I recently had an interesting interaction on social media with a slew of insurance people regarding the benefits of permanent life insurance as it pertains to a financial plan. I found that most participants in the conversation were unable to look past years of insurance product training to recognize the limitations and concerns with permanent life insurance.
Before I go any further, I would like to point out, I am a firm believer in the value of life insurance and its place in a financial plan. Without the life insurance discussion, a financial plan is incomplete. Furthermore, I believe that the less expensive the insurance, generally the better for the client. However, I also believe permanent life insurance can be an incredibly powerful planning tool in the proper situation. Finally, I believe that life insurance should be used as life insurance and not as a replacement for diligent saving and investing.
Now that we have that out of the way, let’s dive in.
The good folks at Merriam-Webster have provided us with a basic working definition for life insurance:
life insurance, noun - insurance providing for payment of a stipulated sum to a designated beneficiary upon death of the insured
In summary: Life insurance insures someone’s life. When that someone dies, it pays a benefit to someone else.
If only it were that simple.
Instead, we live in a world where this simple concept has been morphed into countless iterations that attempt to blur the line between insurance and investment. Life insurance now comes in exotic packages like: Variable whole life, term/universal hybrid life, indexed universal life, and the always popular, variable universal life.
Many of these products are extremely complex, wrought with internal costs, and marketed as one size fits all solutions for all of life’s planning needs. What’s worse, the licensing exams required to be able to sell these products are surprisingly easy – leading to a constantly growing number of commission based salespeople that are incentivized to sell the most expensive contracts in order to make a living (I’ll explain this in more detail later in the post).
Most “financial people” fall into one of two camps, insurance people and investment people. Now there is a rare breed of individuals that are able to marry the two and provide sound advice in light of both ends of the spectrum, but this can be hard to come by. What makes it even more challenging is that all of the aforementioned professionals may refer to themselves as financial advisors, making it rather confusing for the client.
Many times you can tell within a few minutes which camp the financial person falls into. Unfortunately, it is usually determined by the company they began with, the training they have received, and who they were influenced by early in their career. It has been my observation that a great deal of people in this industry choose not to fully think for themselves, rather they simply follow the advice and opinions of the people in their immediate circle and never stop to ask the question: “Is this the best solution?”
I would like to go on record and get my answer to this question down, in writing, for all to see. My position is rooted in facts, backed by data, and reinforced by client experiences. I admit, like everyone else, I have been influenced by those around me, my mentors, and other advisors. However, I have also spent meaningful time on both sides of this argument, hearing from some of the best and brightest on the insurance and investment sides. Additionally, I have done painstaking analysis for clients over the years which has fundamentally altered my opinions along the way.
As a reminder, here is the question: Is permanent life insurance a good idea?
Of course, the answer will vary depending on the individual situation. Let me begin with a list of scenarios where permanent life insurance is a great idea, verging on a no-brainer:
1. Estate tax mitigation – For ultra-high net worth (UHNW) individuals that will face an estate tax burden upon their death. Individuals with a gross estate above the unified credit ($11.58M in 2020 at the time of writing this) will end up with a taxable estate which will be taxed at 40%. The use of permanent life insurance (generally coupled with an Irrevocable Life Insurance Trust) to cover the tax bill incurred at death will preserve the full estate for the heirs instead of slashing 40% of every dollar over the unified credit. The cost associated with a contract like this can be substantial, but the leverage created by the death benefit almost always outweighs the immediate cash outflow concern, especially given the UHNW client that would utilize this strategy.
2. Charitable giving – Clients, small and large, can have a goal to leave a lasting legacy in the form of a charitable gift. While there are many strategies that should be explored for end of life charitable giving (appreciated assets, real assets, retirement accounts, etc.), permanent life insurance is a popular and efficient way to leverage your current assets to create a larger gift for the non-profit at the end of life. The size of the death benefit determines the premiums on these contracts, and the premiums determine the realistic viability of this option for the individual client. For the record, I am a firm believer that giving should be a part of everyone’s financial plan and often times in order to make a meaningful impact, one must make sacrifices. However, overextending a client or neglecting other portions of their financial plan in order to purchase a larger permanent life policy for charitable giving is just unwise financial planning and stewardship. It is my opinion that you should give as much as you can without becoming an unwanted burden on someone else. In any event, this strategy is sound and can fit for a wide range of clients all across the net worth spectrum.
3. Estate creation – Again, this strategy applies to clients large and small that want to create an estate for their heirs. This is often used with working class individuals that will need their savings and investments to fund their expenses in retirement. If such a client has a goal to leave an inheritance but they are likely to spend down most of their assets, funding a permanent life insurance policy can be an ideal solution for this goal. This is, of course, assuming they can afford the cost of the premium for said policy.
4. Insurability protection – This strategy is primarily used with minors. Parents are able to purchase permanent life insurance contracts on their minor children with minimal underwriting. These contracts are usually designed with a feature that allows for additional death benefit to be purchased at future ages for the children without any medical underwriting. The advantage here is if the child develops a health condition that disqualifies them from obtaining life insurance, they still have the coverage that was purchased for them as children and they would be able to exercise the increase options as an adult as their insurance need grew through adulthood.
It is important to note that the first three scenarios are all permanent goals that require a permanent solution, resulting in a lump sum payout after death, and that end result justifies the immediate cost. The fourth scenario is a potentially permanent need that could potentially require a permanent solution in the event of future uninsurability for the child AND a future life insurance need for the child (i.e. the need for a death benefit).
Also, it is important to point out, that each of these scenarios revolves around using life insurance for its defined purpose: insurance providing for payment of a stipulated sum to a designated beneficiary upon death of the insured.
