Is Life Insurance A Good Investment?

Last month, we discussed term life insurance and the important role it plays in protecting your family’s financial future. While term insurance does a great job of providing financial protection in the event of an untimely death, should families use other types of life insurance as long-term investments?

The life insurance industry in the United States is large and growing. According to LIMRA, US life insurance premiums set a new record in 2023 with over $15 billion in new annualized premiums. Only $3 billion of the total represents term life insurance which means 80% of the new premiums were generated from non-term policies.

When life insurance agents endorse the investment characteristics of life insurance, they are referring to permanent insurance. Permanent insurance is a blended product that mixes life insurance with an investment component where a portion of each premium payment is added to a separate cash value account within the life insurance policy.

The cash value account is designed to grow over time based on a set interest rate or it can be tied to underlying investment funds or indices. How the investment component works depends on the type of permanent life insurance chosen.

Overview of Permanent Life Insurance:

Permanent insurance premiums are much more expensive than term insurance for two primary reasons. The first is that the insurance policy is intended to stay in place for your entire lifetime which necessitates a higher initial premium. The second is that a portion of each premium is held in a separate account within the policy called a cash value account. The cash value account is a savings vehicle that can grow over time.

The key concept to understand with permanent insurance is that the premiums paid are larger than what is necessary to purchase insurance. The excess premium is held within the policy with the objective of growing over time.

How the balance of the cash value account grows is dependent upon the type of permanent insurance policy. The types of permanent life insurance include whole life, universal life, and variable life.

Whole Life: With whole life insurance, the investment component can be viewed as a savings account that allows the policy holder to earn interest on the balance invested.

Universal Life: With universal life insurance, the investment portion of the policy can grow based on an interest rate or it can be linked to an underlying stock market index like the S&P 500.

Variable Life: Finally, the investment portion of a variable life insurance policy includes the ability to invest in underlying funds within the policy. These funds are similar to mutual funds and provide the ability to create a diversified portfolio within the insurance policy.

Key Takeaway:

Permanent insurance has higher premiums than term insurance and allows a portion of the premium to be invested within the life insurance policy.

How Permanent Insurance Is Typically Sold:

As we will discuss later, there are certain cases in complex planning strategies where permanent insurance makes sense; however, for most of the population, permanent insurance is not the ideal solution.

Typically, permanent insurance products are marketed and sold by life insurance agents rather than being sought out and purchased by consumers. The life insurance proposition usually starts out with a focus on security for your family combined with the ability to achieve significant long-term growth for your future. Despite high premiums, it is framed as an investment in your future or as a gift to your loved ones – a way to create a legacy for those you care about.

Next the discussion shifts to the tax efficiency of life insurance and how life insurance can allow the policyholder to utilize the accumulated balance for tax efficient income in retirement.

Initially, it sounds like a great opportunity with minimal downside. However, the truth is that permanent life insurance is extremely expensive. The investment component of the policy is burdened with high fees that reduce long-term returns and result in underperformance for those who choose to purchase them.

While many individuals who sell permanent life insurance frame the proposal as advice, it is important to understand that their compensation typically comes directly through commissions from selling the insurance products.

When beginning their careers, most life insurance agents may be given a moderate stipend by the financial institution they represent to help them get started, but quickly they are required to generate significant commissions to meet their quotas and cover their expenses. If they are unable to meet these thresholds, they are forced to move on to a different career.

While this doesn’t mean that permanent life insurance is never appropriate, it does mean that the agents selling the insurance have incentives and pressures to sell products rather than give unbiased advice.

These incentives and pressures aren’t inherently wrong and are commonly found in any sales based industries as well (e.g. real estate brokers, mortgage lenders, car salesmen, job recruiters, etc.). What is unique to individuals selling life insurance is that they often use titles such as “financial advisor” that suggest they are primarily in the business of advice rather than sales.

Accordingly, individuals who are considering the purchase of a permanent life insurance policy need to understand that the individual selling the policy is likely paid to sell insurance. Thus, the purchaser should assume the responsibility for evaluating the policy to determine if it is the best fit for their financial situation.

Key Takeaway:

Individuals purchasing permanent life insurance need to understand that life insurance agents are first and foremost selling a product rather than providing advice.

Why Is Permanent Life Insurance So Expensive?

The primary reason permanent life insurance policies generally provide poor long-term growth is because of the significant fees associated with the policies.

Common insurance policy fees include:

Sales Charges: Sales charges cover the costs of selling the policy including the commissions paid to the agent. Sales charges are often substantial and are the reasons that most permanent insurance policies include a surrender charge in the event the policy is cancelled within the first few years.

Surrender Charges: Surrender charges reduce the cash value the policy holder receives if they cancel the policy within a specified number of years (typically between 5-15 years). The surrender charge is intended to protect the insurance company and help cover the initial costs of the policy if the policy is cancelled before the insurance company has had enough time to recoup their expenses.

Mortality Charges and the Cost of Insurance: The mortality charge is designed to cover the insurance company’s obligation to pay out death benefits to the families of individuals who experience an unexpected death. It represents the actual insurance cost associated with the underlying policy.

Administration and Overhead Charges: Administration and overhead charges represent the costs for the insurance company to manage the accounting and recordkeeping for all the policies.

Investment Expenses: Investment expenses represent the costs of underlying investments for policies such as variable life insurance that offer the ability to invest the cash value into investment products. These investment expenses can vary by policy and investment funds chosen.

Given the many layers of fees and the significant complexity inherent in permanent insurance policies, the average consumer finds it very difficult to accurately compare their policy with other alternative investment options.

In many cases when all the fees are added together, it is not uncommon to see total expenses ranging from 2%-5% of the policy value on an annual basis. With fees this high, it is not surprising that permanent insurance policies often substantially underperform other investment options.

Because of the high fees, most individuals would be better off purchasing term insurance to cover any life insurance needs and using the amounts they save on the premiums to invest directly in lower cost investment options.

Key Takeaway:

Permanent life insurance has very high fees that reduce the long-term performance of the investment component.

Long-Term Permanent Life Insurance Returns:

Given life insurance policies are subject to significant fees, long-term returns are typically well below what can be achieved with other investment options. For example, most permanent life insurance policy returns are based on a stated interest rate that is comparable to a money market fund or bonds. For investors with many years to invest, this approach is often excessively conservative and leaves a significant amount of future growth on the table.

Another option is to utilize a variable life insurance product which allows the policy holder to invest the cash value in underlying equity funds (i.e. S&P 500 fund). While these products allow for market exposure, investors still need to be very cautious of the overall fees which can significantly reduce the net return that investors experience.

Many investors understand the long-term potential of investing in the market, but at the same time, are concerned about the fluctuations of the market. In response to this, insurance companies have developed a product called indexed universal life insurance which we will discuss next.

Indexed Universal Life Insurance:

Indexed universal life insurance is usually bought by individuals with the understanding that when the market goes up, their account goes up, but when the market goes down, their accounts don’t decline in value. To most individuals this sounds like a no-lose situation.

However, to understand how these policies really work, it is important to understand that there are many nuances to how performance is calculated, and it varies from policy to policy. Typically, policies will track an index like the S&P 500.

When tracking a specified index, indexed universal life policies typically track the price of the index which means any dividends paid by companies within the index are excluded. Historically, between 2-3% of the total return of the S&P 500 has come through dividends with the recent average closer to 2%. Accordingly, without considering anything else, simply tracking the price of the S&P 500 index results in approximately 2% lower returns than investing directly and receiving the dividends.

Additionally, these policies usually impose a cap on upward performance that is limited to a certain percentage. For example, a policy may have a 7% annual cap on performance which means any time the index is up more than 7%, the policy holder’s account will receive a maximum return of 7% even if the index itself is up substantially more.

In exchange for not participating in the upside above 7%, the policy may provide a floor of 0% meaning policy holders will not see their account balance decline if the index falls during the year.

While this arrangement often sounds attractive given the protection from market downturns, it is important to run the numbers and see how such an arrangement would have played out historically.

To demonstrate, let’s assume a starting balance of $100,000 to be invested for 20 years. If we run the numbers applying a 7% cap and a 0% floor to the year-end price of the S&P 500 and compare the results to the full S&P 500 return including dividends, we get the following results for various time periods.

Period 1940-1959:

Period 1960-1979:

Period 1980-1999:

Period 2000-2019:

When looking at the charts, it is easy to see that the price only returns of the S&P 500 index with a 7% cap and 0% floor never declines in value due to the 0% return floor. However, it is also clear to see that in every instance the total return of the S&P 500 results in a substantially higher ending balance at the end of the full 20 years.

This occurs because the dividends and the upside in good years more than offset the market declines that happen occasionally. Even the 2000-2019 time period, when the Dot Com bubble burst and the Great Recession rocked the financial markets, ultimately resulted in substantial outperformance for those who were fully exposed to the S&P 500 despite the significant temporary declines.

In addition to underperforming for long-term investors, it is also important to note that the cap and floor returns shown above are simply the gross returns that would be credited to the cash value account within the insurance policy. The significant expenses discussed earlier in this post would reduce the returns further.

