Updated Jan. 9, 2018: You probably already know you need some form of life insurance to protect your family financially. What you may not know is how all of these different life insurance policies compare. A lot of terms get thrown around and it's hard to keep up.
In this post, we're going to look specifically at whole life insurance and answer some of the biggest customer questions: Is whole life insurance a good idea? Is whole life insurance better than term life insurance? Is whole life insurance a good investment? And, most importantly: Is whole life insurance worth it?
What exactly is whole life insurance?
Like all life insurance products, whole life insurance is designed to provide financial protection for people or organizations you care about in the event of your death.
Whole life insurance is a type of permanent life insurance (also called "cash value life insurance"), which is one of the two categories of life insurance. (The second major category is term life insurance.) The biggest difference between these two categories is term life insurance ends after a set number of years. Term life insurance is a "purer" type of life insurance, meaning it offers a death benefit and nothing more. Permanent policies like whole life, on the other hand, cost more because they include an extra savings component, which is referred to as the "cash value."
The "cash value" part of whole life insurance policies is a savings account which is funded by a percentage of your premiums. Your life insurance company will then pay interest on the money in that savings account. The interest is actually a dividend from the insurance company’s annual profits, but most insurers guarantee a minimum yearly return.
You may have heard about whole life insurance because it enjoyed an increase in popularity after the 2008 market crash. Many agents also argue in favor of whole or other permanent policies, in part because they’re more profitable to sell, and in part because they see them as relatively safe savings vehicles.
How does the life insurance part work?
There are three major parts of a whole life insurance policy:
The death benefit is a tax-free chunk of cash paid out by the life insurance company in the event that you die. For example, let’s say you buy a whole life insurance policy with $500,000 in coverage. That $500,000 is the death benefit.
A beneficiary is the person or organization that receives the death benefit. Beneficiaries can be your spouse, your kids, a trust, a business partner, a friend, a non-profit organization and other legal relationships and organizations. You can name more than one beneficiary.
Your premiums are how you pay for your life insurance policy. You usually pay monthly or annually.
Whole life insurance lasts for, you guessed it!, your whole life – as long as you keep paying the premiums, of course. That means if you buy it when you’re 30 and keep paying your premiums until you die at 85, your family will receive the death benefit.
How does the savings account part work?
Every year, a certain percentage of your premiums goes into a savings account held by the life insurance company. This contributes to your policy’s "cash value."
The cash value of your account earns interest. This interest is actually a dividend from the life insurance company’s yearly profits, and the growth rate is generally low compared to other investments because life insurance companies have additional expenses (like policy administration expenses and underwriting costs) that a pure asset manager does not. Life insurance companies usually guarantee a certain amount of growth every year, which is one reason whole life insurance products attracted investors following the 2008 recession.
Here's where whole life insurance (and permanent life insurance policies in general) gets confusing. This cash value is actually a component of your death benefit. Your death benefit is made up of the term life insurance policy that we described above and this cash value. As the cash value grows, the coverage provided by your term life insurance policy gets smaller. Eventually, your cash value will cover the entirety of your death benefit, and your whole life insurance policy will no longer have a term component.
This can be confusing to shoppers who believe that, when they die in old age, they will receive the death benefit provided by the term life insurance policy and the accrued cash value. Instead, the cash value replaces the term life component and represents the entirety of your death benefit.
You can withdraw the cash value out of your whole life insurance policy, and there are various strategies that you can use to do so. Usually, the only way to collect the full cash value before death is to surrender (a.k.a. cancel) your life insurance policy. Life insurance companies usually charge a surrender fee in order to do this. You may also pay taxes and other fees on your cash value.
You can surrender your policy at any time. However, most of the growth in your cash value doesn’t come until you’ve held the policy for two or three decades. If you surrender within the first ten years, it’s unlikely that your cash value will have grown significantly.
What alternatives are there to whole life insurance?
Term life insurance. Term life insurance is a lot like the life insurance part of whole life insurance, except that it ends after a specified number of years. Because term is so much cheaper than whole life insurance, you can buy a lot more coverage (meaning a larger death benefit) for the same amount of money. Term is popular among financial experts because it’s relatively cheap and easy to understand. It is pure protection, with no cash accumulation component.
