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What You Should Know About the Internal Rate of Return on Whole Life Insurance Cash Values

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What if you could combine the best elements of investing and insurance, and get a financial product that would simplify your financial life? It's a touchy subject, for sure, but the survey says: you'll be swimming is cash with a properly designed whole life policy. Properly designed is the key phrase here.

A previous discussion of life insurance myths and facts stirred up quite a debate, and generated no shortage of hate email. There are many reasons why whole life insurance may be good in theory, but does whole life insurance hold up in practice? It should be no surprise that whole life performs well under the right market conditions. After all, observation of reality is where product designs originate from.

In the case of whole life insurance, a need to provide lifetime insurance coverage, along with an integrated savings and insurance plan, was demanded by the marketplace. Savvy insurers rushed to fill this need, and they succeeded. Still, we see ample criticisms made against the insurance industry claiming that whole life is a dated financial product, and has no place in any person's financial plan. However, a second-look at whole life may be warranted based on actual long-term performance of the product.

From Theory to Practice

Observational evidence shows that whole life insurance has performed exactly as illustrated for at least one life insurer. While this does not make the case for whole life conclusive, it does raise questions about the antagonist's motives for arguing against whole life. When comparing actual performance against the illustrations of the insurance company, it will become more clear what you can expect from this kind of product as well as what the value--if any--is in relying on those illustrated performance rates handed out by life insurance agents.

Whole Life Insurance As Self-Insurance

Whole life insurance is a contract which extends the death benefit of the life insurance policy out to your age 100. Because it does this, the insurance company has to come up with a way to make sure that all of the costs associated with providing that death benefit are paid for. With term life insurance, the insurer factors in a probability of death as well as lapse rates (the probability of people dropping their insurance coverage before the end of the term specified in the contract). With whole life insurance, the assumption is that the probability of death is 100 percent.

Insurers do factor in lapse rates for whole life as well, but they have to be cognizant of the fact that people can keep their whole life policy until they die. This naturally increases the cost to provide the insurance. The reason, contrary to what you might have heard, is because the insurer must earn enough interest on the premium dollars paid on the policy to pay the death claim all the way out to your age 100. So, the assumption is that you'll live to age 100, and then die. At this point, the insurer must have enough money to pay the death benefit claim. This is why whole life insurance cash values equal the death benefit at age 100.

As the cash value builds up, the death benefit amount decreases. The cash value is nothing more than a cash reserve for the policy. This cash reserve functions as a sort of savings. It's an advance on the future death benefit claim that the insurer will pay out to you. So, while some folks complain that they do not receive the cash value and the death benefit, they ignore the fact that you also aren't paying for both. If you actually want to pay for both insurance and have a savings, then buy term and invest the difference.

Following the theory of decreasing responsibility (and as I discussed in last week's blog post), you'll have a lot of cash and very little death benefit left when you retire with a whole life policy. You'll have even less as you near the end of your life. This is assuming your financial adviser knows what the heck he is doing and sells you the correct policy for your age. All of this means that whole life insurance is essentially a process of self-insuring with the assistance of the insurance company as an investment guide.

Inflation and Whole Life Insurance

Inflation tends to be a problem for whole life insurance, which pays a fixed rate of return. The insurer guarantees that the cash value in your policy will equal the death benefit you initially purchase by the time you turn 100. But, it doesn't guarantee the value of that money. In other words, it doesn't guarantee what the money will be worth at that age. If you relied on just the guaranteed rate, the value of the policy's cash reserve savings would decrease substantially over time.

There's really nothing the insurance company can do about inflation. The fixed interest paid on the cash value of the policy is driven by the investments embedded in the contract.

Whole Life Insurance vs. Investing

Insurance companies invest the premiums received on whole life policies into their general account. The general account is an investment account that is comprised of various types of bonds, mortgage investments and sometimes common stocks. So much for the idea that whole life insurance cash values aren't an investment. We do say that whole life cash values aren't an investment because the Securities & Exchange Commission will get trigger-happy whenever you say the word "investment" while thumbing your nose at securities laws. But, the cash value of whole life is, de facto, an investment.

Some people might say that it's a poor investment. That really depends on the insurer and what they're willing to pay on those cash values. While there are many, many ways to overcome the plain vanilla fixed rate without losing the guarantees inherent in the contract, one of the strongest ways is through the use of dividend payments.

