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Whole Life

Whole Life Insurance . . .

Is the grandparent of all the various types of cash value policies being marketed today.  When it comes to understanding how the policy works, it is not a complex product, by any means.  A typical Term Life Insurance contract is about 8 to 10 pages long, and a typical Whole Life Insurance contract is only a few pages longer.

These days, both are written in understandable English the “legalese” of the 19th and early 20th century policies is almost entirely gone in a modern policy.  The only reason for the extra pages is the same thing that distinguishes a Whole Life policy from a Term Life policy the cash value.  The extra pages describe the cash value and the rights of the policy-owner in regard to the cash value.

Think of a Whole Life policy as a very long term life contract.  It starts now, at whatever the insured’s age is, and ends at that person’s age 120 or 121 the policy’s “Maturity” or “Endowment” date.  As with term insurance, the longer the term, the higher the cost will be.  But a Whole Life policy also has cash accumulation, which is additional money the policy-owner contributes to the insurance company, and in return the insurance company pays a small, fixed amount of interest (between 3% and 5%) into the cash accumulation.

Because the length of the term is known, and the amount of insurance does not change, the insurance company’s fixed interest rate allows the premium to be calculated in such a way that at the endowment date, the sum of the premiums paid plus the interest credited equals the full face amount of insurance. If the insured has not died by this time, the policy ends and the insurance company pays the face amount of the policy to the policy owner (the small amount of interest would be taxable).

Whole Life Insurance . . . indeed, any form of cash value life insurance . . . should never be though of as an “investment”.  With its 3% to 5% rate of return, Whole Life insurance barely keeps pace with inflation.  Your investments should do far better than that.  Books written for life insurance agents 100 years ago, intended to help them develop a “philosophy” of life insurance, started with a premise similar to this:

        We must take the money from the young man, preventing him from foolishly spending that money on unimportant things, and preserve it for him until he is an old man, when he will need the money for his continued existence.

In other words, young men are too undisciplined to save money on their own, only the insurance company can do that for them.  Life in America today is not that much different than in it was the early 20th century.  People in America have much larger incomes, but they don’t save any more of it today — in fact, as a whole, we save less.  Cash value insurance is one place where money may be saved, but it’s not the most efficient place or way to save.

A Whole Life policy’s cash accumulation may be borrowed against, and in some policies it may be withdrawn.  When you borrow money from the insurance company, the policy’s cash accumulation becomes the “collateral” for the loan.  If the loan and loan interest is not repaid in whole or in part, that amount will be deducted from the death benefit paid to the beneficiary when the insured dies.  But if the loan principal and unpaid loan interest ever exceed the cash value of the policy, the policy will lapse — it will come to an early end.

In recent years, insurance agents have been promoting a concept variously known as “Bank on Yourself” or “Infinite Banking” or “Safe Money Millionaire”.  While technically possible, these devices advertise leveraging cash value life insurance by using the cash accumulation to fund a series of loans to pay for things like cars and college educations.  But plans such as these are dependent on large cash accumulations, scheduled repayment of the loans and loan interest, and, thus, are dependent on purchasing large amounts of Whole Life or Universal Life Insurance with very large premiums in order to build up a large cash accumulation.  Repaying the loans and loan interest requires more money, because premiums still have to be paid.

Some of these plans are also based on receiving “dividends” from the insurance company.  Dividends are the result of “surplus premiums” the insurance company did not need to earn its expected profit this year.  Those premiums were invested by the insurance company, and provided additional profit, so the Board of Directors decides how much it is willing to return to the policy-owners.  This is not the same as earning interest in a savings account or by owning bonds.

The IRS recognizes life insurance dividends as nothing more than a return of excess premiums paid.  Some of the extra pages in the Whole Life policy discuss the options the policy-owner may exercise when it comes to receiving a dividend.  The “Bank on Yourself” plans rely on dividends to purchase “Paid-Up Additions” (“PUAs”) to increase both the face amount of insurance and the cash value of the policy.

While there is nothing wrong with these plans in concept, there are some potential hazards.  First, dividends only happen when the insurance company has a profit — which, for life insurance companies, is almost every year..  But dividends cannot be guaranteed, and they could be smaller in the future than anticipated.  The “plan” could be impaired as a result.  So while I don’t disapprove of these plans, I think they have great potential to harm folks who misuse or misunderstand them.

Additionally, and this is only a prediction at this point in time, because the federal government is spending more money than it collects in taxes and other “revenue”, Congress is looking at every conceivable source of new money it can lay its hands on to try to pay those bills.  Mortgage interest deductions have already been limited for certain taxpayers beginning this year, and could be eliminated for all taxpayers in the future.  Life insurance loans are currently not taxed by the federal government either,, unless a policy lapses with unpaid loan principal or interest exceeding the total of premiums paid, minus any dividends received in cash.

I would not be surprised if the Congress doesn’t take another look at life insurance as a way to collect additional tax revenue as they did in the 1980s, either by taxing the death benefit or by taxing the unpaid loans and loan interest that is deducted from the death benefit.  If Congress does that, they don’t have to “grandfather” or exempt those loans that preceded the law, so folks borrowing money from their life insurance as “tax-free income” today, could be setting themselves up for a big taxable event in the not too distant future. Again — this is just a prediction, an educated guess.

And for this reason, I avoid counseling folks against taking money from their retirement plans or their life insurance policies to pay their bills today, if at all possible.  If these are the only sources of readily available cash, then so be it, but they should always be regarded as the last possible resource.  Every dollar borrowed from a life insurance policy is, potentially, $1.08 or more that the beneficiary will not receive.

As long as the policy-owner does not “tinker” with it, Whole life insurance is a good product, suitable for many income protection needs, and something that meets essentially all of the demands of “Truth-in-Advertising.”  Its most basic premise is as simple and pure today as it was 170 years ago:

You pay . . . you die . . . we pay.

There are very few “escapes” from any life insurance contract for the insurance company, especially once the policy becomes “incontestable” (after two years in California and most states, but after only one year in a few states).  And Whole Life, like term life, only requires that you continue to pay your premiums until the end of the term.  If death occurs before that, the insurance company promises to pay the death benefit.  It doesn’t get much simpler than that.  Aside from the cash accumulation, the only difference between Whole Life and Term Life is the length of the term itself.

An insurance company could easily offer Term Life to Age 121 with a level premium that did not change over 60, 70, 80 years or more.  They don’t because it would be fairly expensive and most people would not be interested.  Yet folks do buy Whole Life insurance because of the perceived value of the cash accumulation.  Term and Whole Life insurance are one of the few thing that “you get what you pay for.”  In Whole Life, you pay for the cash accumulation — the insurance company does not give it to you.


Mario Pinzon

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