Since I keep getting emails and comments on the blog about this, I thought I should devote (yet) another post to this topic. It never seems to get old, which is OK. I could go on proving my point until the cows come home.
I love my work. I especially love my work now that I've made extensive plans to broaden the scope and reach of my business beyond New York State, where I am located. One of the reasons I love my work is that not only do I love the opportunity to improve my skills and broaden my knowledge of the financial planning industry, I love to be challenged. I don't mind inquisitive minds. And, there are plenty of them out there. Sometimes I wonder though if some of these people are working for my competitors. Anyway...
With that being said, here is a question that was posted to the blog recently:
How does UL policies justify selling anyone an insurance policy that detracts from the insureds cash value until the is nothing left andd leaving them with a $0 death benefit unless they reinvest and say that is better that BTID theory?
Honestly, this sounds like the incoherent ramblings of a Dave Ramsey true believer, but I will attempt to give the question some serious consideration. The way an insurance company justifies selling a Universal Life insurance policy is that there are buyers. On a free market, you're free to choose whether or not you buy any particular product.
How do brokerage houses justify selling mutual funds when 94% of them fail to outperform their underlying index? Simple, there's a market for them. If you don't read the fine print of a contract before signing it, that's your fault. They are not responsible for your financial well being. They're only responsible for abiding by the terms of the contract or agreement that both of you sign and agree to of your own free will.
If you don't like the idea of having to read a contract before signing it, then my suggestion is to grow up, be an adult, and take responsibility for yourself and your finances.
As to the question of the vanishing cash value, yes, that does happen. There are many universal life policies today that are not designed for cash value accumulation. I repeat, they are not designed for cash accumulation. So, it should be no surprise that the cash values drain out from them eventually.
These policies include no-lapse riders that keep the policy from lapsing if the cash value is drained from the policy. Older universal life insurance policies were initially designed under a "buy term and invest the difference" idea (it stings, doesn't it?) and did not have this feature. The rising cost of insurance in the later years of the policy were not perceived as a threat (after all it was a new product in the late 1970s and early 1980s) during a time where interest rates being credited to the policy cash values were beginning to rise.
But, I would ask that you check your premises if you think that the insurance industry is out to rip off consumers intentionally. The history of the universal life insurance contract is an interesting one. It was not the life insurance industry that initially conceived of such a beast, it was the securities industry, and E.F. Hutton in particular, that developed and made popular the notion that "buy term and invest the difference" could work as a singular contract.
From this, and from pressure put on the insurance industry from the Federal Trade Commission over what they thought were "low" interest rates on whole life insurance policies, the modern universal life insurance contract was born. Everyone can see how successful that venture has been.
My view is that this product was an ill conceived and not well thought out response to the FTCs call for higher paying interest rates on life insurance cash values during the late 1970's and early 1980s. Another factor contributing to the rise of universal life was the fact that insurance companies were losing money to mutual fund companies and the group life insurance industry, both heavily influenced and sponsored by the Federal Government. In fact, as far back as WWI, the Federal Government thought it was wise to intervene in the insurance industry to help create the group life insurance market we see today.
Now, there are some universal life insurance contracts that are designed more for cash accumulation. The policy design is such that costs are leaned out, even in later years, policy fees are reduced, and the crediting strategy is such that the contract is almost certain to perform as expected. It's no guarantee, but the likelihood of the policy lapsing is small.
With that said, I don't think that anyone is saying that a universal life insurance policy that is designed primarily for death benefits, thus minimizing or eliminating the cash value in the later years of the policy, is better as a cash accumulation strategy than, say, buying a cheap term life policy and investing some money in stocks or mutual funds.
I think what is being said about those types of universal life insurance policies is that they are a great way to buy life insurance that is guaranteed to remain in force for your whole life due to the no-lapse guarantee provision in those policies.
How does WL justify charging double the cost of a term policy to help the insured save money but at the maturation of the policy only give the insured either the face value of the policy or the cash value built up in the policy when it is the insureds onwn moneyy they have been saving?
Since you cannot directly calculate the cost of insurance in a whole life policy, the implication that whole life is "double the cost" of a term life insurance policy is wrong. Speaking strictly of death benefit costs, they should be the same, since both whole life and term use the same mortality tables. As to the costs of the policy other than mortality charges, that varies by company.
If a whole life insurance premium is $100 for a $100,000 death benefit, most people are told that the premium represents the cost of insurance. This is seriously misleading. I often wonder how people who say such things on T.V. and on the radio can call themselves knowledgeable about these types of products.
