A reader recently asked me to take a look at a retirement planning (funding) method using permanent life insurance espoused by Nelson Nash in his book Becoming Your Own Banker.
In addition to the life insurance benefit, the author discusses a "be your own bank" approach to funding major life purchases. He also recommends using permanent life insurance as a way to build wealth and as an income-generation method in retirement.
I want to dig a little deeper into these strategies and, although I admit my personal bias against mixing insurance with investing, take an honest look at the pros and cons of using permanent life insurance in these ways.
In this article, which is part one of a two-part series, we'll look at permanent versus term life insurance, the "bank on yourself" strategy using permanent life, and permanent life as an investing vehicle. In part two, we will look at using permanent life as a retirement funding and legacy strategy.
Permanent versus term life insurance
I have written previously about life insurance in retirement. The focus of that article was mainly on the death benefit aspect, i.e., whether you need that in retirement or not. For those who do, I concluded that, for basic life insurance protection, nothing beats a low-cost term policy. The reason is that life insurance is first and foremost about insuring against the unthinkable—the loss of a life, which would have a catastrophic impact on a family, including their financial health.
With term life, you get the most coverage at the least cost. It is good for a term, a period of time—10 and 20-year terms are the most common. Term plans are renewable, but premiums tend to become costlier as you get older and want to extend the term. Many people stop buying term life in retirement since they are, theoretically, "self-insured" at that point.
The main attribute of permanent life is just what the name says – the life insurance is permanent. The death benefit is always paid (unless the cash value of the policy has been depleted or the policy has been allowed to lapse).
You may be surprised to learn that more permanent insurance policies are sold than term—and I emphasize the word sold. You can go online, compare several offers, and buy a term life policy in less than 15 minutes. You might spend hours with an insurance salesperson to just understand the different types of permanent life insurance policies available to you. The reason is complexity—term is simple; permanent insurance, not so much.
Permanent life insurance comes in different flavors: whole life, universal life, variable life, etc. These all offer permanent insurance and differ mainly in the level of flexibility they provide and how your premiums are invested. You can read more about these different types of insurance on the Insurance Information Institute (III) website. For this article, we will be looking mainly at one type of permanent life insurance: whole life.
A key thing that differentiates whole life from term policies is that the former has a cash value component, whereas the latter does not. As you pay your whole life premiums, a portion goes to funding a cash value savings account that earns interest, which the insurance company manages. It is separate and apart from the policy face amount or death benefit that is paid to your beneficiaries upon your death. As we shall see, you can borrow against the cash value, or under certain circumstances, withdraw it and spend it as you like.
Another key difference between term and permanent life is that permanent insurance is much more expensive—it can cost 10 to 20 times the price of term, at least initially. But the premiums never go up, and they may go down (due to inflation you could be paying with cheaper dollars in the future), or if dividends are used to pay premiums in the future (more on that later).
Term life, on the other hand, tends to be more expensive the older you get. If you have a 20-year term plan from age 30 to age 50, it will be much costlier to renew and establish a new 20-year term for age 50 to 70 for the same amount of insurance.
Cost matters because the high expense of permanent life can make it cost-prohibitive for young families who need life insurance the most. Also, because of the high cost, many people can't afford to keep the policies in effect and let then lapse. According to the Society of Actuaries, almost 40% allow their policies to lapse within the first five years, paying hefty surrender charges and getting back a fraction of what they contributed.
Whole life as your bank
As we have noted, unlike term insurance, whole life insurance policies build cash value over time. It takes a while—this doesn't start until the third or fourth year after purchase. This delay is due mainly to upfront costs and commissions. The significance of this is that, as it grows, the cash value can be used as a source of tax-free, low-cost funds in the "be your own bank" model espoused in Nash's book and elsewhere.
This banking model isn't directly related to retirement, but since many people will need to borrow for one reason or another, either before or during retirement, it is worth discussing.
With this strategy, rather than taking out traditional loans from a bank, you borrow the money from yourself—from the cash value of your whole life insurance policy. Of course, to do this, you must have a policy that has built up enough cash value to furnish you with the funds you need.
Remember, however, that whatever interest you pay doesn't get added back to your cash value, it goes to the insurance company. Even so, with the right kind of policy—one that lets you take out the money but still pays dividends as though the money is still there—you get an interest-free loan (not a bad deal if you can get it, right?).
Another selling point for this approach is that you may be able to borrow at a lower cost and can pay it back whenever you like; you can decide never to pay it back if you want to. Whole life advocates would say that even for those who prefer to save up and make such purchases with cash can save the money more profitably inside the insurance policy than in low-interest bank savings account.
However, there are some (possible) downsides.
During the first 5 to 10 years, the policy won't support much in the way of withdrawals or loans because your cash-value will be low. You may be able to get to the funds later when your cash balance is higher, but depending on the type of policy, you may have to pay interest and pay it back. If the interest is less than what you could get at your bank, and you are reasonably certain you can pay it back, then it makes sense to borrow from the policy.
If you can't pay it back, and you stop making premium payments, any remaining cash value you have will get used up with loan interest and the ongoing cost of insurance. Plus, if you borrow and then pass away before you pay it back, the amount you owe will be subtracted from your death benefit.
All things considered, I probably wouldn't buy a whole life policy so that I could borrow from it ten years from now to buy a car. On the other hand, if I purchased it for the permanent life and investment benefits, and have built up sufficient cash value, it may make sense to borrow from it instead of taking out a more expensive bank loan. It would undoubtedly be a better choice than taking an early withdrawal from a qualified or non-qualified retirement account, which may require you to pay taxes plus a 10% penalty to the IRS.
