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TERM LIFE INSURANCE is best for most people: It’s affordable, simple to understand and provides the two or three decades of coverage they need. But that doesn’t mean that permanent “cash value” life insurance is always bad.
The most obvious situation: You actually need insurance permanently. Suppose you’re a business owner and you want to provide money for your family to pay inheritance taxes. By buying life insurance, you’d make sure your family receives a pool of income-tax-free money upon your death, plus—if you held the policy in an irrevocable trust—the proceeds would also avoid estate taxes.
Alternatively, you might be the parent of a special-needs child who will always be dependent on you—and you want to ensure his or her financial future. In these situations, a 30-year term policy might get the job done. But the only way to guarantee your family is protected is with permanent insurance, whether it’s a whole life, universal life or variable universal life policy.
Another situation: Let’s say you’re a high-income earner who is maxing out your 401(k) and IRA, and you’re looking to sock away additional money for retirement. With a variable universal life policy, you could invest your premiums in the stock market and have the money compound tax-deferred for decades. If it turns out you don’t need the cash value for retirement and you still own the insurance when you die, your policy will pay out all the earnings as an income-tax-free death benefit to your beneficiaries.
Keep in mind that the fees within the policy are higher than if you just invested in mutual funds—and to get the tax-free gains you need to hold the policy until death. Still, for high-earning individuals with other savings to cover their lifetime needs and who have a long time horizon, the tax benefits of this strategy can be powerful and outweigh the higher investment expenses.
More recently, permanent policies have been used for nursing home costs. If you’re looking for long-term-care insurance, you might check out hybrid policies. These are technically universal life or whole life policies, but they’re designed for long-term-care needs. They provide long-term-care benefits if you need care, but return your premiums in the form of a death benefit if you pass away without needing care. The market for these products has grown steadily and current annual sales top $1.5 billion.
If you find yourself in one of these or another situation where a permanent policy might fit, here are some ways to make sure you get the right coverage and the best value for your money:
1. Be clear on your goals. Is your primary goal life insurance or retirement savings? What’s your budget? Are there other features that are important to you, such as long-term-care or critical illness protection? The clearer you are on your goals, the more likely you are to find a policy that meets them.
2. Customize your policy. Permanent policies—particularly universal and variable universal life—are incredibly flexible. There are a multitude of policy forms, premium structures and riders that can be used to optimize a policy to your needs. For example, if your primary goal is pure life insurance coverage, you could structure your policy to have minimal cash values, so that all your premiums are going to cover your death benefit.
On the other hand, if your goal is retirement savings, you could structure a policy to minimize the death benefit but maximize your cash value’s growth. It’s not uncommon for optimized policies to start building significant cash value in just a few years, whereas an “off-the-shelf” policy might not have a cash value that’s higher than the total premiums paid for 15 years or more.
3. Work with an expert you trust. This might seem obvious, but it’s worth emphasizing. Permanent insurance gets complicated very quickly and limited information is available online. It’s also very easy for unscrupulous agents to steer you toward products that maximize their commission, so it’s important to work with someone who puts your needs first.
4. Understand your risks. Most permanent policies have some elements that aren’t guaranteed. For instance, the investment returns or the cost of insurance might not be guaranteed. Make sure you work with an agent who shows you projected cash values under guaranteed and non-guaranteed scenarios, so you understand the range of possibilities. Also make sure that if the worst-case scenario comes to pass, and you only get those minimum guaranteed values, that the policy still works for you.
5. Plan for the long term. According to the Society of Actuaries, close to 40% of permanent life policyholders lapse their policies in the first five years. By year 10, that number is close to 60%. If you purchase a permanent policy, make sure you can afford to keep it permanently, so you get the protection you signed up for.
6. Do an annual review. It’s important to review your policy annually, assessing performance and ensuring your policy is still giving you the protection you need. If it’s underperforming and you need to increase your premiums to keep it in force, better to know that earlier, so you have plenty of time to fix the problem.
Dennis Ho is a life actuary and chief executive of Saturday Insurance, a digital insurance advisor that helps people shop for life, disability and long-term-care insurance, as well as income annuities. Prior to co-founding Saturday, Dennis spent 20 years in the insurance industry in a variety of actuarial, finance and business roles. His previous articles for HumbleDollar include Waiting Game, End Game and Policy Decisions. Dennis can be reached via LinkedIn or at dennis@saturdayinsurance.com.
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I suspect that too many moving parts in an investment product scares away most people?
@mikbarbasol:disqus – yes, I would agree, though that’s not necessarily a bad thing in my mind. The people who really need it can get expert help and/or spend the time to understand it whereas the people who aren’t sure they need it or don’t understand it should probably stay away anyway.
Great article Dennis. I have a close relative with some health issues that may lead him to convert a waning term policy to permanent insurance. It is very challenging and emotional.
@Rick Connor:disqus, thank you for the kind words. I wish you and your family all the best and please reach out if I can ever be helpful.
If you do buy a “permanent” policy be sure that it is actually permanent. There have been policies sold that assumed higher interest rates than turned out, and didn’t project the insured to outlive the policy at lower interest rates. Be certain that the suggested premiums are GUARANTEED to cover the policy for as long as the insured lives. And be sure this is in clear language in the policy.
Thank you for a well written article.
Concerning Variable Universal Life: You state “With a variable universal life policy, you could invest your premiums in the stock market and have the money compound tax-deferred for decades. If it turns out you don’t need the cash value for retirement and you still own the insurance when you die, your policy will pay out all the earnings as an income-tax-free death benefit to your beneficiaries.”
It seems to me, with proper tax efficient investments, you can achieve the same result in a taxable investment account at minimal costs. If you need the funds for retirement, you can sell paying only long term capital gains rates on that portion of the proceeds that are gains. How are cash withdrawals from VUL policies treated for tax purposes — ordinary income or capital gains? And, if you die without drawing any or all of the funds in a taxable account, your heirs would receive those funds on a stepped up basis so all earnings would be income-tax-free to the beneficiaries?
Other than possible estate tax considerations for the extremely wealthy, which you seem to address here — “By buying life insurance, you’d make sure your family receives a pool of income-tax-free money upon your death, plus—if you held the policy in an irrevocable trust—the proceeds would also avoid estate taxes.”
What am I missing?