Permanent life policies pitch savings growth…
at a price
If you’ve ever shopped for life insurance, you’ll know you can quickly get tangled up in a thicket of plans, policies, terms, exclusions, riders, benefits, and all the other paraphernalia that comes with talking to an insurance agent. The biggest of these is the pitch that life insurance can be an investment. Some types of insurance do have an investment component. But is it worth it?
First, a quick intro to life insurance. There are many types of life insurance policies. “Term-life” policies, for example, offer pure protection – there is no investment component. You pay your premium and your life is insured for the stated amount for the specified length of time. Period. It’s a cost-effective way to buy insurance, especially for young families.
Alternatively, there’s a type of insurance called “permanent life.” Broadly, with these types of policies, you pay premiums on a monthly basis for a specific period of time, but the premium payment funds both an insurance component and an investment component by which the policy gains a cash value. The growth in cash value is tax-deferred and can be used as collateral for a loan or can be withdrawn to fund other financial goals.
There are basically two forms of permanent life insurance: whole life and universal life. The premiums for these are considerably higher than for straight term life insurance. Both whole life and universal life policies provide protection, grow your investments, and defer tax. Upon death, your beneficiary will receive the amount of the insurance policy tax-free, as well as any accumulated savings components, which would be subject to tax. But there are key differences.
Whole life locked in
As the name suggest, “whole life” insurance does not have a term, and stays in force until you die. It has level premiums that fund both the insurance component and the investment component that builds up a cash value.
In a whole life policy, you have no choice over the investment component. The insurance company will invest the funds at a very conservative rate, and it takes a long, long time to generate positive returns. There is also some risk involved, as you are investing your money with a single company. Canadian banks and insurance companies are among the most financially sound on earth, but you still have to be aware of the risk involved, however small it might be.
Universal life for some flexibility
Universal life also offers both insurance and investment components, with the key difference that you can alter the premiums, size of death benefit, and amount and type of investment component (as specified by the policy) if your life or financial circumstances change. In addition, unlike whole life insurance, universal life insurance allows you to use a portion of your accumulated savings to pay premiums. The major advantage to this type of policy is that you have control over the investments.
When you are ready to withdraw money from the investments held within the policy, the cost base is equal to the sum of all your premiums – the amount used for both the insurance and investments. This will increase your cost base, so you will pay less tax once you sell your investments within the universal life insurance policy.
Weigh your options
These types of insurance policies might be suitable if you are looking for three types of solutions in one product: life insurance, long-term low-growth savings; tax deferral. The big question is whether the investment portion of a permanent policy is worth the cost.
With a universal life policy, you have a bit more leeway in choosing investments among those allowed by the contract, but it’s often a choice that boils down to either fixed-income or specified mutual funds. Again, you have to weigh the risks of giving up investment diversification over the long term in return for an insurance component and an ending cash value.
Note too that investment returns are not guaranteed, unless the investment component carries some type of internal guarantee of principal, such as segregated funds. These may have uses in some circumstances, but they come with a high cost. In addition, there may be a surrender charge if you take money out of a universal life policy in the first 10 years. Other fees, charges, and commissions may also be involved, further raising your costs for this type of insurance.
Buy term, invest the rest
In general, while they have their uses in some situations, most advisors recommend staying away from permanent life insurance policies, whether whole life or one of the many flavors of universal life. For many people, the old saying to “buy term and invest the rest” is probably the most sensible solution if you’re considering a life insurance policy as an investment. It means simply that you buy term life insurance and then invest the difference in premiums, fees, commissions and charges that you would have paid for a whole life or universal life policy.
In any case, it’s important that you speak with your independent financial advisor (one not tied to selling insurance products from a specific company) to determine both your investment and insurance needs in the context of your overall financial plan.
© 2014 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited.