I have written a lot on Whole Life Insurance (and its cousins Variable Universal Life and Indexed Universal Life) in the past. I’m always a little hesitant to write on these subjects because every time I do I have to endure dozens of agents leaving 1000-word diatribes in the comments section for years afterward. Nevertheless, I think it is an important enough subject to continue to write about.

As a general rule, I recommend against the purchase of these cash value life insurance policies, which mix insurance and investing. Many people purchase them without really knowing what they’re getting. As a result, about 80% of purchased whole life policies are surrendered prior to death. If you’re considering getting rid of your policy, I’ve written before about your various options and deciding whether or not to dump your policy. That decision is entirely different from the decision of whether to buy one in the first place or not. If you have had a policy for many years, it often makes sense to keep it. That’s because the poor returns associated with whole life insurance are heavily front-loaded. Basically the returns are negative for a few years, and then you break even near the end of the first decade. Going forward from there you may see 5% or even 6% returns on your money. Overall, 3-5% per year is a reasonable return to expect from the time of purchase until death at your expected life expectancy.

This post isn’t going to deal with any of that, but I don’t want anyone to get the impression from this post that I think buying a whole life insurance policy is a great idea. It usually isn’t. This post is merely about what to do with a policy you already have that it makes sense to keep. Not only do you want to keep it, but you are now either near or in retirement and trying to decide what to actually do with this asset. At this point it doesn’t matter so much why you bought it (although any given policy may be structured to be better for one purpose or another), you still have the same options for what to do with it. We’ll discuss each in turn, but first, let’s consider a couple of other things.

What To Do With the Premiums

At this point, depending on how your policy was structured, it may be “paid up” meaning you do not need to pay premiums any longer. If it is not paid up, the policy represents primarily an asset, but also a liability. Personally, I think it’s dumb to buy a policy that isn’t paid up at the time of retirement. That’s like going into retirement with a mortgage. But that decision is all water under the bridge. Most policies that you have held for a long time probably have enough cash value that you can use that to pay the premiums (using policy loans-reducing the cash value and death benefit) if you like. If nothing else, you can probably use the annual dividend to fully or partially pay the premiums. That way if you have more money than you need, you can keep the value of the insurance growing by paying dividends. If you need a little more cash, you can pay the premiums with the dividends. If you need more cash, you can let the cash value pay the premiums. If you actually want to do something with the cash value besides leave it to your heirs, then we’ll be discussing those options momentarily.

Sequence of Returns Risk

The real benefit of holding a low-return/low-volatility asset, especially early in retirement, is it reduces your sequence of returns risk. A more traditional investor might use bonds for this, but life insurance cash value works too. You’ve already paid for this benefit by decades of low returns, so you might as well take advantage of it now. This occurs in two ways. First, since part of your portfolio is in this low-volatility asset, your portfolio takes a smaller overall hit in a stock or real estate market crash. Second, you can preferentially take your spending money from the insurance cash value for a couple of years while the market is down, allowing you to avoid selling low and thus further extending the period of time your portfolio will last in retirement.

Withdrawal Options

There are  number of things you can do with your whole life cash value in retirement. I’ve divided these options into three categories- the good, the bad, and the ugly and will discuss each in turn.

The Good

Preparing to rappel off "meat" at Lake Powell

Preparing to rappel off “meat” at Lake Powell

1) Don’t Withdraw It

One of the best uses for life insurance, even permanent life insurance, is to simple buy it and use it for its death benefit. In fact, if you really don’t need or want a death benefit, this probably isn’t the asset for you. But one of the best “returns” on your “investment” in whole life insurance is simply to leave the death benefit for your heirs. While it is probably true if you actually live to (or beyond) an age near your life expectancy that you would likely leave your heirs more money (and just as tax-free as the insurance death benefit thanks to the step-up in basis at death) if you had invested your money in stocks or real estate, that decision is water under the bridge. If your goal is to leave a guaranteed slowly increasing death benefit to your heirs no matter when you die, there is no better product than whole life insurance. (If you don’t need it to increase, buy guaranteed universal life for half the price.) Granted, that might not be the goal of very many people, but if it is for you, great!