This concludes the realistic uses of permanent life insurance where I believe the cost is justified by the need.
Nowhere on this list did you see the words “investment,” “savings,” or “accumulation.” Those are purely byproducts of owning these contracts. If your goals are to invest, save, or accumulate assets, it would be wise to consider an investment, savings, or accumulation vehicle, not an insurance contract.
I was going to make a list of all the scenarios where permanent life insurance is not the best fit. Unfortunately, that would make for an unreadably long post. Instead, I will provide the two situations where permanent insurance is marketed but is rarely the best solution:
1. Tax-free savings – Permanent life insurance contracts, when funded properly, build what is known as a ‘cash value.’ In fact, permanent life insurance is oftentimes referred to as cash value life insurance. This cash value is an account within the contract that is funded by a portion of the contract premium and earns interest, dividends, or can even be invested in certain contract types. Cash value accumulates tax-deferred and you are able to take tax-free withdrawals even prior to retirement for anything from education to home renovations to a trip around the world.
Sounds good, right? Well, when things sound a little too good to be true, they normally are.
These features are not as simple as they sound. First, you have to make a distinction between a cash withdrawal and a policy loan. If you take a cash withdrawal and you want it to be tax-free, you can only take out your basis (what you have contributed to the cash value from your premiums). If you take out any of the gains (interest, dividends, investment earnings), those are taxed as ordinary income.
Now don’t skip past that. Gains withdrawn from life insurance contracts are taxed as ordinary income - gains taken from investment (non-retirement) accounts are taxed at capital gains rates.
Ordinary income rates are usually higher than capital gains rates so this can eat into your take home cash from a withdrawal. Also, it is important to note that only a portion of your premium is going towards your cash value and the older you get, the less of your premium that goes towards cash value. Why? Because there are internal costs. Here is an example of costs and fees you might see in a permanent life insurance contract:
Non-guaranteed coverage charge
Non-guaranteed cost of insurance
Investment fees and expenses
These expenses can eat up more than half of your annual premium, meaning only what’s left over actually goes to the cash value of the contract. So, while tax deferred growth and (partial) tax free withdrawals are enticing, do the benefits justify the cost? Well, that depends on who you ask.
2. All-in-one financial solution – Permanent life insurance has multiple components that can be used for a wide range of financial situations. Of course, there is insurance protection on the life of the insured, there is the aforementioned cash value component, and in some contracts that cash value can be invested and grown and used for whatever you would like. Additionally, there is a strategy known as “banking on yourself” where you are able to take loans from your cash value as a means for cheap cash in a pinch. Therefore, the idea is that permanent life insurance can be your life insurance, savings, investments, and emergency fund all wrapped into one commissionable product.
Here are the facts:
Does permanent life insurance have all of these capabilities? Yes.
Does permanent life insurance do all of these functions in the most cost effective and efficient manner? No.
Let me break this down by individual feature:
Life insurance – for the same death benefit amount, the cost of the premium will be much, much higher than that of pure term insurance.
Cost effective? No.
Investment – Internal costs (listed above) limit the accumulation of cash value and simultaneously eat into investment returns.
Cost effective? No.
Taxes – IRAs and Roth IRAs are dramatically more tax advantaged when saving for retirement. (See IRAs – Traditional and Roth). 529s are dramatically more tax advantaged when saving for education. Non-qualified investment accounts are not taxed on the basis and gains are at the more advantageous capital gains rates.
Cost effective? No.
Banking - When taking withdrawals from your cash value, you can only take out your basis tax free, all investment growth is taxed at ordinary income rates instead of capital gains rates. If you choose instead to take a loan, you end up paying interest on your loan and those interest payments go directly to the insurance company, just like they would to a bank for a regular loan.
Cost effective? Sometimes.
To summarize: There are many life insurance products that provide a variety of benefits including insurance, savings, investing, and tax advantages. There is also a very real value to the permanency and guarantees associated with permanent life insurance. All of this is true.
This is also true:
The permanency and guarantees come at a cost. That cost is what determines the annual premium payments required to purchase to policy. The annual premium payments are what determine the sales commission for the life insurance agent. (Life insurance agents are compensated on a percentage of the target annual premium payment.) Therefore, the more expensive the contract is for the consumer, the greater the compensation for the agent.
This is what’s known as a conflict of interest in it’s purest form.
Unless your insurance agent is held to a fiduciary standard (such as a CFP® professional), there is no telling what truly motivates that person. We can all relate – making a living can be hard, providing for your family can be stressful. Offering a slightly less efficient, slightly more expensive solution that “checks all the boxes” for the client doesn’t sound so bad. This option can be especially hard to avoid when it gets the agent paid substantially more than other solutions.
Now let me be abundantly clear, permanent life insurance is not evil and not all life insurance agents have diabolical schemes in mind. This blog is not intended to scare you off from the idea of adding permanent life insurance to your financial plan. Rather, the intent is to dispel some of the myths surrounding permanent life insurance and to equip readers to have a more educated conversation about their own life insurance needs.
Any opinions are those of the author and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past performance does not guarantee future results. There are fees and tax implications that should be considered with any type of investment account. Consult a financial advisor to discuss all of the risks and costs involved with any type of investment prior to making a decision. Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional. The cost and availability of life insurance depend on factors such as age, health and the type and amount of insurance purchased. As with most financial decisions, there are expenses associated with the purchase of life insurance. Policies commonly have mortality and expense charges. In addition if a policy is surrendered prematurely, there may be surrender charges and income tax implications. Guarantees are based on the claims paying ability of the insurance company.