Nearly everyone needs life insurance, but it’s easy to end up with a bad policy.
I’m specifically talking about permanent life insurance, which provides protection for your entire life as long as you continue paying the premium and the insurer remains solvent. Permanent life insurance comes in three broad flavors: whole life, universal life, and variable life.
Most people who end up with a permanent life insurance policy probably are spending more money than they should for more insurance than they need.
Unlike fiduciary advisors, people who sell insurance don’t have to uphold the fiduciary standard. That means they’re under no obligation to work in your best interest. Instead, they can work in their best interest, or the best interest of the company. It’s a sales pitch when you talk to an insurance agent who wants to convince you that permanent life is something you need to buy.
When choosing between term and permanent life insurance, most people are best choosing term insurance and investing their cost savings into a low-cost portfolio if the goal is long-term growth. There are only a few instances to consider a permanent life policy, such as people who have children with special needs, a taxable estate or other unique asset protection needs.
Here are some common arguments that insurance salespeople make about permanent insurance--and how I would push back against those arguments.
“Buy life insurance while you are young and healthy because rates are low.”
As a young adult, your death wouldn’t create a financial hardship for others, unless you’re married or have children. If you’re young and single, you don’t need life insurance at all.
Premiums are lower for young people who are healthy, which makes sense because your probability of dying is low. But that doesn’t mean you need insurance now. Paying insurance premiums when nobody is dependent on your income is a big mistake, especially if you could be putting that money toward other goals like retirement savings or buying a home.
“Why rent a policy when you could own it?”
Insurance agents sometimes compare buying permanent insurance to building equity in a home, but this doesn’t make any sense to me. The choice to rent or buy a home is completely different because you always need a place to live, whereas your need for life insurance disappears at the end of a term policy, which is typically around the time your retire and your loved ones are less dependent on your financial contribution.
More important, the cost of renting vs. owning an insurance policy is drastically greater than the long-term difference in renting vs. owning a home.
Investing the cost savings from buying a term policy vs. a permanent policy is a far superior method for accumulating wealth. In addition, you can access your investments or savings without the restrictions that come with taking a loan on a permanent insurance policy.
“With the growing cash balance, you can be your own bank and take loans from the policy.”
As a policy’s cash value grows – which, by the way, takes a very long time – you are allowed to take loans against a certain percentage of the cash value. However, to maintain the death benefit and recover the lost effect of compounding on the funds being withdrawn, the policy charges a high interest rate on the amount withdrawn. Plus, you must keep paying premiums.
If you fail to make premium or interest payments, the death benefit decreases and the policy eventually terminates. At that point, you’ll owe ordinary income taxes on the loan amount and remaining cash value minus the amount of premiums paid during the life of the policy.
A permanent policy is not the personal piggy bank that an insurance salesperson might suggest. It is a highly illiquid and costly way to accumulate savings.
“Permanent insurance is a form of forced savings.”
This is a terrible reason to buy insurance. You buy insurance to protect your family against the loss of income and the value of your household contributions.
The cash value built up inside a permanent insurance policy lacks the flexibility and liquidity necessary to live life on your own terms. The best form of forced savings is setting up an automated plan to fund your goals.
“Look at those dividends in the policy. You can’t earn those in your portfolio. Plus, that growth is tax free.”
By law, an insurance salesperson can’t refer to a whole life insurance policy as an “investment vehicle,” and for good reason. Still, they lean heavily on the idea of “dividend growth” when presenting a policy illustration.
Dividends for a permanent whole life insurance policy are a combination of the investment gains the insurer earns on your capital, plus the difference between how much the company collected in premiums versus how much they paid out in death benefits.
Dividends are an estimate, but they are rarely emphasized as such. Policy illustrations often restate projected dividends and future cash value, so the projected growth of your cash value is far from guaranteed.
“You already have some of your savings going to retirement accounts. Think of your policy as a form of diversification.”
You hear this argument when agents pitch you almost any form of permanent insurance. With a variable or universal life policy, you might also hear something along the lines of, “You can capture market upside, but protect against the downside.” This is because part of your premium payments go to the purchase of insurance and the rest goes to a super expensive stock investment.
The most cost-effective and flexible approach is buying term insurance to financially protect your loved ones and investing your savings in a low-cost portfolio for long-term growth.