This is an article that I felt needed to be written about the so-called "Term versus Permanent life insurance debate”. I’ve held my life insurance license for over 19 years now, and since day one this issue / debate / argument, or whatever you want to call it, has come up time and time again at the insurance companies I've worked at, and still often in insurance industry periodicals. My issue with this whole thing is that clients are usually left more confused than when they started. So I specifically wrote this somewhat lengthy article (consider it an “op-ed” or a “white paper”), not as a rebuttal or argument but as a rational analysis of the facts for both sides, and a final conclusion that will end the so-called debate.
Term Life and its Uses
First, let’s begin by discussing what Term Life is and its preferred uses. A “Level Term” life insurance policy is designed to cover you for a guaranteed and specified period of time, anywhere from 10 through 40 years. Term Life is pure protection and will therefore give you the most coverage for your dollar. A Term life policy is ideally used for income replacement should an individual die before retiring, but it also can be used for paying off a mortgage (should you die while still having a mortgage), or for providing coverage until your children graduate college.
Term Life has a few good uses for business planning as well. A Term policy can be used to fund coverage as part of a “Buy-Sell Agreement” among business owners, it can also be used to cover a “Key-Person” employee in the event she dies before retiring from the company. Yet another situation would be if a small business owner took out a large business loan to improve or expand the facility. A Term policy could cover the debt obligations should he die before paying back the loan.
Why Permanent Insurance?
The argument in favor of Permanent over Term is really two-fold.
The first issue is that after the Term policy expires; the insured must re-qualify again to purchase another Term insurance policy, which can be difficult if they are no longer in good health. In addition the older you become, statistically the closer you are to death (this is how life insurance underwriters think). Therefore, your cost per thousand (life insurance is bought in units of $1,000) will be significantly higher than when you purchased your policy 20 or 30 years ago. While most Term policies today have a “conversion rider” (where you can convert to a whole life policy without a medical exam), the conversion must be exercised typically within the first five to ten years of the policy.
A permanent policy such as a “Whole Life” (WL) policy on the other hand, will cover you for your entire life (typically to age 100, and with some companies to age 121). While premiums for a Whole Life policy are between 6 to 10 times more expensive than Term, it not only covers you for life but also has a cash savings element. Which brings us to the second argument for permanent Whole Life over Term.
The Cash Value Feature
Term Life policies do not have a cash accumulation feature. If you purchase a 20-year Term policy, all you are paying for is insurance, no more no less. After the Term policy expires, you technically have nothing to show for it. With a Whole Life policy you now have a cash accumulation component called “Cash Value”. In a standard cash value policy, by age 65 or 67 you should have accumulated approximately 40% to 50% of the policy death benefit amount in cash value. A $100,000 W.L. policy should have between $40,000 to $50,000 in cash value by the time the insured reaches age 65 or 67. Another main benefit of cash value is that it can be borrowed against, which gives you immediate cash on hand.
When you compare a basic Term policy to a basic Whole Life policy, Whole Life is the clear winner. However, there’s just one problem with that comparison. It isn’t fair, nor is it even accurate. Comparing the two is not an “apples to apples” comparison; it’s actually an “apples to oranges” comparison.
Term Life is designed to simply cover you for a period of time and be pure protection. Whole Life is by contrast a “bundled” product. It bundles or packages both life insurance coverage and a cash accumulation element together. A more fair and accurate comparison would be to compare a cash value Whole Life policy to a Level Term policy that is coupled with a side fund.
Term and a Side Fund
As stated, Whole Life insurance is a “bundled” product. The opposite of that is the concept of “Split Funding”, which is keeping insurance and savings separate. Split Funding can give the insured the most coverage via Term, and a greater rate of return by investing the remaining monies into a pure investment product.
Often times proponents of cash value (most life insurance companies and their agents) will illustrate a Whole Life policy Vs a Term policy with a side fund that is A) taxable, and B) generates an average return of no more than 5% a year. Also, the Term policy illustrated is consistently a 20-Year Term, which may not always be appropriate based on actual coverage need. To that I pose several questions.
#1 Why is the side fund which is assumed to be a mutual fund, not held inside a Roth IRA, or at least a tax-deferred account such as SEP-IRA or 401(k)?
#2 Being a mutual fund, why is only a mere 5% average return illustrated?
#3 Why is the Whole Life policy always compared to a 20-year Term and not to a 25, 30 or 40-year Term when appropriate?
While I’m not advocating a 12% return for the illustration, I do believe that a more realistic 8% return would be more accurate. We’re talking about a long-term (20 & 30+ years) accumulation comparison, so in all fairness you can’t have the side fund be in Long-Term Government Bonds (historically averaged a little over 5%). The side fund should actually be a high quality Large Cap dividend-paying stock fund or better yet, a diversified mutual fund portfolio based on the individual client's risk tolerance and time horizon. I also understand that many life insurance agents are either not very sophisticated in investment planning (other than how to sell the one or two variable annuities or index annuities that their company pushes), or are not even securities licensed. And that’s really not their fault (well, partially not); it’s the fault of the insurance company that they work for.
*(Over time the illustration below from Janus Mutual Funds may become outdated, but the fact that stocks outperform bonds over the long-term does not change).
Here’s the result from an example comparison that I ran: a 37-year-old male who qualifies for "Standard Non-Tobacco" rates can purchase a very competitively priced Whole Life policy of $250,000 with Nationwide Life for $2,880 annually. In 30 years at age 67 his policy will have $116,348 of cash value. The policy’s “Internal Rate of Return” (IRR) on the net cash value in year 30 is 1.85%. There is also zero cash value in year one. By contrast our client can purchase a 30–Year $250,000 Level Term policy from Banner Life for only $517 a year. He then can invest that $2,363 annual difference of premium into a diversified mutual fund portfolio (preferably held in a Roth IRA), which historically has averaged at an annual return of 8%. In 30 years at age 67, he can have $289,103 in his side fund investment. By the way, a 37 year old that has a 30-year time horizon will likely be investing into a more aggressive portfolio, one that should average closer to 9% or 10%, but that’s a separate issue.
