Whole Life vs. Term: Buying Term & Investing the Difference Part II
This post is the second in a series discussing the ins and outs of life insurance. You can read part I here.
The previous post in this series discussed some of the key differences between term and whole life insurance. My personal belief is that buying term and investing the difference is a superior decision for an overwhelming majority of people. There are a few cases in which purchasing whole life might make more sense for some people. To see a full breakdown of these hypotheticals, check out this blog post.
The post will delve into the reasons many life insurance salespeople promote when selling insurance. Hopefully, this information can help make you aware of the full spectrum of information so you’re better able to make an informed decision.
Reason 1: Whole Life is Forever and Term is Temporary
Unlike term life insurance, a whole life policy would payout a death benefit no matter when the policy holder dies, but that is assuming the policy is kept in place. In reality, whole life policies aren’t always maintained for life. Based on a LIMRA and Society of Actuaries study , only 21% of people who buy a whole life insurance policy still have that policy after twenty years.
Only 14% of people have their policy after thirty years. So for an overwhelming majority of people, whole life doesn’t actually last forever. In these cases, a term policy may have been better suited for their needs.
Reason 2: Whole Life is a Competitive Investment
Whole life policies accumulate cash value over time, which sounds appealing. A death benefit to provide for your family and cash value to leverage as you need can provide flexibility. Flexibility is certainly valuable for some, but at what cost?
The cash value in a whole life policy does not grow like an investment account such as your 401(k) or IRA. It is actually very complex, and that complexity sometimes opens the door for insurance salespeople to make whole life sound much better than reality.
Let’s use some real life numbers to examine how cash value works.
This example is based on an insurance illustration for a 33-year-old male. The numbers included assume that this individual is getting the best rates based on health. It is also from a leading mutual insurance company that comes up regularly with our members.
The policy example we’ll use here is a whole life policy for $500,000 that costs $8,427 per year between now and age 65. After age 65, the policyholder is no longer required to pay life insurance premiums and the policy would stay in place until his death.
Based on the current dividend rate (which is not guaranteed) here is how the cash value would look over time:
Hypothetical Cash Value Growth (Based on current rates):
|Avg. Annual Return|
Based on these example projections, the average annual return would be negative for the first twelve years. That is an important point for prospective insurance buyers to understand. The breakeven point for whole life policies is generally between 10 and 20 years, depending on the company, policy, and details about the insured.
The breakeven point is the time it takes for the cash value to exceed the total amount of premiums paid into the policy. From a short to intermediate term perspective, the cash value growth for a whole life policy is not very competitive.
Let’s assume the hypothetical man above bucks the trend discussed above and keeps his policy for 20 years. It has to get better, right? No, unfortunately it does not. Assuming he paid into the policy for 20 years, based on these projections, his policy would have roughly $224,077 in cash value. This ends up as an average annual return of 2.90%.
To put that in perspective, the lowest average annual total return over a 20-year period of the S&P 500 since the Great Depression was 3.11%. History does not always repeat itself, but it is important to put financial projections in context.
I based the figures above on a projection from the unnamed insurance company based on current dividend rates, insurance costs, and mortality expectations. The guaranteed figures for this same hypothetical person are actually much lower.
Hypothetical Cash Value Growth (Based on guaranteed rates):
|Avg. Annual Return|
As you can see, the guaranteed figures in the example above extend the breakeven point by several decades. It’s important to note that it is nearly impossible to project how a whole life policy will grow over time because it relies on many factors.
A somewhat conservative assumption is to plan on the cash value being somewhere between the projected rate and the guaranteed rate. But as we saw above, even the projections developed by the insurance company are not very competitive.
That is why unless you fall into the three unique circumstances detailed in the first post of this series, I suggest buying Term and investing the difference. Many insurance salespeople fight against this concept, but let’s look at the math.
Instead of buying the whole life policy described above, let’s imagine that the person in this example could purchase a 20-year term policy for $336 per year. That term policy would cost $8,091 less per year.
Rather than sending that money to the insurance company, what would happen if they invested the difference and earned a 7% rate of return (which is close to the long term historical returns of the market when adjusted for inflation)?
Hypothetical Cash Value vs. Investment Growth (Based on current rates):
If our 33-year-old hypothetical investor purchased term and invested the difference (while earning a 7% return), his family could have received $500,000 if he passed away. His family would have also saved $331,694 as a living benefit.
