Whole life insurance guarantees serve as a constant source for discussion about life insurance and other personal finance related matters. Some might suggest that the whole life insurance guarantees are nothing special. These guarantees represent a paltry return on your hard earned dollars. Alternatively, some might suggest that these guarantees represent a rather remarkable offering from life insurance companies.
Regardless of your initial opinion of such guarantees, I'm going to spend a great deal of time today discussing why they are unique and exploring a very incredible function they serve for all policyholders.
Guarantees: A Confounding Element of Whole Life Insurance
Most of us come to learn about whole life insurance through the various methods life insurers have to market products. There are brochures, flyers, pamphlets, etc. But the single most successful tool the industry uses to explain products like whole life insurance is the voluminous document we colloquially call the “life insurance illustration.”
The illustration is a proposal for insurance that details both narratively and numerically the elements of the policy. It explains various features with truncated policy contract language and it delineates policy values through multiple ledgers that seek to clarify the functionality of the contract.
These illustrations introduce most of us to the notion of a guaranteed and non-guaranteed portion of policy cash values. One column in the ledger shows us what the policy is guaranteed to do while the other shows us what it might do given the current dividend payable to policyholders. These ledgers often look something like the following:
As you can see, this page of the illustration very clearly spells out both the guaranteed and non-guaranteed values of the policy. I've added the red text and arrows to help draw you to the part of the document I'm referencing.
From here we come to understand that whole life has guaranteed cash and non-guaranteed cash and it appears that non-guaranteed cash is higher. This would make sense. Non-guaranteed cash couldn't theoretically be less than guaranteed cash.
But there is an assumption about guaranteed cash that often develops from this depiction of values that causes confusion and misguided displeasure with whole life insurance years after it's bought.
Many people come to assume that guarantees being what they are, they represent the worst-case scenario unfolding for the policy. So if the policy only performs at its guarantee that might be nice that I didn't lose money, but it also means it performed much less than it purported to do originally.
So, when a policyholder looks at his/her policy at some point in the future after paying several year's worths of premiums there's a heart-sinking feeling he/she gets when realizing that all of the current cash value reported in the policy falls under the guaranteed column. “Why didn't I do any better than the guarantee?” They often ask. Seeing cash value tagged as guaranteed immediately associates it all with that lesser column of numbers that significantly trailed the non-guaranteed column; therefore these results must be bad… worst-case scenario bad.
This assumption is an error due to a nuance of whole life insurance guarantees that the ledger omits. This omission isn't on purpose. Truthfully there's no way for a numerical explanation of policy values to capture this important heads up, but the ledger does speak to it very subtly.
Go back to the above ledger and note that in the first year the guaranteed and non-guaranteed cash values are identical. This happens because this particular policy assumes that the policyholder will receive no dividend payment in the first year.
The guaranteed column depicts what will happen to the policy if no dividend payment takes place…ever. It only shows how cash values increase by the guaranteed accumulation rate. During the first year, the guaranteed accumulation of policy values is all that drives an increase in policy values. After the first year, the policy begins to earn dividends and that drives the difference between guaranteed and non-guaranteed values.
But here's the important nuance that most people miss, once a whole life policy has any given amount of cash value, that cash value is the guaranteed cash value. So if, for example, we look at the ledger from above and see that in year 10 the projected policy cash value is $841,032, and that actually happens, then starting in year 10 the new guaranteed cash value in the policy is $841,032, not the originally shown $761,188. This further means that moving forward the guaranteed accumulation rate of cash value will compound off the $841,032 instead of the lesser $761,188, which also mean that future guaranteed values are higher than originally depicted.
Real Life Example of Improved Whole Life Insurance Guarantees
I recently reviewed an in force whole life insurance policy issued several years ago. I happened to have an old in force ledger from 2015 that I could compare to 2019. I was particularly interested in the guaranteed values given this subject.
It turns out that the 2019 guaranteed cash value came in 8% higher than the 2015 ledger said it would be. This is because the policy earned dividends in years 2016, 2017, 2018, and 2019 and those cash values created by the dividend payment become the new guaranteed cash value in the policy.
What's more, in 2019 the projected guaranteed cash value for age 65 improved 3% over the amount reported from 2015. You might be thinking that 3% doesn't sound like all that much, but keep in mind this means an extra $3,000 in guaranteed cash value for every $100,000 of guaranteed cash value in the policy by that time. This policy reports several hundred thousand dollars in guaranteed cash value by age 65.
Also, remember that the policyholder did nothing over this time span to increase the future guaranteed cash value. It happens because the policy earned dividends and those dividends created a new higher guaranteed cash amount off which all future guaranteed compounding occurs. There's also an incredibly good chance this policy earns a dividend next year, which will further improve guaranteed cash value.
Even Experts get this Wrong
I wrote a blog post several years ago noting this concept when a whole life policyholder contacted us for thoughts on a review he paid someone to do about his whole life policy. The financial planner made the same incorrect assumption I noted above. Seeing the current cash value all reported under the guaranteed cash value led the planner to assume that the policy unfolded per the column of numbers that looks dramatically worse than the one showing non-guaranteed projections. He then went on to declare this whole life purchase a complete waste of good money.
Additional Implications of the Guarantees
Because whole life insurance guarantees cannot go away and no one can take them away from you due to bad market conditions, the improvement of guarantees over time makes life insurance an asset you need not worry about as economic times worsen. Your time will likely need to focus on the assets that can suffer losses in such situations, so it's comforting to a lot of people to know they own at least one assets immune to collapsing markets.
Most people come to a realization in life that all of their accomplishments and success are temporary. The good fortune you've accumulated today could evaporate if the wrong events unfold. Perhaps you're up substantially in your 401(k) or you own a home that appreciated substantially over the years. All of this wealth disappears without notice at times leaving lots of people in a very precarious situation. The only way to lock in gains from these assets is to sell them and move the proceeds from the sale to cash.
Whole life insurance is not the same. Its guarantees allow for an essential lock-in and reset each and every single year. So no matter what happens in the broader economy, whatever you accomplished to date with your whole life insurance policy you are guaranteed to keep. On top of that, this guaranteed feature enhances the guaranteed accumulation of value each year moving forward.
Whole life insurance guarantees provide for a 3.5 to 4% guaranteed accumulation rate for the entire life of the contract. I'm sure some will think 3.5 or 4% a low return on money. They are mostly people who formed this opinion through theoretical process reading and participating in online forums, Facebook groups, etc. and don't have a lot of real-world experience investing any substantial amount of their own money for retirement. Guaranteeing that level of compounding interest for someone's entire life is a substantial minimum guarantee…I'm aware of no financial products that come anywhere close.