If you’ve talked to a whole life insurance agent recently, you may have heard the term “forced savings.” Forced savings, besides conjuring images of a reverse bank robber threatening to shoot if you don’t put more money into the bank, is actually a pretty useful personal finance concept.
The idea behind forced savings is that it’s hard to save money. We all know it’s hard to put money aside, and a lot of us feel guilty about spending too much, and yet we continue to not save enough. (Here's an idea of why.)
Forced savings is supposed to help break that cycle. The idea behind a forced savings vehicle is that it takes money out of your hands today in the form of some kind of expense, and then years down the line, you get even more money back. How exactly you get that money back depends on the product.
The concept of ‘forced savings’
For example, let’s look at one of the most popular forced savings vehicles on the planet: a house. When you buy a house, you typically get a mortgage along with it. Pay into that mortgage every year for thirty years, and by the end of it, you have an asset that you own that you can sell, hopefully for a higher price than whatever you put into the mortgage. You’re being “forced” to save in this instance because you have to pay that mortgage bill (if you want to continue living in your house).
A whole life insurance agent may tell you that the same basic principle also holds true for the product they sell. Put money into a whole life policy for thirty years, and at that point, you’ll have an asset that you can play around with or use to fund your retirement.
But whole life insurance often doesn’t work out that way for consumers, and at the end of the day, it’s a bad way to force yourself to save. Keep reading for our breakdown of why using whole life insurance as a forced savings vehicle just doesn’t make sense.
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How whole life insurance agents explain forced savings
In short, here’s how a whole life insurance will try to sell you on the product:
When you buy a whole life insurance policy, you’re “forced” into putting money into a savings account. On top of that, your cash value actually has a guaranteed minimum growth rate. This makes whole life insurance a “safe” investment — plus, you’ll actually be putting money aside, which probably isn’t what you’re doing now.
Cash value: a quick primer
Before we get much further, we need to do a quick lesson on how whole life insurance works. Note that this is a simplified explanation — there are anywhere between 50 and 100 different variations of whole life insurance on the market, and no single explanation can accurately cover all of them.
Whole life insurance is one type of permanent life insurance, also called cash value life insurance. (We’ll get to the other major category of life insurance, term life insurance, a little later.) 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 (and other types of cash value life insurance) have a cash value component (hence the name). When it comes to whole life insurance, that cash value is typically a savings account which is funded by a percentage of your premiums. Your life insurance company will also pay a dividend from their annual profits into your cash value.
Over time, this cash value will grow. In fact, whole life policies have a minimum guaranteed growth rate.
Whole life insurance is much more expensive than term life insurance — five to 15 times as expensive for the same death benefit — because the premiums are going toward the accumulating cash value, plus fees and charges (more on this later), in addition to the death benefit (i.e., the life insurance).
But here’s the truth about whole life insurance
Whole life insurance is a bad way to save and an ineffective forced savings method for the majority of its customers. Why? Here are 3 reasons:
1. The early years are all about fees
In the first few years, most of your premiums are going toward fees, not your cash value. That means your cash value doesn’t really start growing until a few years into the policy. While you can argue that it all evens out in the end, since fees drop over time, it’s just not comparable to other savings or investment vehicles, where fees are much lower and you can start earning money almost immediately.
2. You have a pretty good chance of dropping the policy
The whole point of “forced savings” is that you’re actually forced to save, right? Unfortunately, according to the Society of Actuaries (a.k.a. the worst Marvel villains ever), the average lapse rate in the first three years is almost 10%. According to the White Coat Investor, 80% of whole life insurance policies are eventually surrendered.
Why do these people surrender their policies? It’s mostly because whole life insurance is expensive, and policyholders struggle to keep up with the premiums as time goes on. A whole life insurance policy can cost four times as much as term life insurance for the same amount of coverage, and can easily run you upwards of $500 per month. (We can help you quickly compare life insurance quotes here.)
That may sound reasonable to some shoppers, especially those who are interested in the forced savings aspect of the policy. But once you get to a point where your budget starts tightening, your whole life insurance policy may be one of the first things on the chopping block.
3. If you do surrender early, your cash value will be very, very low
If most of your early premiums are going toward fees instead of your cash value, it makes sense that, if you surrender early, your cash value is going to be very low. On top of that, there are often surrender charges for policies that are dropped within the first 10 to 15 years, which can further eat into your cash value. According to Consumer Reports, it’s not safe to dump a whole life policy until at least year 16 — and even then, you’ll probably only break even.
Whole life insurance does make sense in some financial situations. For people with complex estate plans, or who have maxed out certain tax-advantaged accounts, whole life insurance may be a good option as part of a larger diversified portfolio. But for the majority of Americans? A cheaper term life insurance policy will cover your needs at a price point that makes sense for your budget.
Your alternative: Buy term & invest the rest
A whole life insurance agent may tell you that you can’t be trusted to “buy term and invest the rest,” and that it makes way more sense to buy whole life and force yourself to save. But there are better investment options out there that:
Make it easy to set up auto-deposits, essentially forcing yourself to save, or at least make it harder to forget and
Actually earn you money.
Online investment companies like Betterment and Wealthfront allow you to set up automatic deposits. Heck, even your local bank or credit union should allow you to set up an automatic deposit into a high-yield savings account every month. The simple fact of the matter is that it’s not that hard to force yourself to save — you don’t need an expensive life insurance policy that comes with tons of fees and overhead in order to do it!
Term life insurance
Term life insurance policies also just make a lot more sense than whole life insurance policies. Term life insurance is a quarter of the cost, on average, of a whole life policy with the same coverage amount. (Compare costs by age here.)
In fact, a thirty-year-old male can easily spend less on a term life insurance policy than they would for a new iPhone 7 through Apple’s monthly payment plan. Of course, your final premium will depend on your personal details, but this example does go to show that the price of a term life insurance policy is in line with many other low monthly expenses you might incur.
Be aware, too, that just because some whole life insurance agents may try to sell you on an expensive financial product doesn’t mean that all life insurance agents are out to get you. But you want to go into your life insurance search prepared.