That’s $107,617 more than the cash value projection for buying whole life. In order to match the cash value projection, he would only need to earn an average annual return of 3.3% over a 20-year period.
To put this in perspective, it is slightly higher than the interest rate of a high-yield cash management account (such as SoFi Money®) but less than the expected long-term return of a moderately conservative portfolio (such as with SoFi Invest).
That seems fairly straightforward, but the fact remains that you will not earn 7% every single year for 20 years when you invest in the market. The market will go up and it will go down. That volatility often worries investors and might lead them to the “consistency” of whole life. As long as you invest for the long run and stay invested, those short-term fluctuations should not change your decision to buy term and invest the difference.
In fact, if you look at every rolling 20-year period since the Great Depression, buying term and investing the difference in the S&P 500 resulted in a higher ending balance than the whole life projection used throughout these examples.
That may seem hard to believe, which is why it is important to use facts to assess financial decisions rather than emotion. Think about the 20-year period starting in 1989. That period includes the Dot-com bubble and the Great Recession. Assuming that same hypothetical investor mentioned above stayed invested in the S&P 500 over that time, you would have $294,399 at the end of the 20-year period.
Reason 3: Whole Life Offers Some Compelling Tax-Benefits
There are some tax-advantages associated with whole life, but when you consider that many people do not take advantage of the more common tax-advantaged ways to save, it might not always be that compelling. To help decide for yourself, consider the following questions:
• Are you and spouse, if applicable, maxing out your 401(k)s?
• Are you and your spouse, if applicable, maxing out your IRAs?
• Are you maxing out your HSA, if one is available?
• Are you saving enough for college in a 529 plan?
If the answer to any of those questions is no, then tax considerations likely wouldn’t be the main reason you’d consider a whole life plan. There are plenty of other tax-advantaged alternatives available that could help you save.
Why do I consider accounts like 401(k)s, IRAs, HSAs, and 529 plans to be more helpful? Because all of them provide at least one of the following:
• Tax break on contributions (some 401K, HSA, 529, some IRAs)
• Tax break on growth (some 401K, HSA, 529, IRAs)
• Tax-free withdrawals (HSA and some IRAs)
It’s important to note that when you make contributions to fund whole life it’s with after-tax money and then is subject to ordinary income taxation rates when you withdraw any gains from your cash value.
Reason 4: Whole Life Can be Used for an Emergency Fund, College Funding, or Retirement Planning
Based on the analysis above, you can see that with a Whole Life policy it may take decades to “breakeven” from a cash value perspective. There are ways you can access the cash value for emergencies, college, or retirement but there are also more efficient options available that can help individuals save for each of those goals when compared to a whole life policy.
For an emergency fund, people have the option to leverage a deposit account that pays a competitive interest rate without the costs of insurance.
For college planning, savers can look into a 529 Savings Plan that allows money to grow tax free and make withdrawals tax-free, so long as it is used for qualified educational expenses. Some states even offer a state income tax deduction for contributions. For retirement, you may be able to leverage one of the savings vehicles described above, such as a 401(k) or IRA.
Reason 5: Whole Life Forces You to Save for the Future
Many insurance companies justify the long break even point, low internal returns, and high costs of whole life insurance with this argument.
First you can consider the other options that could encourage you to save, like automating your contributions or having them come directly from your paycheck. Second, because so many people get rid of their whole life policy in the first 20 years, forced savings has generally not been very effective.
Finding a Life Insurance Policy that Works for You
As you evaluate your unique insurance and financial needs, keep in mind that SoFi members have complimentary access to SoFi financial planners. SoFi financial planners can help work through the specifics of your situation and help you determine the course of action that works for you.
The opinions and analysis expressed here are those of Brian Walsh as of 07/09/2019 and are for informational purposes only. Views may change as market, economic, and other conditions change. This information isn’t financial advice. Investment decisions should always be based on specific financial needs, goals and risk appetites.
The hypothetical insurance information included throughout the examples are based on a whole life insurance policy illustration generated by a leading mutual insurance company for a 33 year old male that is in the best underwriting class and is not a tobacco user. This is designed to be an example and will not apply to every policy as the figures will change based on company, age, underwriting classification, and tobacco status. Before making any specific decisions related to your insurance or other financial needs you should consult a qualified professional and understand the unique trade-offs facing your decisions.
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