Whole Life Insurance has a bad reputation in the FIRE community! Does anyone here have a Whole Life Insurance (WLI) policy? Anyone? It seems so toxic that even if anyone had a WLI policy they’d be afraid to admit it for fear of ridicule. I only recently “came out of the closet” when I was chatting with folks at the April CampFI over lunch and the topic came up. People were astonished: Huh? Big ERN has a WLI policy? And his wife, too? Isn’t WLI only for naïve and unsophisticated folks that fall for the insurance salespeople’s pitches? Sometimes! But just like many all other issues in personal finance, there’s rarely a simple, clear-cut and universally applicable recommendation. I would argue that WLI is not a bad option if certain conditions are satisfied! And it’s a loooong laundry list of issues to consider and conditions to satisfy. I came up with no less than ten things to consider and in an absolutely shameful, “clickbaity” kind of way, I call them the Ten Commandments of Whole Life Insurance.
Let’s take a look…
I: Thou shalt first maximize all other tax-advantaged opportunities before even thinking about whole life insurance!
The appeal of whole life insurance is that the gains are tax-exempt (but note the caveats, see Commandment IX below). The big disadvantage, of course, is that a good chunk of the tax advantage is offset and simply arbitraged away through high fees and thus lands in the hands of insurance companies and insurance salesmen. I would argue that the only way anyone can make a case in favor of WLI is that its returns compare favorably with those in taxable accounts. Thus, if you haven’t already maxed out all other routes of tax arbitrage (401k, Health Savings Accounts, IRAs, Roth IRAs, 403b, 457 plans, etc.) Whole Life Insurance should not even be on your radar screen!
II: Thou shalt not forget that longevity risk is the real problem in retirement planning!
Life insurance hedges the risk of your early demise. It’s great for young families that want to cushion the risk of a spouse (or both) dying young and leaving the survivors without an income. In contrast, running out of funds in retirement is normally a result of living too long combined with Sequence Risk and a withdrawal rate that was set too high. This alone tells me that WLI can never play a major role in retirement planning, certainly not early retirement planning. The bulk of our assets belong in productive high-return assets that ensure we don’t run out of money should we live into our 90s and beyond.
That said, it doesn’t mean that retirees – even those with a sizable nest egg – should have zero life insurance. Sure, with a stock portfolio large enough one could simply “self-insure” against the loss of a spouse. It sounds mathematically feasible. And I’m a big fan of math, so don’t get me wrong. But let me also pose the following question:
How many of you seven-figure-net-worth readers out there have collision coverage on your $20,000 cars?
If you indeed keep collision coverage and thus you don’t self-insure against this pretty trivial loss then you should ask yourself: Isn’t your spouse worth more than your mildly used Toyota Camry? Here in the ERN household we currently don’t have a car but once we have one again it would be a new or mildly used car in that price range and we will probably keep collision coverage at least for a few years. As we had with our previous car(s). Despite being multi-millionaires! Yes, we could self-insure but we won’t. Being in a car wreck is traumatic enough and potentially correlated with some other nasty crap – hospital stay, medical bills, etc.! So, we don’t want the additional expenses on top of that.
In the same vein, having (permanent) life insurance is rationalizable even for folks who could theoretically “self-insure” because losing a spouse prematurely is a tragic and traumatic event that may also be correlated with large expenditure shocks, especially medical bills! Moreover, while some expenses of the surviving spouse may be lower (one spouse eats less than two spouses) others probably stay the same (most surviving spouses stay in the same house instead of moving to a house half the size/cost) and other expenses may even rise. That’s because the surviving spouse, especially in old age, is more likely to have to hire external help. And the surviving spouse will lose the married tax filing status. So, again, don’t go overboard with the coverage. But a small policy with a death benefit in the low six-figures to hedge against some of the uncertainties of an early death of a spouse doesn’t look so bad!
So, in other words, much of the WLI opposition is simply due to a classic logical fallacy: The False Dilemma Fallacy. If my only two choices were 1) no WLI at all and 2) my entire retirement savings in WLI, then, absolutely, I would pick option 1, too. But that’s not how the world works!
III: Thou shalt consider policies with the shortest possible premium period!
Normally, you’ll have to pay whole life insurance premiums for as long as you live. Both my wife and I have policies that have front-loaded payments for only a specified number of years, e.g., twelve years in the case of my wife. In contrast to term life policies, though, where the coverage ends when you stop making payments, our policies are still whole life policies with coverage until we pass away. Needless to say, the accelerated payments are higher. The advantage of accelerated payments, though, especially for early retirees, is that the payments fall mostly into our working years while we still had high incomes. So, we limit the outlays while in retirement and thus reduce Sequence Risk. In fact, ideally, I would have preferred to make just one single payment upfront (pre-retirement) and be done with it. But there are limitations from the IRS about how to structure a whole life insurance policy (see Commandment IX – Tax Issues).
IV: Thou shalt not over-extend yourself!
If you ever consider buying whole life insurance make sure you minimize the risk of future cash flow problems, i.e., not being able to afford your premium payments. Having to surrender the policy will ensure you’ll have a low, often negative rate of return! So, my guideline is very simple. I made sure I could afford the total (!) cumulative premium payments (annual premium times the number of years) in one large lump-sum payment at the time I start the policy. I would never spend money on WLI that I don’t already have. And with “afford” I mean not having to sell all my assets but rather being able to pay that total cumulative premium easily out of a year’s worth of cash flow. Just to give you an example: My wife’s policy costs a bit over $3,000 a year. The total over twelve years is just under $36,200, which is significantly less than the six-figure sums we would routinely save while I was still working.
Of course, you’ll very quickly realize that your insurance salesman might try to size you up and see how much you can afford to save every year and try to grab as much of that as possible. That’s how high earners like medical doctors end up with WLI policies costing $50k and more per year. That’s clearly way too much coverage and it obviously violates several of the Commandments listed here.
V: Thou shalt not fall for the sunk cost fallacy
OK, imagine you just realize you bought a policy many years ago that you now learned to hate after reading so much bad press in the FIRE community. Or your parents started the policy and you’re stuck with it now. Should you pull the plug? Well, there is no unique answer. It depends on your specific situation. It’s possible that you should have never gotten the policy (low ex-ante expected returns) but from today’s perspective, it’s still a good idea to keep it. Unfortunately, calculating the surrender vs. keep decision is not as trivial as some in the blogosphere want to make it. I’ve seen people in the blogging world simply applying the Excel RATE function:
=RATE(# of years of remaining life expectancy, (-1)-times Premium, (-1)-times CurrentCashValue, DeathBenefit, 1).
But that’s incorrect! The proper IRR calculation has to take into account the expected cash flows, i.e., flows weighted by the death probabilities each year. It’s the actuarially correct way and I did some calculations like that in a case study on WLI a few months ago. It turns out, keeping the policy in place had a very respectable IRR going forward! Not taking into account the death probabilities along the way will likely underestimate the true IRR.
VI: But thou shalt not fall for the Loss Aversion bias either
In other words, with a truly bad enough policy, i.e., one that has an awful looking IRR even looking forward (considering the low initial returns a sunk costs) one would, of course, be better off to pull the plug. In response to the WLI case study a few months ago I got a few comments and emails from folks with WLI policies that didn’t seem like worth keeping! Don’t throw good money after bad! In fact, the last thing you want to do is to cash out after reaching a capital gain. That’s because you’ll lose the tax-advantage of WLI and you’ll have to pay taxes on those measly gains. Cut your losses as early as possible!
VII: Thou shalt not compare WLI with equity returns!
Often people point out that the expected (and realized) whole life insurance returns will likely fall short of what you’d expect from equities. I completely agree. But so what? By that same logic we should never invest in bonds and simply hold 100% stocks! In fact, most folks in the FIRE crowd have at least a small percentage of bonds in their portfolio for diversification purposes. So, if WLI has an expected return lower than stocks but still higher than bonds then we should at least consider replacing a portion of the bond portfolio with WLI. That was my rationale to sign up for WLI. I had compared expected returns for the WLI contract, slightly above 5.5%, with bond yields that were around or even below 2% at that time.
Side note: The 5.5% figure is the IRR using the non-guaranteed death benefit, but so far both the cash value and death benefit have increased ahead (!) of the estimated non-guaranteed schedule indicated in the policy documents. We are now probably looking at an expected IRR North of 6%!
So, as someone who holds very little money in bonds, I rationalized our WLI engagement as a pretty good bond alternative! Never an equity alternative!!!
VIII: Thou shalt only work with a highly-rated mutual insurance company!
