Should Life Insurance Be Purchased as an Investment?
Before purchasing life insurance as an investment, a potential investor should understand a few things about the types of life insurance and how they work. Basic life insurance can be broken down into two major categories, term insurance and whole life insurance. (See also: How Healthy is Your Life Insurance Plan?)
Term insurance is insurance for which one makes annual premium payments in exchange for a death benefit. This is the least expensive type of life insurance and cannot be purchased as an investment. The death benefit is all that one receives from term life insurance, provided one passes away while the policy is active.
This type of insurance is ideal if you do not believe you will need life insurance in your later years; the older one becomes, the higher the premiums for term life insurance. The primary purpose of term life insurance is to protect those people who depend on you; as one gets older, most people accumulate retirement savings and/or their children become self sufficient, decreasing the need for term life insurance.
Whole life insurance, also known as permanent or cash value life insurance is the second type of life insurance and can be broken down into whole life, universal life, variable life, and variable universal. In general, cash value life insurance offers protection throughout one's entire life, and also includes an investment — the cash value. Only a portion of the premium payments on a cash value life insurance policy cover the actual insurance. With the other portion of the premium, the insurance company sets up an investment known as an accumulation account which is invested in interest-bearing securities.
The cash value reduces the amount at risk to the insurance company and thus, the insurance expense over time. The owner can access the money in the cash value through policy loans or other options which reduce the death benefit. Accordingly, premiums for such policies generally tend to be higher than those associated with term life insurance, at least in the earlier years.
The appeal of whole life insurance as an investment stems from the tax treatment of its accumulation account. The money in the accumulation account grows tax deferred, meaning taxes are postponed on income and capital gains. Nevertheless, there are many factors that make this type of insurance an unattractive investment option:
- There are incredibly high fees and expenses associated with buying permanent life insurance. Unless one buys a no- or low-load insurance policy, the fees and expenses erode the returns so much that it is almost impossible to compete with the returns of securities such as mutual funds. These fees and expenses are so high that they can eventually outweigh the tax deferral benefits of such policies.
- Further, the insurance companies generally provide unrealistic policy illustrations to show potential clients what their premiums and cash value will be in the future by using unreasonable interest rate forecasts. From a purely financial sense, many insurance experts suggest buying a term life insurance policy and investing the difference in premiums between the plans on your own.
- Finally, with cash value life insurance, the only benefit paid to your family upon death is the face value of the policy.
Based on this evidence, it is quite apparent that permanent or cash value life insurance is not a recommended investment. Individuals with access to other tax-deferred retirement savings opportunities, such as a 401(k) or a ROTH IRA, should be maximizing their contributions rather than investing in a cash value insurance policy.
Sources
- Life insurance, an investment? Despite what you hear, it's rarely a good choice (BNET)
- Should you use Life Insurance as an Investment? (Financial Web)
- The Truth About Life Insurance (Dave Ramsey)
This is a guest post by Michael Pruser. Michael is the managing editor of the popular personal finance blog, The Dough Roller, and also writes for the credit card review sites, Credit Card Offers IQ and Prepaid Cards 123.
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Our son intends to purchase our dairy farm for $500,000. My husband and I figure we would like to recieve $200,000 for ourselves and $300,000 for the rest of our 3 children. Would it be prudent for our son to fund a whole life policy on my husband who is in excellent health in order for the other 3 children to inherit their share?
It depends on when you want the other children to receive their share. If you want them to receive the money at your husband's death then, yes. If you want them to receive the funds after both of you have passed then you should utilize a Survivorship (2nd to die) policy because the premiums are much cheaper.
Another option could be to simply purchase the much cheaper term insurance (there are 10, 15, 20, and 30 year policies available) and set up a plan to pay off the siblings over the same time period. For instance, your son buys a 20 year term policy for $300,000 on your husband while simultaneously making yearly payments to his siblings in the amount of $5,000/year. If your husband passes during the payoff period then the policy pays out $300,000; otherwise, the policy expires after 20 years and the siblings have been paid off.
I'm not a financial adviser, but I must say this sounds like a horrible idea. You should talk to a fee only (non-commission!) financial adviser on what is the best option. Especially since the intricacies of your goals and the tax implications therein (as well as timelines, etc.) cannot be summed up easily in the comments section of this blog. Please do yourself a favor and hire a financial adviser. Not a CPA or a lawyer (though maybe eventually they may be needed). An adviser who doesn't receive a large commission up front can advise you on the best way to handle this transaction or series of transactions.
I used to think that life insurance as an investment didn't make a lot of sense. However, it appears that no one trusts the stock market these days. Insurance as an investment vehicle may make some sense, but make sure that you talk with a professional.
I can't speak for all insurance companies, but I think many would invest at least a portion of your money in the stock market.
I think that whole life policies only make sense after you have maxed out your 401K and IRA - and even then I think that you might be better off investing in stocks in a tax efficient manner (say doing DRIP on stocks with a track record of increasing dividends) vs a lower return on your whole life policy.
Just backing up Jeff with his comment. Most insurance companies operating costs, exceed their revenues. They make their money by investing your premiums in the stock market. Therefore, if you think stocks are a bad investment, so is insurance.
WOW! I am a huge fan of Wisebread, but after reading this biased article towards Term Insurance I have my doubts. The writer clearly does not fully understand the basic fundamentals of life insurance. "Buy term and invest the difference" Are you kidding me? I run a successful business based on educating my clients and helping them understand simple money concepts so that they make wise decisions, but this article is hog wash. You sound like a Primerica agent. It's evident that the writer did not do complete research. I have sat down with clients who have been told to buy term and invest the difference and 8 out of 10 do not "invest" the difference. The fact is people have habits of spending and not saving. If properly structured and funded a permanent life insurance policy can be a great vehicle for retirement, heck some even offer guarantees that the money will not loose. Let me end it with this, what other vehicle allows one to put money away, that is protected from litigation, is tax FREE if properly withdrawn, and little to no interest charged for borrowing your own money? Lets ask the wealthy where they have their money... Read Tax Free Retirement by Patrick Kelly
I'm guessing that the 2 out of 10 people who do "invest" the difference are the type of people who regularly read wisebread. So the fact that this message doesn't reach the other 8 out of 10 is fine.
You actually go against whole life because #1, you said the money is tax free IF taken out properly, which probably 8 out of 10 don't do it properly, and #2, 'little' interest is charged for people to take out their own money. Also, although it may guarantee you won't lose money, are you given the chance to make much money? I don't think so...
As a financial advisor what I tell clients is that the main purpose of a life insurance policy is to provide a death benefit. Whether term, some sort of permanent life insurance, or a combination of the two is most appropriate depends on a number of factors including the insured's age, income/cash flow, their stage of life, and how long they anticipate needing the coverage. Permanent insurance can have its place. I do agree that purchasing life insurance as an investment vehicle is generally a poor idea.