Whole Life Insurance
Updated: Dec 5, 2022
Recent market volatility has led to a resurgent discussion about non‐correlated assets including whole life insurance. Let’s revisit what whole life insurance is, how it may help secure an overall financial plan, and put it into context with other commonly held asset classes.
Whole life insurance is a financial mortality product also known as “dividend” or “participating” life insurance. Unlike term insurance which typically expires prior to life expectancy, whole life insurance is a permanent financial contract that will remain in‐force for the insured’s lifetime and pay a death benefit to the designated beneficiary if contractual obligations are met.
Specifically, whole life insurance is a legal contract between a policy owner and a mutual insurance company. The policy owner contributes contractual premiums over a specified number of years and the insurance carrier invests the premiums and guarantees a minimum interest rate to endow the contract for the policy owner. Endowment in insurance jargon describes the age when the premiums plus interest equal the death benefit. An example of a guaranteed endowment illustration for a female age 22 who allocates $10,000 per year for ten years is shown in Chart 1 with its corresponding after‐tax internal rates of return (IRRs) net of all insurance costs shown in Table 1:
At age 121 the guaranteed after‐tax IRR on both the accumulated cash value and the death benefit is 1.51%; therefore the contract value endows at $412,588. Granted, a 1.51% annualized return over a 99 year period is not very enticing. On the other hand, what non‐governmental entity could realistically promise more than 1.51% over such a long time frame? If this were the end of the story, very few people would allocate to whole life insurance. (Note that the insurance company’s guarantees are only as strong as their claims‐paying ability so there is counterparty risk in these contracts).
More importantly, when you purchase whole life insurance you become an owner of the insurance company that issued the policy. This means that, in addition to the guaranteed interest, the insurance company can also pay an annual non‐guaranteed “participating” dividend, which, when left inside the policy, can increase the value of the contract. Chart 2 shows the same contract (female age 22) but includes the projected dividends at the 2022 dividend scale:
In Table 2 we see that the contract is still projected to endow at age 121 but because the non‐guaranteed dividends are projected to be more than the guaranteed interest, the contract IRRs and contract values are higher.
Chart 1 and Chart 2 show that the return path for both cash value and death benefit is very predictable. Predictability in financial products is valuable. Whole life insurance performance is uncorrelated to most other financial products because it depends mainly on the insurance company’s mortality pricing and experience, their ability to source and manage credit and default risk when investing client premiums, and the policy owner’s specific policy activity (whether contractual premiums are paid as planned, whether the policy owner takes any policy distributions, and when death occurs).
Is whole life insurance attractive? To put whole life insurance returns into context, here they are alongside historical annualized holding period returns as of 2021 that could have been earned in other commonly held asset classes. To make things more relatable, I measured the returns for three imaginary clients born in different years: 1954 (Baby Boomer), 1977 (GenX), and 1984 (Millennial). I have assumed each client allocated the same $10,000 per year for ten years into each respective asset class, beginning at age 22, and assumed zero taxes along the way for simplified illustrative purposes:
Notice that the results in Table 3 are not apples to apples. The person born in 1954 has had 46 years in the markets. The person born in 1977 has had 23 years. The person born in 1984 has had only 16 years. But it’s helpful to examine three different holding periods to better highlight how a whole life insurance policy can complement a client’s plan over their entire lifetime; both when they are younger and also when they begin to approach life expectancy.
In most cases, the longer the holding period, the higher the return. However, notice that the highest return in Table 3 is the whole life insurance death benefit return of 15.09% for the Millennial. This return is actually beating the S&P 500 Total Return over the same period. This is not a fluke. Rather, it’s one of the most important features of whole life insurance and is exactly the intended result of a mortality product. The purpose of a mortality product is to advantage clients who die early. Of course we all want to live a long, healthy life but mortality products exist to protect us against the risk of early death. The “protection” provided by mortality products is specifically to allow beneficiaries to capture excess returns that are otherwise lost when untimely death abruptly stops the compounding process.
For the 50% of clients who will instead experience longevity, whole life insurance naturally ages/transitions into an asset providing a bond‐like return profile which can be accessed for tax‐free liquidity during the client’s lifetime. The predictable and always positive returns from whole life insurance help explain why this product has been around for over 100 years and continues to be popular across the entire net worth spectrum. Furthermore, the non‐insurance realized returns in Table 3 would have been lower because of taxes paid on dividends, interest, coupon payments, and realized capital gains along the way. After taking taxes into account, the complementary nature of whole life insurance as an asset becomes clearer.
By providing protection against the risk of early death, as well as maturing into a seasoned tax‐advantaged cash vehicle, whole life insurance is a multi‐faceted asset and should be considered as an important financial tool in building a balanced portfolio. It is a tried and true instrument that protects against mortality risk, tax drag, and tax regime uncertainty. Finally, the death benefit is paid to the beneficiary income tax free, and, if properly structured, estate tax free.
Whole life insurance is one of the simpler and more elegant options available for wealth accumulation and wealth transfer. It is a unique non‐correlated asset that is not as complicated as it may seem. Its place amongst client assets becomes clear when considering access, return volatility, tax considerations, and ultimately, legacy.
Past performance is never a guarantee of future results.
Narra Megli is the Senior Manager of Products and Case Design and works with the life insurance consulting team to provide customized proposals for current and prospective clients.