Dividend Paying Whole Life Insurance

A mutual life insurance company is an insurance company owned by its policyholders. This means that the company may share its profits with the people who own the company. Instead of paying dividends to regular shareholders, the company pays dividends to policyholders. Like any other business, dividends are not guaranteed. Unlike other companies, dividends are tax-free for life insurance policies as long as the policy remains in force and the dividend becomes part of the policy.

Dividends may be used to purchase additional insurance. This insurance is "paid up", meaning that no other premiums are required to keep the additional insurance in force. That's good because constantly increasing premiums on whole life would suck badly.

Most financial advisers incorrectly argue that dividends are a return of premium that you've previously overpaid. The IRS says this, and even insurance companies have folded and explain it this way. This is partially true in a sense, but it doesn't capture the entire story. Life insurance companies do collect more premium than they need to sustain the functions of the policy. But, this money is invested and then returned to you as a dividend. Part of that dividend necessarily will be comprised of whatever the insurer gained on that investment. The evidence of this is that dividends can and usually do exceed the amount of premium you pay on the policy at some point. How does everyone explain what dividends are when they are 2, 5, 10, or 20 times the premium? How could a dividend be a return of premium if it exceeds the premium payment?

In any case, dividends add a variable component to a whole life policy. The dividend function adjusts annually based on the performance of the insurer's investments as well as how many claims they had to pay out. The fewer the claims, the higher the investment return, the more the dividend payment is.

Performance of Whole Life

I won't belabor the point that dividend-paying whole life ought to perform quite well given the nature of the product and the fact that insurance companies normally run a tight ship. Before I reveal an example of actual performance numbers, I want to make it clear that I am not in any way endorsing the company I am about to put on display. I am not making any kind of recommendation for you to buy their products. This is just for illustration purposes and to be used as a visual aid in presenting my view.

Look at this historical dividend study on Mass Mutual's whole life product:

whole life
Limited-pay whole life insurance has had a tax-free real rate of return
of 6.52%! WOW!

I want you to take note of the fact that Mass Mutual's worst performing product is their Convertible Whole Life from the MM Block. The internal rate of return (IRR) is 4.49%. The best performing product in this study is the 10 pay whole life. The internal rate of return (IRR) is 6.52%.

OK, what does all of this mean? Internal rate of return is the rate of return after all fees, expenses, commissions, etc. are paid. This is the net or real rate of return on the policy's cash values. Not bad eh?

But, it gets better. These values are also tax-free returns, since cash values are not taxed when removed from the policy (as long as the policy isn't surrendered, you may use the cash values for any purpose you want during your lifetime on a tax-free basis). The IRR on the 10-pay translates into a taxable return of a little more than 7.65% assuming an average tax rate of 15% (that's low if you are assuming that that includes state taxes as well). Most people would kill for that kind of action; especially if the investment was guaranteed never to lose value (which is exactly what a whole life policy guarantees).

Take note that this is not the "illustrated" rate of return, but the actual performance of the policy. I want to stress that point, because detractors immediately start in with "yeah, that's what they say you'll earn. But, you'll never get those returns." Erroneous. These returns are what the policy actually paid. Even if you did only realize the illustrated rate, 4.23% on the 10 pay policy isn't too bad for a fixed interest product.

These policies were tracked from 1980 onward. It stops at 2008, when the study was completed, but 2009 and 2010 saw dividend payments that are in line with the general trend you see in the study. You cannot predict dividend rates, since they depend on certain functions which are outside of your control. What the study shows is that insurance companies often do not pay what the illustration says they will pay. That's not to say that they always pay more. Sometimes, they pay less than the illustrated rate.

Is Whole Life A Good Investment?

Some of the performance of your policy has to do with the expectations you set for yourself and for the policy. The performance of the policy also has a lot to do with when you buy into a policy. If you bought into a whole life policy in 1990, then watched as interest rates dropped, your policy values today would be less than what was illustrated in 1990. But, interest rates are low now, and that's to be expected. You might not like it, but it is what it is. Rising interest rates may allow you to realize that illustrated rate at year 30. For those buying in today, your policy values could be astronomical compared to the illustrated rate.

Thumb your nose at people who say that whole life is, or has been, a shitty investment. I'd say that, today, a well designed dividend-paying whole life policy is an excellent buy.

This entry was posted on March 18th, 2011 by David C Lewis, RFC. Edits may have been made to keep this entry current. · No Comments · Insurance & Savings

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