We all think of life insurance as a way to protect our families and/or business associates from the economic impact of premature death. The purpose of this article is to show you how, in addition, you can benefit by using Whole Life Insurance as a supercharged, multi-purpose, fixed income asset, which also protects you and your family with a unique combination of benefits, unavailable in any other financial asset.
I know, you’ve heard your whole life that whole life is a “bad deal”, low rate of return, etc. etc. “smart people buy term and invest the difference.”
You’ve also probably heard other popular myths that turned out not to be true. A few examples that come to mind:
- Einstein failed math as a child.
- Sink drains reverse in the southern hemisphere.
- Adults don’t grow new brain cells.
- Sir Isaac Newton was hit on the head by a falling apple
All of the above are untrue. Do yourself a favor -- -- suspend for a moment what you “think you know” and open your mind. What you’ll learn may materially contribute to your wealth and your security.
The Disadvantages of Whole Life
There are several disadvantages to whole life. Let’s address them first. That’s my preferred way of doing things. Let’s look at all of the negatives. If none of them are “deal-killers”, then let’s look at the benefits. It’s the full disclosure, up front, that I expect from people with whom I deal, and you are entitled to it also.
First Disadvantage: Acquisition and sales costs consume most of the first year’s premium, and in some cases, much of the second year’s premium. That makes whole life a terrible short term asset. So if you’re considering whole life for a short term need, please don’t. Over the long term, the compounding tax deferred growth in cash value makes up for this, and then some. But it’s still a bad short term asset.
Second Disadvantage: Not everyone can get this product. You can be on your death bed and still buy bonds, CDs, money markets, etc. But in order to qualify for whole life (or term for that matter), you must meet medical and other underwriting criteria.
Third Disadvantage: You can’t get any amount you want. Insurance companies will only issue an amount of death benefit insuring your life equal to your “Human Economic Value”. This the rough equivalent of the capital necessary to replace the income you are earning. In other words, it is equal to the economic loss to your survivors caused by your death.
Fourth Disadvantage: The premium for a good whole life policy is ten to fifteen times the premium of a term policy of the same death benefit. So if you need lots of protection right now, and have minimum cash flow, you need term insurance—not whole life.
Term Life Insurance—Great Short Term Protection
So let’s talk about term life insurance. It’s a great product! It serves an important need. It protects against the financial consequences of premature death, at a low current cost. With term we pay a premium to a multibillion-dollar insurance company to bear this risk. Just like car insurance and homeowners insurance, each year, if nothing bad happens, your premium is gone. That’s a good thing—we would rather have a good life than a good return on a casualty insurance premium.
Whole Life Insurance vs. Term Life Insurance—-The Bicycle and the Race Car
With most types of insurances (e.g., homeowners, auto, malpractice, medical, and disability) annual “term” coverage is all that is available. Life insurance on the other hand is a different matter. Life insurance comes in two flavors—term insurance and cash value insurance. Whole Life (one type of cash value insurance) has a higher premium—much higher. That’s because whole life can do several things that term insurance can’t do:
- Build guaranteed cash value and additional cash value through dividends1
- Stay in force until death at a ripe old age.
- Continue cash value building in the event of disability.
- Protect the cash value from creditors in Florida and many other states.
- Provide a stream of tax-preferred retirement income.
I personally own millions of dollars of whole life insurance, and no term insurance. For me, whole life is my principal fixed income asset. Whole life is more of an asset allocation decision than a protection decision.
Congress created tax incentives designed to encourage people to protect their families and provide for retirement security. They did this by granting cash value life insurance several distinct tax advantages:
- Cash value grows tax-deferred.
- Death benefit is generally tax-free.
- Withdrawals are tax-free to the extent of premiums paid.
- Policy loans are tax-free.
As you can see, term life insurance and whole life insurance are two totally different products, with similar names. It’s like a bicycle and a race car. They are both wheeled transportation vehicles.
The Big Picture—Fixed Income Assets vs. Equity Assets
Now that you understand the basics, let’s see what you can do with whole life insurance that makes it such a valuable financial asset.
First the big picture: With whole life, you can accumulate cash value at a similar rate of return as other safe assets, and you get a whole laundry list of financial and other benefits with no additional cost.
Let’s first understand the difference between fixed income assets and equity assets:
- Fixed Income Assets are assets such as CDs, bonds, savings accounts, and money markets. They are considered safe assets and as such, their rate of return is lower.
- Equity Assets, such as stocks and stock mutual funds, have a potential for higher return than fixed income assets, but also the potential for loss.
Most prudent investors have both fixed income and equity assets.
Whole Life—The Ultimate Fixed Income Asset
Whole life insurance is a fixed income asset. As such, its rate of return should be compared to other fixed income assets, not assets at risk in financial markets. Let’s look at the benefits of using a whole life policy as a fixed income asset in your portfolio. In this hypothetical, we’re going to assume you are a 45-year-old, healthy, male non-smoker.
Rate of Return
We’ll create a whole life policy with a $25,000 per year premium which we’ll plan to pay for 20 years. You will have paid a total of $500,000 over the twenty years, and the cash value at the end of year 20 will be $724,408. This is a cash-on-cash return of approximately 3.41%*2.
If you were investing in corporate or government bonds, the interest would be subject to income tax each year. If you are in the 31% marginal tax bracket, you would have to earn 4.94% to net 3.41%, after tax. This is called “the Pre-Tax Equivalent”. This return equals or exceeds most other safe assets, and provides additional benefits, unavailable from any other asset.*
With whole life insurance, however you have gotten a lot more than just a rate of return and cash value. The original death benefit for this policy was $1,093,298. By year 20 the death benefit will have grown to $1,662,047. A $1,000,000, 20 year level term insurance policy over this period of time would have cost you almost $2000 per year, with nothing to show for it, and no further life insurance death benefit.*3
Disability and Creditor Protection
If you own whole life and are disabled along the way, the entire whole life premium will be paid for you4. This benefit certainly would not have been available had you been investing this money in treasury bonds. This benefit is in addition to any disability income insurance you may (and should) have.
If you were to have a legal problem, your bond portfolio would have been subject to the claims of creditors. Your life insurance cash value is protected from creditors in Florida, and in many other states. This a valuable and special protection afforded to only a very few assets.
Retirement Income
Assuming for a moment that you retire at age 65, you can receive an income stream from the policy. For example, you could take a tax-free income stream of $43,665 for the next 20 years, and still have $334,815 of cash value and $610,731 of death benefit at age 85.*5
This policy also has a flexible rider which permits you to add additional premiums to “supercharge” the performance of the policy. If you chose to put an additional $20,000 per year of premium into the policy during the 20 year pre-retirement period, the cash value at age 65 would be $1,478,375 and the death benefit would have risen to $3,049,344. The cash on cash return would be 4.52%, which for a 31% bracket taxpayer, is an astounding 6.55% pretax equivalent!*6
Under this second scenario your annual tax-free income would be $93,681. After 20 years of this income stream, the remaining cash value would be $703,386, and the death benefit would be $1,225,799.* Try accomplishing all of that with bonds, CDs, or money markets. The benefits don’t end there. Under the whole life strategy, you have postretirement death benefit. With term insurance you would have nothing at all.
Life Insurance Protection After Retirement
Often people mistakenly conclude that they don’t need or want death benefit after they retire. Their reasoning is that they’ve accumulated retirement assets, and that those retirement assets will be sufficient for their survivors, forever, and under all circumstances.
However, even postretirement death creates a financial consequence to survivors. Social Security and other pension benefits disappear. There may have been significant expenses associated with long-term care or medical care that need to be replaced. Most importantly, post-retirement death benefits, on a guaranteed basis, give you options for additional cash flow while you are alive.
The guaranteed death benefit permits you to spend down assets, knowing they’ll be replaced, receive cash flow from real estate using reverse mortgages, defer capital gains tax using charitable remainder trusts, and otherwise enjoy more of your wealth while you are alive.
More Flexibility with IRAs and Retirement Plans
Another benefit relates to IRAs and pension plans. There is significant income tax due on the IRA and pension accounts as they are received by your survivors. Many people use rollovers and stretch-outs to defer this tax. There is a down side to that. All future growth in those accounts remains subject to restrictive rules and ultimate taxation at ordinary income tax rates. With post retirement death benefit, your family has the option of taking the lump sum, paying the tax due as of that date, and enjoying investment and withdrawal flexibility and favorable capital gains treatment, thereafter.
More Available to Charity
Another IRA strategy is to leave the IRA to a charity—that eliminates the tax. The life insurance death benefit goes to your family tax-free, replacing what they would have gotten, after tax, from the IRA. The charity can be a donor advised fund at a community foundation, the income from which can be directed to various charities by your descendents in perpetuity. So the death benefit indirectly funds a family charitable pocket book, and reduces the tax paid to the IRS. This is a win—win that can only happen if you have permanent death benefit.
Long Term Care Expenses
As we get older, we sometimes need expensive long term care. The Enhanced Accelerated Benefit Rider that can be part of the whole life policy, at no additional premium, can fund some of the costs of a chronic illness. While it is not a substitute for long term care insurance, it is a significant additional financial benefit to you and your family during your lifetime.
Summary
So now let’s summarize the benefits we can have with whole life, that are not available with other safe assets:
- Competitive rate of return
- Pre-retirement death benefit without paying term insurance premiums
- Disability protection
- Creditor protection
- Tax preferred retirement income
- Post retirement death benefit which may enhance postretirement cash flow
- Contribution to costs of long term care
As long as this is a long term asset allocation decision, and you can meet the medical and other underwriting requirements, the case for including whole life insurance in your portfolio is a compelling one.
End Notes:
These hypothetical illustrations are not valid without a complete Guardian illustration showing guaranteed values and other important information. Please contact Randall Ellington, (407) 774-6343, info@smartwealth.net for a full illustration.
1. Dividends are declared by the company’s Board of Directors and are not guaranteed.
2. The values shown are for an L95 policy (generic form number 06-WL) issued by The Guardian Life Insurance Company of America for a 45 year old male, preferred non-tobacco, with $100 per year enhanced paid-up additions rider, and a dividend option of paid-up additions. The values shown are based on the 2007 dividend scales and are not guaranteed. The assumptions on which these values are based are subject to change by the company and the actual values may be more or less than those shown. Please refer to the complete policy illustration for the guaranteed values and other important information.
3. Based upon $1,000,000 Level 20 Year Term Gold issued by Guardian Life Insurance Company. Please see the complete policy illustration.
4. Disability waiver of premium rider based on total disability of insured for six months or greater.
5. Surrendering to basis, then borrowing. Please see the full illustration.
6. The values shown are for an L95 policy (generic form number 06-WL) issued by The Guardian Life Insurance Company of America for a 45 year old male, preferred non-tobacco, with $20,100 per year enhanced paid-up additions rider, and a dividend option of paid-up additions. The values shown are based on the 2007 dividend scales and are not guaranteed. The assumptions on which these values are based are subject to change by the company and the actual values may be more or less than those shown. Please refer to the complete policy illustration for the guaranteed values and other important information.
7. See full policy illustration for description and limitations of Enhanced Accelerated Benefit Rider.