you.
Thanks for the opportunity to post. What I didn’t say is why I personally own WL insurance. I’ll try to be brief: As PART of your overall plan for retirement, I believe owning WL allows you the permission to spend down your remaining assets more freely.
Assuming a retirement age of 65 (or 55 or 70), how long will you live, and how can you insure that you don’t run out of money? Will you live 15 more years or 30 or longer? There are actuarial statistics, but your mileage may vary.
Since you don’t know, it makes sense to be cautious. Monte Carlo stats suggest spending less than 4% of your assets to ensure you don’t run out of money. However, if you have WL in place, you can be more aggressive with spend-down, since you have the cash value within the policy to supplement income IF NEEDED. Now I can actually plan to spend investments assets over a 15 or 20 year period. I’m comfortable planning to spend down 6% annually rather than 4%.
I will definitely concede that buying term and investing the difference will LIKELY (though not absolutely) result in having more assets over a 30-year time frame. But de-accumulation is just as important as accumulation.
Bob
I think this is a lousy reason to buy a whole life policy. If the concern is running out of money, buy a SPIA. That’s an insurance policy against living too long and running out of money. The older and sicker you get, the better deal it is.
If the concern is leaving a legacy, but holding onto that legacy just in case you need to spend it, then leave the legacy in traditional investments. Your heirs get it income tax free thanks to the step up in basis, and if you run out of cash, then you can raid it. Meanwhile, it is growing a heck of a lot faster than it would be in a whole life policy. I just don’t see leaving a legacy as a good reason to buy a whole life policy. Now, if you want to make sure you can leave at least $1 Million (or whatever amount) no matter when you die, and you don’t actually have $1 Million to leave yet, then sure, buy life insurance. Most people cover those types of issues with term life insurance though.
Most people I’ve talked to want to have enough money to meet their own needs, and then leave as much as possible to heirs. The way to do that is traditional investments, not insurance. Why leave a legacy of $1 Million when you are likely (but not guaranteed) to leave a legacy of $2 Million instead by avoiding the whole life policy?
This is the whole point of this series. What financial goal does whole life do better than any other investing or insurance product? None! Sure, it can be used for lots of different stuff, but it doesn’t do any of it well. There’s a better way to do everything. Agents selling this stuff plop out one reason to buy it, then when someone shows there is a better way to meet that need/desire, the agent moves on to the next reason to buy it ad nauseum. It’s a product that is sold, not bought. Who in their right mind would go looking for a product like this to meet their needs? No one. That’s why it has to be sold and why the commissions to do so are so high.
WCI, you said: “What financial goal does whole life do better than any other investing or insurance product? None! Sure, it can be used for lots of different stuff, but it doesn’t do any of it well.”
My reply: Yeah it does. (If it is a participating WL policy), it guarantees a person’s savings without locking them into a low bond rate and subjecting them to interest-price risk, and without sacrificing liquidity, while also providing a death benefit if one wants/needs insurance protection. Nothing else really does that.
If a person is thinking: “yeah but I can get a higher rate of return on ___________”, that’s not the point. The point is that you can’t predict your future equity returns, no matter how sophisticated the financial model is, and whole life is one way to hedge against that fact.
It’s a question of cost: Are you willing to pay $XX to guarantee X% of your future savings?
Some people are, some aren’t.
The guarantees aren’t worth much. The guaranteed scale is usually less than inflation. Bonds traditionally outpace inflation.
When I say they guarantee savings, I mean once CV is earned, it can’t be lost be lost in a correction. These are the guarantees people typically purchase. Also, see Glenn Daily’s article on CV insurance guaranteed column.
So, those guarantees aren’t worth much…to you. They’re worth a lot to other people though. That’s very different from saying it has no value whatsoever for anyone.
I’m just saying the guarantees are oversold. What is actually guaranteed (as long as you make your premiums) is a very low rate of return and a death benefit. That’s it.
Oversold compared to what?
Anything that doesn’t pay a 50-100% commission when sold? 🙂
My policy pays $75 per $1,000 of premium for the first year and then maybe a % or two on a small fraction of that for the next few years. That’s 7.5%. That’s lower than term commissions. Try again. 🙂
Yes, paid up additions have lower commissions, thus the benefit of properly designing a policy for what you want it to do. I assure you the typical policy a doc brings to me has premiums far higher than the ones agents like you sell to themselves. 🙂
Possibly. But what does that matter? All that tells you is that the docs you see have done business with bad agents. What about good ones? I can assure you, low cost policies aren’t *just* sold to agents. Every industry has bad actors, which always look disproportionate to the good guys.
Assuming you’re one of the good guys, you’re terribly outnumbered.
Right. But, how is that different from every other industry? Most professions have averages, and those averages (which, by definition, constitute the majority) usually give mediocre or bad advice or do mediocre or bad work. That doesn’t make their service or product inherently bad.
Hi-
Just wondering if you can shed some light on this…
My father passed away leaving me the beneficiary of a whole life policy from John Hancock. It is an 8k policy with dividend and it is participating. Sorry I don’t know what that means.
Any idea what the I will see as the death benefit? At least 8k?
He bought the policy in 1969. It was paid up in 1984.
He passed in 2016.
Thanks for any help.
David
Are you the insured or was he? If he was, why does the policy still exist? Shouldn’t you just have the benefit in your bank account? Call John Hancock with the policy number and they can tell you how much you’ll get and when. But if it was $8K in 1969, it’s probably double or quadruple that.
If you, you’ve got a few options- borrow against it, surrender it, or just hold it until your death. Personally, if the face value is only $8K and it’s on me, I’d probably just cash it out to keep my financial life simple.
One of the things to remember is that there are 2 different types of whole life policies out there: participating and non-participating. This post discusses participating, where there is an opportunity to receive an annual dividend payment. Non-participating whole life has a guaranteed 4.5% cash value growth, most starting in year 3, and does not have any sort of dividend option. This means that the onus is on the Life Insurance company to pay out the cash value if the client so chooses, instead of on the client to choose the right type of investment vehicle for their insurance. Insurance is not meant to be used as an investment…it is for income replacement should a catastrophic loss occur, and continued insurability. Remember these differences when you are discussing whole life.