The False Promise of Life Insurance

I have a permanent variable universal life insurance policy. I had it written and issued on my life in December of 2018 for two specific purposes:

• To protect my partner against the financial loss of my death.
• To fund my potential need for assisted living in my later years.

Respectively, the life insurance policy provides a significant death benefit that increases over time with the accumulation of the cash value within the policy and has a rider attached to the policy that provides for the long-term care cost in my later years. As a variable policy, the cash value of the policy is also invested in the stock market through an aggressive subaccount (which is more or less a mutual fund, to use investment parlance), and thus has the option to grow the cash value in excess of what a fixed interest rate might offer. The policy costs $5,865.96 in premiums out of my pocket per year, and after two years, and has cost a total of $11,731.92 so far. Despite not realizing investment losses, the cash value is now $7,281.18, and there’s still no surrender value (which won’t appear until the 10^th year of the policy). I knew how this would work when I bought the policy and am comfortable utilizing the policy solely for its insurance protection benefits. However, there is a greater issue with whole and universal life insurance products that often don’t make it into the marketing for the policies. As a CERTIFIED FINANCIAL PLANNER™ Professional, today I’m going to highlight the extreme issues in the marketing of permanent life insurance and how it rarely accomplishes the goals it’s marketed with. If you’d like to see a real case study of how it’s misrepresented, you can read my piece from April, Wolves at the Gate Part 2.

The Cost of the Insurance

The metaphor used to explain how permanent policies are funded is that of a bucket with a spigot. Your premiums are water poured into the top of the bucket and the costs of the insurance policy are poured out of the spout. As time goes on, the costs might increase, but theoretically, so long as there’s water in the bucket, the policy stays in force. What often comes up in the marketing of permanent life insurance is its “living benefits”, which are often touted in two forms: Tax-free appreciation of the cash value and the ability to borrow from the policy. However, these characteristics are not with great merit, as I’ll explain shortly. In the meantime, an insurance policy is an extremely expensive mechanism for investing. To use my own policy as an example, each month the “investment” is $488.83. Immediately a number of expenses come out of the premium:

• $40.36 for the cost of insurance (the literal thing I’m buying)
• $8.00 monthly policy charge to offset the time value of money by not paying the premium in full annually in advance
• $21.42 for the long term care rider
• $1.14 for the “Mortality and Expense” Risk Charge (whatever that is)
• $158.33 for policy issue charge (recouping the $6,745.85 commission the agent was paid one month at a time)

So, right out of the gate, only $259.58 is being invested and the rest is pouring out of the metaphorical bucket. The policy issue charge will eventually go away in the fourth year of the policy, but in the meantime, I’m effectively investing 53 cents on the dollar

It’s not Tax-Free Investing

As mentioned earlier, one of the often touted living benefits of permanent life insurance is that the cash value is tax-free. This is not actually the case. The illusion of tax-free investing comes from two mechanisms: First, the government does allow for life insurance to be internally tax-advantaged in that the investments do not pay taxes as they grow. This is done to avoid reducing the cash value internally in the policy and to keep the cost of the insurance lower since the government recognizes that life insurance is not typically beneficial to the insured party. However, when distributions are taken of the cash value by the owner (presumably after a decade or two long surrender penalty period), they also receive their distributions tax-free. Marvelous! Except this is not actually a tax-free distribution. This is simply a return of the cost basis of the premiums paid into the policy. Because life insurance distributes cash value on a “first in first out” basis, meaning that premiums paid are paid out of cash value before returns on investment. This means that the entire cash value might be paid out tax-free if the cash value has never exceeded the cost of the premiums. However, if the policy has existed long enough to generate enough return on investment that the cash value exceeds the premiums paid, then the excess cash value above the premiums paid will be (you guessed it!) taxed. So the argument of tax-free investment falls flat on two fronts: First that you’re investing less than your whole dollar and thus starting your investment out at a loss, and second, that if you actually realize a return on the investment, you’ll be taxed like any other investment!

Borrowing from the Policy

In the case of whole life insurance and some cases of universal life insurance, rather than simply taking cash out of the policy, you are instead “loaning” the money to yourself. This pops up in the hokey radio ads you’ll hear about “banking on yourself” and “the secrets the ultra-wealthy use to build sustainable wealth”. While lending yourself money from the insurance policy is perfectly fine, the argument for this often relies on the case that the interest rates will be preferable to normal interest rates and that because you’re borrowing from yourself, you net the value of paying interest to yourself. However, the applied purpose of this strategy is not for the benefit of the customer but for the salesperson. After all, people often don’t like the high premiums they have to pay for life insurance, and when they realize that the interest rates aren’t as good as they thought (on top of having to keep paying the premiums), they might want to cancel the policy. But if they bought a policy to finance something like a real estate investment (where this is popularly marketed as a strategy), now you’re stuck with the policy for decades, because not only have you borrowed the money but now you must pay it back, thus ensuring that you’ll be paying for the policy for many years to come. And if you die before you pay it back? Worry not, Uncle Sam will show up with his hand outstretched to claim taxes on the loan.

So what’s better?

Literally, anything else makes a better investment vehicle if that’s all you need. I’m serious about that. For the average member of the public who doesn’t even maximize their 401(k) contributions every year, their 401(k) would be perfectly adequate. If they are lucky enough to earn enough to maximize their 401(k) contributions and still want to save more, then they can utilize a Roth IRA (it can be a back door Roth IRA or a standard Roth IRA, but Roth IRAs are available to anyone at any income level), and even after the use of these tax-advantaged retirement vehicles, they can go one step further and simply invest in tax-efficient index funds and exchange-traded funds. In any of these cases, the whole investment dollar will go into the investment, and even if it goes into a taxable account that pays taxes over time, those taxes should (if efficiently invested) be limited to no more than 15% (20% or more in some cases, but not for the average investor). At that point, even net of taxes, the 85% net-of-tax gains have more than beaten the 53% invested dollar out of the gate, and the amount of investment return on those whole dollars will have proportionately grown significantly more.

Now I know some of my clients are reading this and going “Dan, didn’t you recommend permanent life insurance for me?” I sure did! Next week, I’ll provide you with a few best use cases in financial planning for permanent life insurance (remember, I own one of these myself), so if you’re curious, stay tuned.