The fact of the matter is when comparing the rate of returns of a cash value whole life policy to a highly rated stock mutual fund (or ideally a mutual fund portfolio); the side fund crushes the cash value component. Even when comparing mutual fund sub-accounts in Variable Life policies, the fees within the policy will reduce the returns of the sub-account version giving the edge to the actual mutual fund. So from an accumulation standpoint, Split Funding works best for the client.
Advocates of cash value also fail to mention that any access to the cash value component of a Whole Life policy will result in two things simultaneously. There will be an increase in premium (as you have to borrow = interest), and a reduction in the death benefit. Let’s say (hypothetically) that you were paying $4,000 a year for a $350,000 Whole Life policy and the policy had a loan interest rate of 6%. After you decided to borrow $25,000 of cash (assuming there was more than $25k of cash available), your policy as a result of your loan would reflect an increase in premium to $4,240 and a death benefit reduction to $325,000. It is important to remember that anytime you access (borrow) the cash in any type of cash value policy, your death benefit will be reduced accordingly until you fully repay that loan.
In regards to the side fund (mutual funds) being held in a Roth IRA, you actually can withdraw money from the Roth without any penalties. It doesn't affect your life insurance, as you are keeping your insurance and investments separate from the beginning. While I don't recommend it, the IRS does allow you to withdraw up to your contribution amount tax-free/penalty-free anytime. So in our client example, the $2,363 annual contribution is what the calculation will be based on. Let's say in ten years our client wants to withdraw money for whatever reason (again I prefer he doesn't), he can have access to a maximum of $23,630 tax-free/penalty-free, and doesn't ever have to pay it back. It is when he dips into the interest accumulation, which by definition is a penny over the $23,630 and beyond, then taxes and penalties will be in effect.
My reason for not taking the money early as you may have guessed, is because it will significantly reduce the total amount he will have accumulated by age 67. Unless of course he decides to pay it back, as the maximum annual contribution limit (as of 2019) is $6,000 ($7,000 if age 50+). So if he were to pay back his "loan", he could double up his contribution to $4,726 every year for the next ten years and still be within the max contribution limit of $6,000 a year. Again I don't recommend it, but it still is a better "borrowing option" compared to accessing the cash value of a whole life policy.
*The 2019 annual income limits to qualify for full contributions to a Roth IRA are as follows:
Single = $120,000 or less.
Partial contributions are allowed for singles with incomes between $120,001 to $134,999.
Married Filing Jointly = $189,000 or less.
Partial contributions are allowed for married couples with incomes between $189,001 to $198,999.
The issue that still remains however is the lack of coverage after the Term policy expires. Providing of course that there is still actually a need for coverage, which may not always be the case. There are very few situations where the need for coverage may still be required, one such instance would be in business succession planning of a family-owned business. In this case, the owner (let's say the father) would want to leave an equal inheritance to all four of his children (two that work in the business, and two that don't). The solution for such a need would be purchasing a Non-Cash Guaranteed-No-Lapse Universal Life policy. The Guaranteed U.L. (aka GUL) is a permanent policy that does not have a cash accumulation component. The specific need here is for permanent coverage, so paying for a cash accumulation component that would otherwise not be utilized would be a waste of money. GUL policies cost about half of what a Whole Life policy would, and provide coverage for life (age 100+). By purchasing the bulk of your coverage in Term (to cover you until retirement), and the remainder in GUL, you can have the optimal amount of coverage for both today and permanently (if needed) while still being able to accumulate significant assets in a side fund.
High Net Worth & Estate Tax Planning
When it comes to the estate tax planning needs of high net worth families, life insurance may still be a viable solution. Often times, the majority of the family's wealth may be tied up in some type of non-liquid asset such as a business franchise, an extensive art collection, or several real estate properties. This is known as being "asset rich but cash poor" (as the assets cannot easily be converted to cash).
In this case, the more affordable and updated Guaranteed-No-Lapse Survivorship Universal Life (aka SGUL or Survivor GUL) policy would be an ideal fit. The premiums in these Survivor GUL policies are reduced to a point where there is minimal cash accumulation for only a few years, before it fully diminishes and the policy provides pure protection only. Again, the need here is a guaranteed and permanent coverage to pay for an inevitable estate tax, not a cash accumulation component that will not be utilized. And as stated earlier if the cash value is ever utilized, it will defeat the original intent for the coverage, as the insurance death benefit will be reduced.
The Survivor GUL policy offers you protection for life, which would pay out the insurance death benefit upon the death of the surviving spouse, when estate taxes are then due. This can be an affordable alternative to an otherwise potentially costly estate tax situation. These policies should also held inside an irrevocable life insurance trust (ILIT), to be sheltered from your taxable estate.
For other situations where permanent coverage may be needed, please view my blog post about "Wealth Management" HERE.
It seems that once you break down the facts and the mechanics of an insurance policy, there really is no debate. Term life insurance will suit the majority of income replacement coverage needs. For any permanent coverage needs, either a GUL or a Survivor GUL are the best solutions. For any long-term cash accumulation goals, pure investment products such as Mutual Funds held inside a tax-sheltered account will result in significantly more growth.
For a free consultation, please contact us for an appointment.
*This blog is strictly the opinion of Michael A. Malleo and not those of
ASH Brokerage Corp., nor any of our affiliates.
Malleo Financial Services LLC cannot and will not give any specific tax or legal advice.
Please consult your tax professional or legal professional for such advice.