Monday, November 22, 2010

"Diversify" With Whole Life Insurance?

In response to my recent post about life insurance, a commenter said:
Great blog, thanks for your efforts. I'm curious if you think there is a diversification value in whole life insurance. That is, are there circumstances under which one is better off putting $500 per month into an S&P index and $500 per month towards a whole life policy as opposed to putting $1k into the S&P?
That's a good question.  Diversification can be powerful and sometimes whole life policies are marketed this way.  However, I think that they are often disingenuous in this regard.  For example, a policy might promise you a minimum 4%/year, but often what you get is not what you expect.  Also, the purported diversification is extremely costly in your example.  See below for more details.

First of all, let me say that these deals vary a lot.  My impression is that the insurance companies purposely make non-uniform products so that customers have a difficult time comparing them.  I think that they do this because it makes it more difficult for customers to bring market forces to bear to lower the cost of the product.  I think that the insurance companies have learned from their experience with term life insurance (which is a uniform, commodity-type product - and consequently highly amenable to price comparison) which has been rendered very low margin for them due to market forces.  By making products that can't be directly compared, the insurance companies avoid the "commoditization" margin-killer that happened with term. 

For our purposes, recognize that not all of the aspects below may be present in the same policy - or there may be additional aspects that the insurance company has come up with.  There are very smart and experienced people in insurance companies - with very good marketing - and they are very interested in making money for themselves.  It is often difficult to understand the product you are purchasing.  That should be a warning sign to stay away, not a sign that you should trust them.

That being said,  here are some reasons why, assuming you buy a policy that "guarantees" a "4% rate of return", that you may not get what you expect.

1) Surrender charge
Surrender charges are often huge.  Typically, they take away the earnings from about the first 7 to 10 years (although it varies based on specific deal).  That is, if you cash in the policy after 5 years, even though you were promised 4%/year, you may get nothing - or may end up having to pay the insurance company! 

2) The 4% rate of return may not be compounded.
I thought that this was a tricky one when I saw it. At first it seems like it's not a big deal, but after 10 years 4% non-compounded is 40%, while 4% compounded is 48% - not a huge difference.  After 20 years, it's 80% vs. 119% - getting meaningful.  After 30 years, it's 120% vs. 224% - almost double.

That 120% over 30 years expressed in terms of a compounded rate of return is really only 2.66% - and it gets worse as you hold the policy longer.

3) Use payment from "life insurance" to fund "4% return"
Keep in mind that each year's payment to the insurance company is going to be split by them into 1) an amount that they consider to be the cost that they will charge you for life insurance (as set by them - including both the actual cost of the life insurance and some profit), and 2) an amount that they will credit your account as an "investment".  Sometimes the "life insurance" charge is locked in - but often it is not. 

Let me clarify that - each year they get to tell you how much you have to pay them - and they get to make the split.  Consequently, if your "investment" return is lagging, then they can just up the cost that they charge you for life insurance and use the additional amount that they charge you for life insurance to make up for the "investment return".

The insurance companies want you to think of these as two separate products, but in reality it's a complicated deal in which people get distracted.  To put it at it's most simple -  You pay money to them yearly, they decide how much.  Then they decide how much they are going to give back to you by crediting your "investment account."  Then they keep the rest.

4) Use payment from "account maintenance" or "investment management" to fund 4% return
In addition to the cost for the life insurance, the insurance companies may charge a fee for "account maintenance" of the investment fund - as well as "management fees" for specific investments.  These fees are usually pretty sizable.  Additionally, I have seen some deals where it looked like the "guaranteed" 4% may have been before the account maintenance fee was subtracted.

Now, for a regular SP500 mutual fund, the management fee may be 0.1% or less.  However, for a similar investment through your insurance investment account, the management fee will typically be much higher - maybe as high as 2%.   I have also seen very high account maintenance fees as well.  This sets up the opportunity that if for some reason the investment return is not keeping pace, then the insurance company may be able to get you your 4% return by just charging you less in fees.

5) Your "investment account" often isn't one

In summary, from the insurance company standpoint, these types of products are excellent.  They take the money from you and invest in a well-diversified way that makes about 8%/year pretty reliably.  If they don't make 8% at first during the early years of the policy, well then they have the surrender charge to cover themselves.  Also, if they are really doing poorly, then they can slide some money that they get from you for life insurance over into your account - so that the 4% is really pretty much funded by you.

However, to say that your "investments" have "returned" 4% in this situation does not really reflect reality.  For example, if you have a money market fund that makes 2%/year and you contribute another 2% to the fund, you would not go around saying that your money market fund made 4% for the year - but that's effectively what this arrangement may be doing in some cases.

Now that we have a better understanding of the product, let's take a look at the "diversification" aspect under which these types of insurance products are often sold.  More specifically, we are typically not talking about increasing the diversification of specific investments - the "investment account" may be invested in a slice of market assets that we may already be invested in.  Instead, the specific aspect of diversification that is being addressed here is typically the "guaranteed" 4%.

However, the "guaranteed" 4% is both costly and disingenuous.  Costly in the send that your total return is likely to be limited to 4-6% and you will miss out on the long term SP500 return averaging 10% over your 30 year working history. Over 30 years, a 6% return turns $1K into $5.74K, but a 10% return turns 1K into $17.45K - that difference of $11.71K is a HUGE price to pay for the 4% guarantee.  Additionally, the 4% is often disingenuous for at least the reasons listed above.

Bottom line, I don't think that there is a "diversification" value to buying whole life insurance.


  1. Thanks for taking the time to discuss this life insurance thing, I feel strongly about it and love learning more on this topic. If possible, as you gain expertise, would you mind updating your blog with more information? It is extremely helpful for me.

  2. Some types of life insurance have cash benefits available while you're living. In these types, a portion of your premium goes into a cash reserve and builds on a tax deferred basis. You can access this money, called cash value. Some people use it to help education costs, enhance retirement cash flow or for any reason. Two of the most common types of "permanent life insurance" are called a term life insurance quote and universal life insurance.

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