Whole life as an investment
The more earnest proponents of using whole life products to invest for the long-term and into retirement would say that the most significant advantage is that you have a death benefit available while you are simultaneously investing. It's kind of a "two birds with one stone" thing.
Life insurance, as a concept, is pretty easy to understand. You pay out premiums with the understanding you are paying for the ability to transfer a catastrophic risk that you cannot afford to an insurance company for a price that you can afford. Most people don't think of insurance as an investment.
Life insurance that includes an investment component is a different animal. These products tend to be complicated with lots of different rules that alter the simple nature of the "negative bet" that you make with plain term life insurance. They also significantly change the cost structure. Part of your annual premium goes toward the cost of insurance, and the rest is invested by the insurance company on your behalf.
Ultimately, you either get the death benefit (after you die) OR the cash surrender value of the policy (while you're alive) but not both.
That is one reason why many financial advisors recommend saving and investing for retirement using tax-deferred accounts such as 401(k)s, IRAs, etc. When it comes to life insurance, their advice is usually "buy term and invest the rest." Since term life is simple and typically much less expensive than whole life, the idea is to buy more coverage for less and then invest the difference in your retirement accounts.
Someone following this advice will probably get to retirement age with a decent-sized retirement savings account but with little nor no life insurance (as the term life will expire and will be costly to renew; plus, it may no longer be necessary.) Therefore, any desire to leave a legacy for heirs would have to be fulfilled with other assets.
When it comes to the return-on-investment (ROI) of whole life, we have to separate the insurance and investing components. As with any life insurance, if you die young, your ROI relative to the premiums paid will be extremely large. At your life expectancy and beyond, the ROI declines significantly.
The ROI of the investment component (as reflected in the cash value) will be relatively modest. Plus, it will take several years for it to be positive. From there, it will mimic historic bond returns. (Also keep in mind that such returns are not "guaranteed" as they are based on the company's investment performance.)
Therefore, whole life could be viewed more like any other fixed-income investment in a retirement portfolio when considered net of fees, taxes, insurance needs, etc. As such, it can be an alternative to bonds or bond funds, which would allow the risk-based investment portfolio to be invested more aggressively (i.e., more "stock heavy").
Whole life returns versus risk-based investments
One of the main arguments for "investing" in whole life insurance is that the growth is somewhat predictable and that it holds up better during times of stock market upheaval. Plus, a minimal amount of growth (interest) is guaranteed.
But keep in mind that the cash value in an insurance policy is an investment, and like most others, it carries some risk. It may be less risky (because insurance companies tend to be conservative investors), but only minimal returns are guaranteed; anything higher is left to the vagaries of market performance. No matter what, you won't lose money like you can with risk-based investments (stocks, bonds, commodities, real estate, etc.).
We also need to remember that investing for retirement is a long-term proposition. Consequently, it would be best if you looked at average annual returns over multiple decades, not what happens during an individual, short-term market event. In the final analysis, it depends on whether one type of investment outperforms another over long periods of time. This is especially important for long-term investors who can weather a lot of the markets' ups and downs.
If you invest in whole life instead of contributing to a 401(k) or IRA type account, you will miss out on the first 5 or 10 years of compound growth you would have had in the retirement accounts. That's because most policies are front-end loaded with fees and expenses that reduce the cash value, and it takes a while just to get back to where you started.
You will also miss out on the up-front tax benefits you get from contributing to a traditional 401(k) or IRA. Whole life insurance premiums are not tax-deductible in the year you make them like contributions to traditional 401(k) and IRA accounts.
Based on the research I have done, someone who buys a whole life policy in their 30s and holds it for 30, 40, or 50 years, will get guaranteed returns in the 2 to 3% range per year and projected returns in the 4 to 5% range on the cash value. Actual performance is likely to be somewhere in the middle (3 to 4%), which has historically been possible using intermediate and long-term bonds. (That's also comparable to what you might expect from a deferred fixed income annuity.)
For some people, that will be acceptable, especially since, as an investment, whole life rates high on the "sleep well at night" meter. Not only are you building cash value, but your money is growing (albeit rather slowly), and it will be mostly unaffected by stock market gyrations. Sound pretty good, right?
Well, here's the thing: Most long-term retirement investors are looking for a better annual average return than 3 to 4%, which barely keeps up with inflation, and because the S&P 500 has averaged around 10% per year for the last several decades. (And remember, your dividend rate is not a return on your investment—it's not the same as a stock dividend—we'll look at dividends in the next article.)
These mediocre (albeit reasonably reliable and somewhat "safe") returns are mainly due to how whole life policies work. Your premiums purchase insurance (just as they would with a term plan), and part of it goes toward overhead and profit, including the commission for the salesperson. The rest adds to the cash value of the policy, which grows based on insurance company calculations tied to the performance of their internal investments.
That is something you have no control over unless you purchase a product such as variable or universal life that has an underlying investment sub-account that offers you different investment options.
What about retirement income?
Having discussed how whole life compares with term life, borrowing from your policy, and also with investing in tax-advantaged savings accounts, in the next article we'll turn our attention to what role whole like has in retirement income planning. If you currently own a whole life policy, that article will be of particular interest to you. If not, you may or may not decide to purchase one; it really depends on your retirement income strategy and how you decide to implement it.