Whole Life Insurance: Deal or No Deal?

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As if going through these tough economic times isn’t bad enough, it is extremely disheartening to see a slew of professional financial advisors trying to make a quick buck by playing on people’s fears. Fear allows rational and highly educated people to make completely irrational decisions. One of the biggest financial planning mistakes that an individual can make is buying the wrong type of life insurance.

Life insurance, by its very inherent nature, is a financial product that often puts the client’s interest in conflict with the advisor’s interest. The financial incentive to sell the wrong insurance policy is so high that it can “blind” the most ethical of advisors into selling policies that are wrongly structured and overly expensive.

Life insurance can basically be two types: term and permanent. Generally term life policies offer death benefits if you die before the “term” of the policy expires. It basically helps your family members in case of accidental death. If you live past the term, the money you pay in premiums is lost. Permanent life insurance offers death benefit and a savings mechanism (“cash value”) whereby if you live long, you can reap some advantages of earnings on part of your premium. The purpose of this article is to discuss one type of permanent life insurance—the whole life policy and it’s efficacy as an investment vehicle.

Whole life insurance is a type of permanent insurance where the premium is generally fixed and due each year over the contract life. There is usually a fixed death benefit, which may be increased over time through use of dividends or decreased by borrowing against cash values. Although some policies come with “vanishing premiums”, the premiums never really vanish. They are basically paid out of the investment earnings inside of the cash values. Even with fully paid policies, the premiums can re-appear in the future based on investment performance.

The premium of permanent life insurance, including whole life, consists of three components: 1) Mortality Charge, 2) Sales Commission & Other Expenses and 3) Investment return. Most financial planners, who believe in the whole insurance policy as the panacea, promote it as the great investment vehicle especially in light of favorable tax treatment.

The biggest benefit of a whole life insurance is the “guaranteed” component of investment earnings. In addition to the guaranteed component, if the investment company does well, the returns can be even higher. Most investment gurus would agree however, that the net return on whole life insurance never exceeds 4% after considering all the internal and external costs and the value of tax savings. Although you can take the cash value out of the policy at any time, there are severe penalties and tax consequences to prematurely cancelling the policy. Loans against most policies also come at an above average interest rate. Imagine paying interest to borrow your own money! It is also interesting to note that the first year’s sales commission to your financial advisor is almost 90% of the “target” premium.

In a bear market, touting whole life insurance investment performance as stellar is like calling a money market account the best performing mutual fund in the country. Investors should be wary of advisors who will take advantage of the current economic climate to scare people into buying whole life as a great investment vehicle. Certain estate planning and corporate organization scenarios are the right forums to discuss whole life and its efficacy. Investors should discuss their life insurance illustrations with at least 3 experts, including their CPA and other financial advisors, before making the ultimate step to buy life insurance.

Amol Nirgudkar, CPA is the managing partner of Reliance Consulting LLC can be reached at (813) 931-7258 or via email at amol@reliancecpa.com

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