While indexed universal life insurance policies are structured in such as way that they sound like a win-win proposal, individuals need to review the details of their specific policy and understand exactly how the policy works including its limitations and historical results before proceeding. Keep in mind that the cap and floor strategy shown above is just an example, indexed universal life policies can be structured in many different ways which puts significant responsibility on the policy holder to ensure they understand the nuances of the policy they are considering.

Key Takeaway:

Long-term investment returns within insurance policies usually are significantly below the returns individuals would achieve by investing directly.

Is Permanent Insurance Ever Needed?

There are a few instances where permanent insurance may be necessary. They typically involve situations where an individual will need liquidity at death even if death occurs at the end of a normal life expectancy.

For example, if a family expects to have a significant estate tax burden and an illiquid estate, it may make sense to purchase permanent life insurance to provide liquidity when that time comes.

Another example would be funding a buy/sell agreement where partners in a business will need to buy out the deceased partner’s interest when one of them passes away.

The key point is that the situations where permanent life insurance usually makes sense are limited for most individuals, and even in those cases, the permanent life insurance policies are held primarily to provide liquidity upon death rather than as a long-term investment vehicle.

Individuals who need to protect their family as well as invest for the future generally will be better off purchasing term life insurance and investing the savings in non-life insurance investments.

Key Takeaway:

While permanent life insurance can play a valuable role in select circumstances, individuals who purchase permanent insurance should understand why their situation is unique enough to require the complexity and expense of permanent insurance.

What Options Are Available For Direct Investment?

Most individuals have many options available for direct investment without needing to consider permanent insurance. Many of these options also provide significant tax savings such as 401k plans through work; small business retirement plans for the self-employed; direct IRA, Roth IRA, or back-door Roth IRA contributions; and HSA accounts.

It often also makes sense to begin building a non-retirement investment account to create a pool of funds that can be accessed at any time to provide flexibility for early retirement or unforeseen needs the future.

The simple conclusion is that there are plenty of investment options that will allow individuals to efficiently grow their wealth without the complexity and significant fees of permanent life insurance.

What If You Need Advice?

One of the biggest challenges in the financial services industry is the difficulty for consumers to differentiate between advisors providing advice and salesmen selling products. The life insurance industry has grown to massive proportions by recruiting insurance agents to sell products on commission.

Often the individual buying the insurance product assumes the insurance agent is providing financial advice with a fiduciary obligation to do what is best for the client at all times. In reality, the insurance agent is offering a product for sale which puts the responsibility on the purchaser to independently evaluate the merits of the product being offered.

For many individuals who want advice, the best option is to work with a fiduciary, fee-only, independent financial advisor who can provide guidance on their entire financial situation.

A fiduciary financial advisor is legally obligated to put the client’s interests ahead of their own at all times. This ensures the client receives quality advice by aligning the client’s goals with the advisor’s legal responsibility.

A fee-only advisor is one who receives no commissions or kickback compensation from any third-party sources. All compensation comes directly through a transparent fee arranged directly with the client. This removes the incentive to recommend one product or solution over another due to commission based or behind-the-scenes compensation that the client doesn’t see.

Finally, an independent advisor is not simply a representative of a larger financial institution. Independent advisors do not have internal quotas of specific products that need to be sold and aren’t restricted to a specific institution’s products. An independent advisor can offer a strategy that is unique to you based on the best solutions available.

Key Takeaway:

For individuals who need or want financial advice, we recommending looking for a fiduciary, fee-only, and independent financial advisor.

Conclusion:

Life insurance in the United States is a massive industry with the majority of premium volume generated by the various forms of permanent insurance policies.

In most cases permanent insurance is not sought out by consumers. Rather life insurance companies have agents who are tasked with selling products to individuals. The commission-based compensation and sales structure within the insurance industry creates an environment where insurance agents are rewarded for selling products rather than providing advice.

While there is nothing inherently wrong with a commission-based system, it is important for consumers to understand that the system is sales focused rather than advice focused. Accordingly, the consumer who chooses to purchase a permanent life insurance policy must take personal responsibility for ensuring the product purchased is the best solution for their specific financial situation.

Although some consumers are comfortable taking responsibility for each financial decision on their own, others will look for advice from a trusted advisor. When that is the case, we recommend a fiduciary, fee-only, independent advisor to maximize the alignment of incentives and remove commission-based conflicts of interest.

For families who would like to work with a fiduciary, fee-only, independent financial advisor to learn how to protect their family’s future while also investing efficiently for the years ahead, we would love to connect to see if what we do is right for you.