The “is whole life insurance a bad investment?” discussion is a great example of the classic advice we were given when the internet was a fairly new phenomenon and we had only just begun to use it as a resource for information. As we were out searching the world wide web with Metacrawler we were commonly reminded that we must be careful about the information that exists on the internet because anyone can put whatever they want on it–fact or fiction.
Blogging has become another source of mixed information that is sometimes difficult to dissect when it comes to fact or fiction. And on the subject of personal finance, and specifically insurance, there are a lot of opinions. I’ve discovered that most of the not so friendly cash value life insurance adherents tend to develop their opinions in deeply rooted ignorance, and today we’re going to walk through one such example.
Cleaning up the Internet one Corner at a Time
Today’s example of a spot of the internet that needs a little spritz of Mr. Clean comes from Matt Becker’s Mom and Dad Money. Now, I don’t know Matt personally, and I don’t wish to make any accusations or assumptions about who he is or the quality of his work. Quite honestly I haven’t spent a lot of time looking at his site, one post in particular that was brought to my attention (and then a few others on the topic of insurance).
What’s important is not who he is or what he’s trying to accomplish, but rather some glaring inaccuracies that exist in a post he published titled Why Whole Life Insurance is a Bad Investment
With that out of the way, lets get started.
Seven Big Problems
There are seven big misconceptions laid out in the argument along with an additional theme that is ubiquitous among the anti-cash-value life insurance crowd. We’ll address them one by one.
#1 Whole Life has no “Term”
This one is really picky and I understand that, but in the interest of being a subject matter expert and being able to convey mastery of the topic, his statement while introducing the different types of life insurance and trying to state the basic differences between term life insurance and whole life insurance has a technical misstep that makes me wince a little. He states simply that whole life insurance has no term.
I understand this comment was made in the context of differentiation from level term insurance. My problem is simply that whole life insurance very much does have a very clearly defined term. That term is the time between the age of the insured at issue and their age 120. Without this clearly identified term, it would be impossible (under current actuarial paradigms) to calculate the premium for the policy. It would also be impossible to derive the Modified Endowment Contract Premium and the 7702 Cash Value Accumulation Test compliant premium.
This one really doesn’t need to be belabored, whole life insurance has a term, it’s 120 minus the age of the insured at policy issue.
#2 Whole Life Insurance is Undiversified
There’s a lot to tackle on this one. The point begins with a discussion about diversification with a misleading reference to Modern Portfolio Theory regarding the theoretical achievement of decreasing risk while not decreasing expected return. While that could be inferred to be correct, the more precise goal of MPT is that through diversification one can decrease his or her risk exposure without disproportionately decreasing expected return.
As much as I’d love to further explain that point, I’m a little worried about the length of this article so I’m going to resist. For those who understand the fundamental concept of differential calculus you should understand exactly what I mean. For those a little in the dark, I’ll have to revisit this subject in the coming weeks.
He then states that whole life insurance is by definition undiversified. I’m not really sure what that means. He then further mentions that you give one company a lot of your money and you are at their mercy regarding rate of return. FALSE.
Every state in the United States has legislation that speaks to the required amount of surplus an insurance company must share if it wishes to issue participating insurance products. In fact, several insurers have miscalculated the correct number from time to time (generally by a dollar or two per policy holder), and have faced litigation for the mistake. The mutual insurance company tag line is not just a feel good marketing pitch; it’s a legislative imperative.
But further, the suggestion that whole life insurance is undiversified is incorrect. Whole life insurance cash values are backed by the insurer’s general account, which is largely bonds, but it also includes a wide array of investments, meaning the policyholder has some indirect exposure to a number of different (and sometimes exotic) investment strategies. We talked about this all the way back on Financial Pro Cast episode number one.
Furthermore, who said one should place all of his or her money into a life insurance policy?
#3 Positive Returns take a Long Time to Appear
Is five to seven years really that long? And in some cases less. We achieve that sort of thing with blending all of the time.
But why does this matter? Unless the plan is to take the money and run there are few places besides a bank account or a coffee can that would be suitable so we wouldn’t be talking much about other products anyway. And on top of this, just because I’m not positive on the return in say year 3, doesn’t meant I don’t have access to money, which is more than I can say for a 401k or traditional IRA.
He then goes on to make a very bogus comparison of current policy projected returns to historical 10-year treasury returns. Current projections are based on current interest rates, if we wanted to really make an apples to apples comparison we must look historically as well, and remember what we learned here–whole life insurance does work pretty well.
#4 Whole Life Insurance is Illiquid
This one was the most egregious of the bunch. He starts with a definition of liquidity quoting investopedia. He then claims whole life insurance is illiquid for the three following reasons:
- For the first decade or so the returns will be negative: this is both incorrect and irrelevant to the liquidity
- Many policies have surrender charges: no whole life insurance has no surrender charge, if you lapse the policy, the stated cash value is yours
- You can borrow money from the policy, but you have to pay interest: this is true, but paying interest on a policy loan has nothing to do with liquidity, and the fact that money is available would mean the asset actually is liquid, especially since taking money out does not effect the asset’s price a key to the definition provided by his source investopedia. He further claims that you have to borrow and pay interest on money even if your simply taking out what you’d put in, which is also false as you can withdraw money and it comes out on a First-in Fist-out accounting basis.
He emphasizes that liquidity is important because it gives someone options. I personally pulled (borrowed yikes interest!) $55,000 out of a life insurance policy recently to purchase some real estate at about 50 cents on the dollar, and I already have a buyer lined up. Please explain to me where I was so disadvantaged.
If I were the typical person with most of my assets tied up either in a 401k or my house, this sweet little transaction probably wouldn’t be taking place.