Another great benefit of using the cash value as an inheritance is that it provides financial security. You always could change your mind and go back and spend it if you get into dire straits. Some retirees have a behavioral issue with spending their money. Insomuch as a life insurance policy on the back burner gives them “permission to spend” their other assets, it’s a good thing.

2) Spend the Dividends

Another option for those who don’t need the cash value of the policy to meet their needs is to simply take the dividends (assuming the policy is “paid up”) and spend them. Your death benefit won’t grow as quickly (if at all) but it won’t shrink either. So you have that guaranteed inheritance plus some spending money. Not a bad combination at all.

3) Partial surrender

One of the coolest things about whole life insurance is how the money comes out of the policy. Unlike annuities, in which the first money pulled out of the policy is your gains, with life insurance the first money out is your basis- meaning it’s tax-free AND interest-free. So if you had a whole life policy that cost $10K a year and paid it up over 30 years, and it gained 4% a year on average, on the eve of your retirement you may have a cash value of $583K. The first $300K of that you pull out will be 100% tax-free because it’s just your basis. Granted, after 30 years of inflation, the $300K you pull out won’t be worth anything near the $300K you put in, but it’s better than a kick in the teeth. Remember that your partial surrender reduces the death benefit substantially.

4) Borrow from the gains

Once you have maximized your partial surrender, any further withdrawals from the policy must come out as loans (or else they are taxed at your regular marginal tax rate.) These loans are tax-free, but not interest-free. Depending on your policy, however, the interest may not be too bad. Many policies have a relatively high interest rate if you borrow in the first decade or two, and then a lower interest rate after that. Even better, it is possible to structure a policy so that the dividends on the cash value don’t take loans into account- that means you can borrow the money out and still receive the dividend on the borrowed money. You still have to pay interest on the loan, but if you are borrowing at 5% and the dividend is 5%, you’re basically borrowing for free. That (combined with using paid-up additions to get to the break even point faster) is what the Bank On Yourself/Infinite Banking types get so excited about. This type of policy is called “non-direct recognition.” It’s not a no-brainer to always get a non-direct recognition policy, but if you plan to do a lot of borrowing from it, it may be a good idea.

The Bad

5) Exchange to a Variable Annuity (VA)

Exchanging your cash value to a very low-cost variable annuity (Vanguard or Jefferson National) is a pretty good idea for those who have been paying into their whole life policy for a while but realized they really don’t want a whole life policy. Faced with decades of ongoing premium payments if they stick with the whole life policy, this option allows you both to preserve a loss (and thus get tax-free growth back up to the basis) or to keep gains growing tax-free. However, for someone who’s 70 and has had a policy for 30 or 40 years already, I think you’re probably better off keeping the whole life policy. This isn’t the time to be ramping up your risk and the low returns of the past are already water under the bridge.

6) Exchange to a Single Premium Immediate Annuity (SPIA)

I like SPIAs. They, especially when combined with Social Security +/- a pension allow you to put a floor under your retirement spending. You’re essentially taking a lump sum and purchasing a pension with it, backed by an insurance company (and if the SPIA isn’t too large, further backed by the state insurance guaranty corporation.) However, purchasing a SPIA is generally a way to ramp down the risk on your portfolio and acquire a guaranteed income stream. With a paid-up whole life policy, you’ve essentially already done that (maybe too early in life, but still, it’s done.) The cash value almost surely isn’t going to go down and while the dividends aren’t guaranteed, it’s been a long time (the Great Depression) since anything really happened to them for long. Besides, if the dividends dry up, you can start doing partial surrenders and/or policy loans. So while I prefer the approach of buying term and investing the rest and then considering a SPIA around age 70, if you’ve already got a substantial whole life policy, I don’t think you’re gaining much by exchanging it to a SPIA and you are losing the death benefit.

7) Exchange to a Long Term Care (LTC) Policy

Another option with whole life insurance is to do a tax-free exchange into a LTC policy. If you really don’t want a death benefit and really want a LTC benefit, I guess that’s not a terrible idea. But I think that’s an unlikely scenario. I don’t like LTC policies for two reasons- first, only a small subset of people really need them. Those with little assets should spend down to Medicaid levels. Those with substantial assets (like huge whole life policies) can self-insure this risk. Second, these policies are relatively unproven. Nobody really knows how to price them well, especially with the rapidly escalating cost of LTC. How lame would it be to take your whole life cash value, exchange it into a LTC policy, and then have the LTC insurance company go bankrupt?

