Written By Ben Lacomis, CSLP®
Whole life insurance is often debated in financial circles. Is it a bad investment? Yes. If you’re thinking of (or are being pitched) whole life insurance as an investment strategy, that is a bad idea.
Is whole life insurance a scam? No, but even though it isn’t a scam, it is almost certainly a bad deal for growing your wealth if you’re intending to use whole life insurance (or are being sold whole life insurance) as an alternative to investing.
Think of it this way: hammers are great for some aspects of carpentry, but would you hire a carpenter who only brings a hammer? Similarly, whole life insurance has its specific uses but may not be the all-in-one financial tool some make it out to be.
The nuts and bolts of life insurance and whole life insurance
Life insurance products offer protection through death benefits paid to your beneficiaries. The cost of the payout and the policy is the premiums you pay to the company.
Permanent life insurance products such as whole or universal life insurance offer a permanent death benefit, offering a death benefit for your entire life. Whole life insurance policies specifically have a cash value component and can allow partial access to the death benefit values while you’re alive.
Where does the money go? Your insurance premiums fund the cost of the policy and administrative costs of the insurance company. In exchange for your payment, life insurance companies guarantee the duration, death benefit amount and how much of the death benefit becomes accessible for withdrawals over time through the policy’s cash value.
Related: Life Insurance for Physicians: How to Decide on the Best Policy
Term insurance: A comparative look
Term is another type of life insurance. It offers death benefit protection for a limited number of years. You don’t get lifelong coverage, but you’ll pay significantly lower premiums per death benefit protection. This is because the death benefit is generally guaranteed for a limited amount of time. Once this term expires, the insured usually will cancel the policy.
A term life insurance policy doesn’t have any cash values associated with it. It’s also the purest and least expensive form of death benefit protection for limited durations.
Investment aspect of whole life insurance
Unlike investment vehicles, all insurance products aim to provide financial protection through guarantees and death benefits rather than to generate returns. With insurance companies understanding the outcome of a permanent death benefit, the further you are in the contract and in life, the more cash they let you ‘borrow’ against what they would ultimately owe through a death benefit in a claim.
The company uses the premiums paid to (relatively conservatively) invest. If it’s a stock company, the excess returns are paid to their shareholders and investors. If it’s a mutual company, the excess returns are paid as dividends to their policyholders. Dividends in these participating whole life insurance contracts are not guaranteed and can increase the cash values and death benefit values in a policy.
Related: Why Term Life Insurance for High-Net-Worth People Is Essential
Comparing returns: Cash values vs. the stock market
When you buy a whole life policy, typically the initial premiums of the contract are partially front-loaded to cover the contract’s costs and mortality charges for the death benefit, which are based on your lifetime rather than a shorter duration. For this reason, it is not a surprise to see $0 cash value growth for the first two years of most whole life insurance contracts.
Depending on the structure of your policy and the duration of the premium-paying years, the guarantees may lead to break-even of cumulative premiums and cash values in a decade or even twenty years.
Over the long-term, whole life insurance contracts typically guarantee a cash value accumulation somewhere in the range of 1% to 3.5%. For perspective, historic long-term inflation has averaged 2.85% over the last 40 years but was almost double that in the last three years, with an average of 5.60% between 2021 and 2023.
For the most part, only discussing participating whole life insurance is relevant over the last few decades. Considering these companies pay non-guaranteed dividends, the historical performance for premium-paying contract holders that I’ve seen has been in the 3% to 5.5% range.
A zero-value investment account?
While zero cash value is expected in the first two years of whole life insurance, you wouldn’t expect the same from an investment account. When putting money into an investment account, whether a brokerage account or retirement account, you wouldn’t expect the accessible value to be $0 for the first few years.
Granted, you may not want to pretend your retirement accounts are that way anyways. These accounts are a good investment and offer far more liquidity than whole life insurance in that sense, especially non-retirement accounts.
Comparing the value of risk in rate of return
Since 1957, long-term US equity investors have seen an average rate of return (ROR) of ~10%. Just for illustrative purposes, let’s look at how crazy impactful a 10% ROR is relative to a 5% ROR over a 40-year period of time.
