Does whole life work as part of a retirement strategy?

Does whole life work as part of a retirement strategy?

When the economy tanked in 2008, whole life insurance (and other types of permanent life) seemed like a reasonable alternative to a plummeting stock market. People were losing their shirts, not to mention their jobs and their homes, on investments. For some families it wasn't a question of "How should I diversify to protect myself?" but rather, "Is there anything I can invest in that's safe at this point?" And if you were an insurance agent, you could point to whole life and say, "See this? Its return rate is guaranteed, and it's protected from the turmoil of the stock market. Can whole life work as part of a retirement strategy? Absolutely."

For that reason--and undoubtedly because the commission for a permanent policy can be 10 times that of a term policy--sales have been good since the Great Recession.

Sometimes agents push back that permanent life products are unfairly demonized. It's true, in some cases (especially with other permanent products besides whole), it can be a valid tool to add to your retirement savings strategy. And yes, it can be a good way to protect some of your money from market fluctuations. But those arguments for whole life are outmatched by the arguments against it. Here are some of the strongest.

The estate tax problem has largely gone away

One of the classic arguments in favor of permanent life insurance was that it was a good way to cover your estate taxes so that your heirs wouldn't have to. It was harder to argue against this fifteen years ago when the estate tax exemption per person was $675,000. But today it's over $5 million, and double that for married couples. For the vast majority of people, this has become a non-issue, and if you're someone for whom this matters, you are almost certainly planning a customized estate strategy with a financial expert or two.

"Guaranteed growth" = "very little growth"

Although it's true that most types of permanent life offer guaranteed growth and protection from the fluctuations of the stock market, it's also true that historically (even factoring in the Great Recession) the stock market outperforms the bond market that insurers typically invest in. A whole life policy pays a dividend, not a true rate of return, and the annual amount is determined by the insurer based on several factors, not all of which are made public. This dividend may have a guaranteed floor, and the insurer may have a stellar record of paying it, but in exchange for that security you'll be settling for growth that at its best is only competitive with low-risk/low-return investments like bonds, and at its worst has a growth rate that's lower than the rate of inflation.

Whole life only benefits the most conservative of investors

Permanent policies are typically presented as safe alternatives to the unpredictable stock market, and under certain circumstances that's true. The Wall Street Journal looked at projected returns on a low-cost permanent policy versus an average term policy over 20 years and found that a customer who buys term and invests in bonds will stand to gain about $10,000 less than he would through a permanent policy. But even this example comes with caveats. The first is that the Wall Street Journal admits it used an ideal permanent policy that costs far less than what most people end up buying. The second is that the permanent policy only outperforms the most conservative of investment strategies:

"For example, if he invested the money in bonds and earned a 5% annual return, after 20 years he would end up with $126,306 after taxes, assuming he was in the 35% tax bracket[...] If he invested in a stock portfolio that earned 8% annually, he would come out with $180,812 after taxes, assuming a 15% long-term capital-gains rate—but would have taken more risk. And if he bought the permanent-life policy and cashed it in after 20 years, he would net $134,686 after taxes."

There are other risks besides market fluctuations

And finally and perhaps most important, if only because it's rarely discussed when arguing about return rates and taxes, there's actually a huge risk to buying a permanent policy because of the time commitment you're forced to make, and because the odds that you'll abandon the policy early--and lose a significant portion of the money you've paid into it so far--are surprisingly high.

There are two factors at work here. The first has to do with how your premiums are used in the early years of ownership. Whole life policies are front-loaded with fees, including the agent's sizable commission, so the bulk of your annual premiums for the first few years are diverted to pay for those charges instead of routed into the cash savings side of your policy. You'll save far less of what you pay in years 1 through 5 than you will in years 10 through 15.

The second factor is that the rate of policy abandonment is much higher than you might suspect. The Society of Actuaries reported that in the early 2000s, 26% of whole life policies were terminated within the first 3 years, and 45% were terminated within the first 10 years.

If you abandon the policy shortly after you’ve reached the 3-year mark, only a portion of those first 3 annual premiums—which is almost certainly over $10,000--will be available for you to withdraw. (And this doesn't take into account any cancellation fees you'll have to pay to get out of the policy.)

In terms of financial protection for your family or estate--which is ostensibly why you bought life insurance in the first place--the level of protection you actually paid for will be very similar to if you'd just bought a term policy for those 3 years and then stopped paying on it. The difference is that with term, it's unlikely you'd have even broken the $5,000 mark in unrecoverable premiums after the first 3 years, and you could have invested the other $5,000 or so elsewhere.

In other words, you have to use quite a narrow definition of risk to argue that a whole life policy isn't risky; committing the next several decades of your retirement savings to a complicated financial product with a low return rate and a high abandonment rate involves some pretty significant risk taking (although you can see why insurers love this product category so much).

For most people—especially now that the individual estate tax threshold is so high—life insurance should be a temporary stopgap, to be used during that period of your life when you have family and financial obligations but haven't yet built up enough savings to self-insure. That usually means it's a tool to employ while you have a mortgage, or co-signed student loans, or a business that you own, or children to raise and put through college. As time passes and those obligations go away, if all has gone as planned you should be able to cover more risk on your own, and your need for a life insurance policy will decrease. In this sort of scenario, a cheap, easy-to-understand term policy can make more sense.

But even if you see a need for whole life coverage, you should max out your 401(k), Roth, and HSAs first, and then keep a skeptical mind as you weigh the pros and cons of a permanent policy. Your agent might genuinely have your best interests in mind when helping you decide, but the extremely high commission creates a natural conflict of interest. And she might argue that there are newer forms of permanent life that are designed to address some of the most common complaints against whole life, but she might be overlooking or underestimating some of the problems that still remain. These issues alone should be enough to give pause; any insurance product this complicated deserves a much closer look at its true benefits and costs.

Photo: Scott Schiller