Other permanent (cash value) life insurance. There are other types of permanent life insurance policies besides whole. They are called variable life insurance, universal life insurance, and variable universal life insurance. These all differ in how the cash value portion of the policy works. Whole life is the simplest and least risky version because its cash value portion is a simple savings account, whereas the other three all incorporate an investment product with variable returns.
Who sells whole life insurance?
While insurance companies are the ones who offer whole life products, you shouldn’t try to buy them directly from the companies. Instead, you should speak to an independent agent or broker, who can help you compare whole life insurance policies from a variety of companies. This advice is the same if you’re looking for term life insurance as well. (Policygenius can help you quickly compare life insurance quotes here.)
What's good about whole life insurance?
Whole life insurance lasts for your entire lifetime. As long as you keep paying the premium, your whole life insurance policy stays in force.
Your premiums typically stay level for your entire lifetime. Most whole life insurance products feature level premiums, which means your insurance company cannot raise prices as you get older or if you get sick. Term life insurance also features this, but because whole life is meant to last much longer, this point is sometimes of concern to shoppers.
Some of your premium goes into a tax-deferred savings account with interest. Like all insurance products, your premium goes to the insurance company to help spread out financial risk among a large group of people. However, what makes cash value life insurance products like whole life insurance unique is that some of your premium is being set aside into a savings account, which your life insurance company will deposit dividends into as an interest payment.
You can potentially recapture some of the money you’ve spent on premiums. Because some of your premium is being put aside into a savings account, you have the potential to recapture that money. Note that this comes with many caveats. Often, if you attempt to make a withdrawal from your savings account in any way (such as a loan to yourself), the insurance company will charge you administrative fees, penalties, and other charges, and you’ll pay a tax penalty. These fees and penalties will eat into any earnings you’ve made on your savings.
Your returns are usually guaranteed. Typically, your life insurance company will set a guaranteed minimum growth rate. Remember, however, that this "interest" is actually a dividend from your life insurance company’s profits, and the growth can vary wildly from year to year.
Your money is protected from the stock market. If the stock market tanks, you don’t lose any of your cash value. And because your returns are guaranteed, your cash value will grow even if other investments stay stagnant or lose value.
What's bad about whole life insurance?
Whole life insurance is significantly more expensive. Premiums are often much higher than a term life insurance policy with the same amount of coverage because you’re paying for an insurance policy as well as putting money into the cash value portion of the policy.
Most policies are abandoned because they’re too expensive. Many people overestimate their ability to pay the large premiums year after year. Approximately 26% of whole life insurance policies are surrendered within the first three years and 45% are surrendered within the first ten years.
If you surrender your policy too early, your cash value will be very low. While your premium may be level, the percentage of it that goes into your savings account is not. In the first few years of your policy, a very small percentage of your premium goes into the savings account while the rest is used to pay for upfront costs like administrative fees and the agent’s commission. While this percentage increases over time, it’s often a bad deal for the 45% of policyholders who surrender the policy within the first ten years.
Is whole life insurance worth it?
While many agents, brokers, and insurers argue in favor of permanent life insurance policies like whole life insurance, these products do have their critics.
Dave Ramsey calls whole life insurance "one of the worst financial products available." Suze Orman put buying whole life on her list of "Forever Nevers." Clark Howard describes whole life insurance as a "formula for failure."
Whole life insurance products, however, are useful for some people. For those with high incomes who have already maxed out their other tax-deferred accounts, whole life insurance can be a useful part of managing your estate. And if you have a special needs dependent who will need care after you are gone, whole life is a good option. You can read more about when whole life insurance is better than term life insurance here.
But for the vast majority of people – and especially the 45% who surrender whole life insurance policies – a term life insurance policy is the better option. You’ll get more coverage at a cheaper rate than you would with whole life insurance, making it more affordable for the decades that you’ll be paying premiums.
It’s also a good idea to avoid combining insurance and investment or savings. Insurance is not an investment, and shouldn’t be treated as an investment vehicle. If you’re trying to put together a long-term financial strategy, get expert help from a financial adviser or tax expert. They can help you structure your finances in such a way that you pay the least amount of tax and have a high growth rate.
Image: Kristina Alexanderson