8) Accelerated Death Benefits

If you are near death, and need cash, many insurance companies will “accelerate” your death benefits and allow you to get some money now in exchange from less money later. This can even be done with term policies. Insurance companies started doing this in order to counter the many life settlement/viatical companies out there who were filling this niche. It is in the insurance company’s best interest to give you a better deal than the viatical company (discussed below), so if you’re in this sort of situation, this may be worth looking into. Nevertheless, you and your heirs are probably overall better off doing a partial surrender or policy loans than accelerated death benefits.

9) Bank on Yourself

I’m not a huge fan of “Banking on Yourself” (overfunding a non-direct recognition whole life policy early in life in order to then borrow from it to buy consumer items or investments) but I don’t think it is the worst idea in the world. However, if you’re sold on the idea and want to go for it, I think the time to do that is in your working years, not when you’re 60 or 70. Plus, Banking On Yourself works best when done with a policy specifically designed for that. Chances are you don’t have one of those unless you specifically bought your policy in order to do that. So it won’t work as well with you. Plus, if your goal is to consume the money, then go ahead and do that. That’s exactly the same as # 4 above. But if your goal is to borrow money from your insurance policy to further invest in real estate, I’m not convinced retirement is the time to do that. In general, you should be ramping down your leverage in retirement, not increasing it.

The Ugly

10) Surrender the policy

If you liked your whole life policy enough to pay premiums on it for 30 or 40 years, now is not the time to surrender it. Not only do you lose the difference between the cash value and the death benefit, but when you surrender any gains are taxed at your regular marginal tax rate (whereas the death benefit is tax-free.) Probably not a good move at this point. If you’re 2 years into the policy and realize you’ve been had, then sure, surrendering is a reasonable option. (Although there is a better one.) But not now.

11) Sell the Policy to the Insurance Company

Insurance companies realize that many purchasers no longer want their policy and simply want to get out of it. Some policies are structured such that the cash value is relatively low, but the death benefit is relatively high. These policies attract life settlement/viatical companies. They offer the owner of the policy more than the cash value but less than the death benefit. When the person dies, the investors in the company get the death benefit. If they die soon, the return is good. If they live a long time, the return is less good. But once it is sold to the life settlement company, the insurance company is almost surely going to pay the death benefit at some point or other. So rather than do that, they will either offer accelerated death benefits (if you’re terminally ill) or purchase the policy themselves. As a general rule at this point, keeping the policy is a better investment than selling it, whether you sell to the viatical company or the insurance company.

12) Sell the Policy to a Life Settlement/Viatical Company

As noted above, this usually isn’t a good idea. These are fairly illiquid assets and there aren’t many buyers. Your broker will get a cut, the life settlement company will need to make a profit, and the investors are going to want double digit returns on their investment. Where do you suppose all that comes from? That’s right, the death benefit you’ve been paying so diligently for years to get. While I don’t think these are terrible investments (although illiquid and in a market filled with scammers,) I think the policy owner (and especially his heirs) are generally getting a raw deal. If you can’t afford your premiums or just need cash I think you’d be better off going to your heirs directly for assistance rather than selling to either the insurance company or a life settlement company. Better to not get into a situation in the first place where you’re “life insurance poor.” Even if you love whole life insurance, don’t make it a big chunk of your portfolio.

13) Exchange it for another whole life policy

The worst idea I could come up with is to exchange your current whole life policy for another whole life policy. Remember the low returns of whole life insurance are heavily front-loaded, primarily due to the massive commission (basically the first year’s premium payment) paid to the insurance agent. No sense in going through that twice with the same money. I doubt there is any whole life policy that is sufficiently better than your current one that it makes sense to exchange after 30 or 40 years of making payments. That seems even dumber than just surrendering it for the cash value to me.

One thing whole life policies do is give you lots of options in retirement. Some are better than others. Try to choose one of the “Good” options above if you are in this situation.

What do you think? Do you have a whole life policy? What do you plan to do with it? Why? Comment below!