He then tries to explain away the illiquid argument against 401k’s and traditional IRA’s, basically by saying that it doesn’t matter that they are illiquid because they bring other benefits to the table. Including “true tax deferral” whatever in the hell that is.
#5 Cash Flow Inflexibility
The claim here is the common misconception about whole life insurance. I like to refer to it as the Pringles claim. Once you pop you can’t stop. Truth, however, is that you can stop paying premiums on a whole life policy. And if the policy is designed correctly then a lot of the premium is discretionary anyway.
We can easily design the policy to accommodate cash flow fluctuations. We can even suspend the need to pay a premium in certain years by making use of a premium offset, premium loan, or potentially using dividends to pay the premium.
The suggestion that premiums on a whole life policy must always be paid and if not paid will result in a policy lapse is incorrect.
#6 Tax Free Suggestions are Misleading
I simply don’t get this one. He admits from the start that the tax free income aspect that whole life is well known for being able to accomplish is true, but then takes issue with the fact that his is done by a policy loan where there is interest accumulated (oh the horror).
Additional attempts to vilify the product by suggesting that one could destroy their policy by taking out too big of a loan is an argument I’ve never followed as it’s entirely possible to incorrectly execute any financial product and end up ruining your plan, life insurance is no different, and no more complex. It certainly doesn’t come with worries that your principal amount will drop 10% and this will dramatically throw off your initial income assumptions.
There seems to be some confusion over whether the interest washes out the tax-free situation, which I would argue is not the case.
Remember, just because interest accumulates doesn’t eliminate the fact that guaranteed interest and dividends are still paid on the values that act as collateral for the loan, so the net impact is much smaller than suggested. This is one of the chief reasons why we see the top performing carrier in the Blease Income Comparison yield an income of nearly 7.6% of it's principal balance when income commences (do keep in mind that comparison projects income to age 85, where we’d rather see it go to age 100 so we believe it should be a tad lower, but it’s still pretty good and really great when evaluating the taxable equivalent yield).
#7 Lack of Transparency
This argument is somewhat common and I’m sort of sympathetic but at the same time a little annoyed by it. Annoyed might be the wrong term, I feel as though it’s a cop out argument made mostly out of context and this situation is no exception.
The issue taken here with whole life insurance is that you never really know what the expenses in the policy are. Though one could easily subtract what they put in by what they have in cash surrender value after adjusting for the cost of insurance, and the industry came up with a method to do that a really long time ago.
But ultimately who cares? Does anyone really honestly think they will know about all of the fees associated with various transactions they become a part of in life? And if the net result is favorable what difference does it make?
This doesn’t mean I changed my mind and no longer think that details matter, but there’s a different between simply worrying about details, and worrying about details as part of a bigger overall goal. Argument is a lot about the former and completely neglects the latter.
There’s also a glaringly inaccurate statement found within this argument. On the subject of undisclosed costs Mr. Becker mentions “And these costs can change over time…” No, simply no. One of the fundamental tenants upon which whole life insurance is built is guaranteed expenses–they simply do not change. This is sort of like saying I tried Veganism, but I really wanted to follow a diet that was dairy free.
And Lastly, It’s just not the Best
The last item is more of an overarching theme that can be picked out of the article and it has to do with the notion that there are better options. There are, for example better options because whole life insurance returns are not guaranteed and comparatively low when it comes to “other investments.”
In fact, the lack of guaranteed returns is one of the major reasons listed for why whole life insurance is bad, which confuses the hell out of me.
Again, so what? I’ve said before that if it weren’t for the dividends, we wouldn’t be talking about whole life insurance. The guaranteed side of the column is not all that attractive (though certainly much better than the guarantees associated with an indexed fund, ETF, or bonds of any sort). Though I have a sneaking suspicion that I shouldn’t be confused, but rather deeply disappointed.
Further there are suggestions that you can use better options like IRA’s or 401k’s where you are allowed to invest in a multitude of different things. Remember all that business about lack of transparency and fees? 401k’s are so well known for transparency.
And on the subject of investment options, what options? Unless someone wants to pay the money to have a broad platform, most plans are restricted to the investment options offered by the custodian. And since most people rely on the fund company itself to acts as custodian, the investment options are generally limited to the fund company’s offerings.
Of course, like all of these arguments, the attack is never fully substantiated.
Someone merely says it’s not good, and makes up some blanket statement about why something else is better. Like “whole life insurance is a terrible investment because you can investment in so many other things in a 401k and you’ll get a better return.” We don’t know that is actually true, and it’s not even a logical argument, but for some reason it passes muster with people.
I’ll admit that I went back and forth on this particular example.
On the one hand, I noticed another article about his personal experience trying to decipher life insurance when he made a personal purchase (apparently they don’t teach you much about life insurance in CFP school). And there was a cringe-worthy anecdote regarding an agent who, when asked about the underlying mechanics about whole life insurance, merely stated something to the effect of “I don’t know how my watch works, but it tells time and that’s good enough for me.”
I understand some of where he’s coming from as a layperson.
But he certainly has no problem brandying about the fact that he is working towards his CFP and wishes to project expertise on personal finance subjects. And because of this, writing up an article about whole life insurance that is so utterly false is a major fail.
Further attacking something without a coherent argument and an obvious lack of knowledge on the subject is disheartening. Whole life insurance is not bad, people who try to apply it incorrectly are.
That is done largely out of ignorance and/or greed. We don’t like those people and feel they deserve all of the admonishment that comes their way. And Mr. Mom and Dad Money falls squarely within their ranks for being so careless with misinformation surrounding this topic.