Since there is a cash value component, some of that $100, actually, a good portion of it, is being set aside to cover the underlying investments that have to be made in order to meet the terms of the contract, namely the cash value - which is substantial for some policies.
The way they justify giving the insured either the death benefit or the cash value is because the policy owner is going through a process of self-insuring. When you buy a whole life insurance policy, even when you buy a term life insurance policy, you are leveraging a future savings that you don't have right now and paying for it on a month to month basis. That savings is something intended for your current and future financial responsibilities like a mortgage, or car loan, or any other debts you have incurred or are expecting to incur (i.e. funeral costs).
With the whole life insurance policy, you have the added component of the cash value which will become a sort of savings that you can use during your lifetime.
I know what the BTID folks are thinking. You're thinking that when you buy term and invest the difference, that you have both your savings and your death benefit (from the term life insurance) and therefore, you get to pass along more money than if you just had the whole life, which offers you the cash value while you're alive or the death benefit to your beneficiaries after you die - but not both. The misconception here is that the cash value and the death benefit are totally unrelated in a whole life policy. They're not. The cash reserve represents money set aside to pay for a future claim (the death benefit). The cash value replaces the death benefit over time. This is how the insurer can afford to insure you to your age 100.
The same life insurance companies that are vilified for selling whole life insurance also either sell term life, or are re-insuring companies that do sell term life. Either way, they're not stupid.
A life insurance company does not make money by paying claims. I'll say this again. A life insurance company does not make money by paying claims. They make money by retaining their reserves, retaining customers (and policy fees), and investing money. A major reason that term life insurance is so cheap is that most term life insurance policies never pay a claim. This is due, in large part, to modern medicine, and our life expectancy. It's also no coincidence that premiums rise dramatically after age 60.
If term life was guaranteed to pay a claim, then I guarantee - I GUARANTEE - the cost of term life insurance would skyrocket and it would cease to be the perceived deal of the century. As it stands, only about 1% of all term life insurance policies ever pay a claim. If you only had to pay out on 1%, or even 5%, of the promises you made, and you were an insurance company, do you think you could afford to offer those promises at rock-bottom prices? I think so.
It takes a lifetime to build up a savings assuming you are using the same risk profile for a "BTID" strategy and a "buy whole life" strategy. Term life represents a bet against yourself in some respects. Your beneficiaries get the death benefit if you die within the term. But, you have to die, and there won't be much in the way of savings.
Now, if you live out the term, your renewal rate on that term life policy is likely to be totally unaffordable (especially if you bought a 30 year term policy at age 30) and you'll drop it because you have a sizable savings. If you want to keep the term life policy, you'll have to destroy your life's savings to pay for those premiums.
On the other hand, paying whole life premiums may not yield a large savings for many years, and you'll almost certainly have a smaller initial death benefit with the same cash layout as the BTID approach, but at the end of 30 years, and in some cases at the end of 10 or even 5 years depending on the policy, your whole life insurance is guaranteed to be paid in full regardless of what happens to interest rates or dividend scales. In some respects, the whole life policy is a bet on your own success--the complete opposite of a term policy.
What's nice is that, with a good whole life policy, your cash value continues to grow and you end up with the same, or larger, savings as you would have had under a BTID strategy after 30 years. You'll also have more death benefit than you would have had under the BTID approach (because you dropped the term policy due to the cost of premiums). When you die, your beneficiaries get the death benefit. While you're alive, you have use of the cash value.
So, you see, you really don't get both the term life policy death benefit and your savings by buying term and investing the difference. You get one or the other, just like with the whole life. The difference is with BTID, your savings is your death benefit after you drop the term life, while the whole life death benefit remains intact.
The other difference is that the whole life insurance passes income tax free, while your savings from the BTID does not. That may or may not make a huge difference in the amount of money you leave to your beneficiaries.
I hope that clears things up for you Tammi. I always appreciate comments and legitimate questions, and while I try to be civil, some of the questions I get are not so much questions as they are "arguments from intimidation" (i.e. "Why do insurance companies rip people off...?") posing as legitimate questions and that, my dear readers, I simply won't stand for.
Enjoy the weekend, and keep those questions coming!
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This entry was posted on August 8th, 2009 by David C Lewis, RFC. Edits may have been made to keep this entry current. · 14 Comments · Insurance & Savings, Philosophy In Financial Planning