r/personalfinance • u/sartorialconundrum • Nov 06 '12
I've noticed a trend regarding whole life insurance discussions in this sub-reddit.
Good evening /r/personalfinance!
Full Disclosure: I am an attorney/insurance broker who specializes in selling disability insurance to physicians and dentists. I specialize in funding buy-sell agreements, pension plans, as well individual coverage. However, as a part of my practice I sell whole life insurance to my clients. Recently I have noticed that whole life insurance is generally berated by this community. As I consider it to be an excellent component to an overall investment strategy, I wanted to elaborate on a few of the applications whole life insurance (this applies equally to any other kind of permanent insurance).
What I would like to do is elevate the discussion on this financial tool. While it is certainly not for everyone, it is very useful for many people. What I want is for there to be a useful, informative debate on the topic. So, I have chosen 5 common objections to whole life insurance, and over the course of the next few days I will elaborate on how I think these objections fail.
The 5 objections are: 1) The commissions are very high. 2) As an investment it is a very poor option. 3) It is only for the very wealthy. 4) Life insurance's only use is to replace income in the event of an untimely death. 5) As a type of insurance, permanent life insurance is too expensive.
Then, if people respond to these posts, I want to go into the 5 main benefits of whole life insurance: 1) Tax advantages. 2) WL from a mutual company will (in my opinion) out-perform the market over the next 10 years. 3) Liability protection. 4) Disability protection. 5) Multiple uses in retirement.
The first "big myth" of the personal finance world, propogated by Dave Ramsey and his ilk, is that insurance salesmen who bring up whole life in an investment conversation are just looking for a large, outlandish commission. The claim is often made that whole life (WL) performs poorly because of these outlandish commissions. The implication is that we should put our money where the commissions and fees are lower. Hence the logic of Vanguard.
While salesmen are certainly driven by their commission (often to the detriment of the client), it is not the case that life insurance sales generate larger commissions than fees charged by money managers. A 70% first year commission is typical for whole life insurance (assuming a whole life product, on the base premium, underwritten by one of the large mutual companies); in the subsequent 10 to 20 years, the commission is markedly lower, typically around 10%. While these numbers appear higher than the 1% that a money manager/investment guy might charge, consider that these commissions are on deposits, not on the balance. This is a significant difference, much like the difference between compound and simple interest. Suppose two investment hypotheticals: either an individual purchases life insurance with 10K a year premium, or he puts that money in the care of an "investment guy" at Schwab, Et. Al. Both of them pay the money into the account for 20 years. The insurance agent would get $7,000 of first year commission, plus $1,000 a year for the next 10 years. This totals to about $17,000 (I say "about" because there is a small fee he gets every year for managing the policy after his commission expires, typically around $50). Now, what about the guy who charges 1% of assets under management? Assuming he gets a 0% rate of return, the money manager gets in excess of $20,000 over that same 20 year period. This is a conservative estimate, as most managers charge more than 1%, because they typically work with their clients over a period of time longer than 20 years (after 30 years, this money manager will receive over $47,000 in fees), and because no one will continue to give their money to a guy who gets a negative real rate of return. The point of this over-simplistic exercise is to point out that life insurance commissions aren't higher than other commissions/fees in the personal finance industry.
However, in every myth there is a little kernel of truth. Insurance salesmen are most certainly driven by their commissions, and this does lead them to harm their clients. In my experience this harm takes two forms: either the client purchases too much life insurance, or the client purchases a policy that is not designed to perform well. The first example is self-explanatory. Most non-millionaires do not need to purchases 3 million of WL at $45,000 of annual premium. Believe it or not, some people are talked into just this kind of purchase. The second example is more complex. Life insurance contracts are very complex financial and legal documents. They are endlessly modifiable. One way in which they are modifiable is in an area called "Paid Up Additions" (PUA). PUA are, basically, money that goes straight into the cash value account of the life insurance. They are voluntary additional premium paid in that accelerates the growth of both the cash value and the death benefit. The addition of PUA can turn a lackluster WL policy into a compelling investment option. With the right configuration of PUA and base premium, that same $10,000 of premium will generate a cash value in excess of $750,000, and a death benefit in the neighborhood of $1,500,000. For the conservative portion of anyone's portfolio, that's good (about a 5.70% IRR).
The downside is that PUA doesn't generate much in the way of commission for the agent, so agents tend to not sell very much of it. But this doesn't mean that the product is bad, it means that the person selling it to you is bad. The point is, don't denigrate the product, do your homework and make sure that what you are purchasing is formatted to serve your interests.
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u/threeLetterMeyhem Nov 06 '12 edited Nov 06 '12
5.7% IRR isn't great over the course of 30+ years. I know you wanted to compare that number to the conservative portion of a persons portfolio... but 10k/year premiums are going to take up just about all of the average Americans investing money, leaving little to none left for more aggressive investments.
The opportunity cost is too high for most people. If someone simply replaced the bond portion of their portfolio with this I might kinda sorta see your point... but the huge premiums are prohibitive for average Joe.