An initial deposit of $10,000 can grow to nearly $540,000 over 40 years with a 10% ROR, even if you don’t contribute anything else toward it. Now, compare that to investing the same amount over 40 years with a 5% ROR, and your balance ends up below $75,000.
Guarantees sound nice and may be appealing, but they aren’t sufficient for long-term financial goals. Looking at the different RORs above shows how not taking on enough risk to reach longer-term goals can stunt your wealth-building potential. In the end, these guarantees only function as a ‘guarantee’ to be tremendously behind where you would have otherwise been.
In my view, the cash value functions more as a glorified savings account that lets you borrow from the death benefit you created when buying the product. This is less of an ‘investment option’ and more like a ‘glorified savings vehicle’ when comparing whole life to how investments work.
Here’s what it comes down to: wealth accumulation is a function of how much you put in and how much those assets return. If you take on little-to-no risk and use an expensive ‘investment’ option, such as paying for a permanent policy and other high-cost guarantees, then you’ll have to save a lot more to reach your financial goal than if investing.
When is whole life insurance a poor choice?
Is whole life insurance worth it? Understanding why whole life insurance might be a bad investment starts by looking at it from a financial planning perspective.
Financial plans have two distinct time periods that may exist for different goals — a period of accumulation and a period of distribution. Very simply, using retirement as an example, the accumulation phase is your working era where you earn income and save or invest. Distribution is when you need to pull money out of the account rather than getting a paycheck.
On the accumulation side, economic forces like inflationary risk work against you over time and reduce the value of the dollars you’ve earned.
Winning the battle of growing wealth against economic forces requires strategy. You must make sure your long-term investments are subject to enough risk that it can have an attractive risk: reward tradeoff to significantly outpace inflation. If you don’t fight that battle at all, you can’t plan for future financial independence without a savings rate that is the majority of your income — requiring you to live off of rice and beans during your career years. It’s unlikely you’ll ever be able to retire without a sufficient savings rate and risk-reward profile.
How efficiently you spend your wealth or whether you leave it to heirs or causes isn’t relevant if you don’t efficiently build enough wealth to live off comfortably in retirement.
Whole life insurance is bad for wealth accumulation
When it comes to growing wealth, tax-efficient investment vehicles like a Roth IRA or employer-sponsored 401k and 403b let you take sufficient diversified investment risk in. These are what I think of as a Ferrari in a long-term race. Conversely, I would consider whole life insurance to be a horse-drawn carriage.
If someone suggests whole life insurance as an alternative to investing for retirement or longer term goals, run.
Whole life insurance is bad for short-term death benefit needs
For short-term death benefit needs, whole life isn’t cost-effective. You can get the same death benefit protection for your family for a limited duration at a much lower cost.
For instance, a 35 year old male with an average $2 million term insurance policy for 20-years might pay $59 per month. But for a whole life insurance policy? That same man would pay five to 15 times more for $2 million in life insurance coverage.
Whole life insurance is bad for liquidity
We already noted earlier that the first few years of a whole life insurance contract provides nothing in terms of cash value.
After that, it takes years, if not decades, to break even.
Life is unpredictable and if you or your loved ones have an unexpected financial situation in a few years, you’d get no sympathy or understanding from your whole life insurance policy. Buying a whole life insurance policy and then having to cancel it is a terrible outcome.
When you need to invest, invest
If your goal is to grow wealth for your future and you haven’t been maxing out your personal retirement savings and tax-deferred employer-sponsored retirement plan, focus on investing first. You should also consider making significant contributions to a non-retirement brokerage account before putting money into permanent insurance products.
If your cash flow doesn’t permit you to do everything you want in terms of spending, the best financial strategy is to pay down debts and build short-term savings first, such as an emergency fund. Then you can move into medium and long-term investing. But you should probably stick with term life insurance for the temporary death benefit protection and invest the difference.
When you just need life insurance for “now,” buy term life insurance
Do you already own a whole life insurance product? If its premium payments are keeping you from living the life you want to live or from being on top of your goals, you need to assess your options for reducing or canceling the policy. Before canceling, talk to a financial advisor to assess your options, and make sure you buy enough term life insurance to fulfill the death benefit protection to keep your family and dependents secure.
