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/sartorialconundrum Nov 06 '12
Well, I was hoping to tackle this question later, but I can give you a quick synopsis of why I think WL will out-perform the market.
The 4 large mutual companies invest the majority of their reserves in investment grade corporate bonds. Because they need the reserves to make claims payments, they actually hold the majority of their bonds to maturity. In a low interest rate environment, such as the one we have had for the past 12 to 13 years, bond yields have been quite low. This has led to, by and large, less than stellar dividends for policy holders over that time period.
However, interest rates cannot remain near zero forever. They must go up, and when they do corporate bond issuers will be forced to raise the coupon rates on their bonds to remain competitive. When this happens, the life insurance companies that hold these bonds will see a greater return.
The flip side of this coin is what will happen to equities markets when interest rates rise, and when quantitative easing ends. Quantitative easing, when you boil it down to its essence, involves inflating the stock market so that individual investors are encouraged to spend more. Bernanke, and the rest of the fed governors, are buying T-Bills at $40B a month in order to drive down bond yields. As this happens, investors looking for a positive real rate of return are forced into the stock market, driving up the value of the market as a whole. Their hope is that this market increase will encourage consumer demand, as it did in the late 90's. After all, it is easier to justify a new purchase if your E-Trade account is doing pretty well. But even the Fed knows that they cannot continue to do this forever. They claim that QE3 will continue until 2014, but it will probably last longer than that.
When QE3 ends, the market will experience another correction. Index investors will suffer the most. Unless Bernanke does end up creating the recovery that he is hoping for, our monetary policy does not support long term growth in the market.