Some bloggers have made the claim that because WLI companies invest their insurance reserves in a bond portfolio, a WLI policy can’t perform better than that bond portfolio. That’s not true! First, insurance companies, especially those with high credit ratings will likely hold reserves way in excess of what’s necessary to satisfy all future payouts. Second, because so many unsophisticated WLI clients surrender their policies ahead of time (i.e., they likely don’t heed Commandment II above) returns for those who don’t surrender their policies can be higher. In other words, someone else’s misfortune (=a low IRR from cashing out the policy early) will likely result in higher IRRs for those smart (or lucky?) policyholders that don’t let their policy lapse. Isn’t that ironic? In a way, I should just keep my mouth shut and let the WLI bashers keep at it to entice more folks to surrender their policies. It would raise my own IRR through higher dividends.
And talking about dividends, I also like the concept of the mutual insurance company where policyholders (at least those in WLI policies) are shareholders. The math is simple: dividends are likely higher if profits don’t have to be shared with equity owners of a publicly traded corporation.
IX: Thou shalt consider all tax consequences of whole life insurance
The tax benefits of WLI come with (at least) two asterisks. Todd Tresidder at Financial Mentor has a great article about the pitfalls of WLI and I liked the section about the potential tax headaches a lot. First, gains are certifiably tax-free if you keep the policy until the end (i.e., your end). Loans against the policy are OK as well but only as long as they don’t completely exhaust the cash value. But if you were to surrender the policy before you die then any gains would be taxable.
Another way WLI could lose its tax advantage is if it were to become a “Modified Endowment Contract.” Any effort to “front-load” the insurance premium payments too much could void the tax-free status. A good insurance agent should be on top of this constraint and make sure this never becomes an issue. Check out this interesting CNBC article on the tax issues of WLI.
Talking about taxes, there is one frequently ignored benefit of WLI. It has to do with the fact that many view it as a fixed income substitute. Of course, most people hold bonds in their tax-advantaged accounts for tax efficiency. Thus, moving a portion of one’s bond portfolio into WLI frees up space in our tax-advantaged accounts to shield more of the equity portfolio from the drag of taxable dividend income. From personal experience, this dividend drag was particularly onerous during my high-income years. How much of a difference does that make? With a dividend yield of roughly 2% for the typical U.S. equity index fund and a 28.1% combined marginal tax rate (15% federal for qualifying dividends, 3.8% Obamacare and 9.3% California) while still working, I got an additional 0.562% through better tax efficiency. Per year! Not that there was ever any doubt that the typical bond mutual fund (AAA corporate bonds to match the credit quality of my WLI company) would vastly underperform the tax-free return of our WLI policies. But with this added tax benefit, our WLI contracts really mop the floor with the average (investment-grade) bond mutual fund!
X: Thou shalt avoid all opaque and overpriced “riders”
When we got our respective whole life policies I learned about all sorts of “riders,” effectively additional insurance products covering other risks not already covered in the life insurance policy. Most common is the so-called “waiver of premium rider” which waives the premium in case the insured becomes disabled and unable to work. Sounds like a nice option but I found it overpriced and I don’t like the uncertainty about what the insurance company will eventually deem “unable to work.”
Another example: The “Accidental Death Rider!” If I’m dead I’m dead. I’m not any “deader” if I die in an accident. In fact, if that option existed, I would almost prefer the opposite rider, the “die after a long and painful terminal illness rider” because that at least would hedge some of the medical costs. Talking about terminal illness, one rider that’s normally provided free of charge or for a small fee is the “Accelerated death benefit rider.” One would have early access to all or at last a portion of the insurance benefits if one can prove to have an incurable medical condition that will result in certain death soon, e.g., terminal cancer, etc. It’s a nice option to have for folks without any other assets facing big medical bills but seems quite useless for us in the FIRE community with plenty of other liquid assets. Money is fungible! If it’s a free option go for it but I wouldn’t pay anything extra for this rider.
Though not called a rider, another overpriced feature is the monthly payment option. Instead of forking over the entire annual premium at the beginning of every policy year you can stretch out the payments into semi-annual, quarterly or even monthly payments. But the monthly payment is more than one-twelfth of the annual premium! The IRR of that twelve-month payment plan can be 10% and more. I don’t think it’s worth it to pay that much “interest” for a monthly payment plan.