Last time, I took a look at what life insurance is, the different options available, and what makes sense. After doing the math, I found that paying for term life insurance and investing the difference provides a much larger nest egg in retirement than whole life insurance could. So as I said at the end of the article, I called my insurance company to tell them I was cancelling my whole life policy.
As expected, my insurance agent tried to get me to keep my policy. But I was steadfast in my conviction to cancel and make the most of my investments. We even discussed the math I did to come to the conclusion that going with a term policy would provide me with more money at retirement.
We continued talking and he conceded that market investments would perform better than the cash value in my whole life policy. I thought to myself “Success! You admit it!” But then he mentioned that one of the major benefits of whole life insurance is the fact that it never goes down in value, unlike other investments, and since it doesn’t go down in value, it’s a good place to pull money from when the general market is down.
I thought about it for a minute and realized that I never actually looked at the math for that scenario. Thinking back to the numbers from my last article, the difference between the two options was so large, I didn’t think that market downturns would bridge the gap. But it wasn’t a sure thing either since I couldn’t easily run the numbers in my head. Would it be better to have an account that doesn’t go down in value during a market downturn? Would that ultimately give me more money?
By that time, I had already paid that month’s premium. This was probably a sales tactic but it was convincing enough to make me pause and think about it. So I decided to postpone cancelling my insurance and run my numbers again to see if he was right.
Term Life Portfolio and Whole Life Cash Value
I took my calculations from last article and expanded them out to include withdrawals in retirement. As with the last article, I want to be conservative in my analysis to avoid my bias towards term life insurance. While I was talking to my insurance agent, I was able to get updated estimates and found that the model I created from the 2015 estimates provided higher numbers than the new estimates I got from my insurance agent. The 2018 estimates showed 10% lower numbers than the 2015 estimates. Again, to give the edge to the whole life policy and avoid biases to the term policy, I used the model based on the 2015 estimates.
So here’s a summary of my assumptions. The whole life policy would cost $100/month and would be paid for 30 years. During that time, the premium would stay constant. The growth of the whole life cash value would be based on the (rosier) 2015 estimates I got from my insurance agent and withdrawals would be tax-free.
My term policy would be $13/month and would increase according to inflation each year which would be estimated at 3%. The difference between the whole life and term policy ($87 initially) would be invested each month into an investment account earning an average of 9% annually. After 30 years, the term life policy would be dropped and the investment account would reallocate the investments to be more conservative and only earn 6%. Any withdrawals from the investment account would be taxed in full at 30%.
After 30 years, I would have an estimated $62,000 of cash value in my whole life account while my investment account from using the term insurance would be worth about $141,000. Not a surprise, since we already knew that we’d have more cash value going the term life insurance route.
So now’s the time to see if my insurance agent was making a desperate attempt to keep me or if he was truly looking out for my financial well-being. Let’s assume that 5 years after retiring, the market goes into a recession. Using the logic from my insurance agent, the purpose of the whole life insurance is to be able to supplement income during down markets in order to provide more money in the long run.
During the recession, we’ll either pull money from the cash value in our whole life policy or the investment portfolio we made with the savings from going with term life insurance. The whole life insurance cash value will decrease according to the model based on the estimates from my insurance agent. On the other hand, the term life portfolio will decrease in value from the market. For 3 years straight, the investment portfolio experiences a 20% decline on top of the withdrawals. During that time period, we withdraw $1,000/month to help with various expenses.
After that period, both scenarios would have about $60,000 left. If we stopped there, it would seem that the term life portfolio ended up in the same place as the whole life policy. You would have taken substantially more risk by investing in the market but ended up in the same spot!
But life wouldn’t stop there. After the 3 year recession, we’d no longer pull money from the portfolio or the whole life insurance and we would let them grow. The term portfolio would grow again at an average of 6% annually while the whole life cash value grows according to the estimates. After a few years, you can see in the graph below that the value of the term life portfolio is much higher than the whole life policy.
As you can see, the term life option does result in more money in the long run. Yes, they had the same value at the end of our hypothetical recession but let’s review all the things we assumed.
- Whole life values are created from more positive 2015 estimates compared to 2018 estimates
- Whole life withdrawals are taken out tax-free while withdrawals from the term life portfolio are taxed fully at 30%
- Term life policy premium went up with inflation while whole life premium stayed constant
- 3-year market decline worse than The Great Depression
As I said in the beginning, I used the higher 2015 estimates for whole life insurance. Using the newest 2018 estimates would show even lower cash values for my whole life insurance.
My insurance agent also tried to tell me that my withdrawals from my whole life policy would be tax-free. But after digging into the details of how that could be, I found out that after I withdrew the amount I paid in premiums, future withdrawals would have to be done as 8% loans from the account to avoid taxes. After a few years, the interest from the loans would easily balloon! That sounds worse than being taxed on withdrawals!
In addition, I went ahead and taxed the full withdrawal from my term life portfolio to keep things simple. In reality, only the profit would be taxed and it would likely only be taxed at the long term capital gains rate of 15%.
Notwithstanding the tax analysis, the term policy went up each year with inflation. In reality, most term life policies you purchase will have their rate locked for the duration of the policy.
Finally, the 3 year market decline was especially bad to make the term portfolio perform poorly. To put our hypothetical down market in perspective, during The Great Recession the S&P 500 experienced an annualized 20% decline from it’s height in June 2007 to the bottom in June 2009. In our scenario, we’re using a “conservative” portfolio which wouldn’t be fully exposed to market declines like that. With a 50/50 stocks to bonds portfolio, a 20% decline in the S&P would be a 10% decline in your portfolio. Yet in our analysis, our conservative portfolio experienced a 20% decline meaning that the market declined closer to 40% each year and the decline lasted for 3 years not 2! Even the Great Depression, the worst financial market ever seen, was a better market than our hypothetical one, declining 30% annually from 1929 to 1932.
Even with all these advantages given to the whole life policy, it barely manages to keep up with the term portfolio.
Now that we can be confident that the whole life policy is not the optimal option, let’s see how a more realistic scenario would play out. We’ll compare the whole life policy to the market’s actual performance over a period of time.
This time, instead of hypothetical returns for the term portfolio, the returns would be the actual historical returns. The term portfolio would invest in the S&P 500 from 1974 to 2004. I chose this period because it includes the bull markets of the 80s and 90s but also the flat/bear markets of the 2000s. The portfolio would be fully invested in the S&P 500 during the dot-com bust so it loses substantial value, going from nearly $225,000 to about $120,000. After 2004, the term portfolio would switch to a 50/50 allocation between the S&P 500 and bonds, as measured by the AGG index. This would result in losses on some of the stocks but the portfolio would be more stable moving forward.
We would withdraw from the term portfolio and the whole life cash value during the recent recession from 2008 to the end of 2009. The withdrawals from the term portfolio would happen by selling stocks or bonds to keep the allocation as close to 50/50 as possible.
With this setup, our value over time can be seen below.
As you can see, the whole life policy is blown out of the water. There’s no comparison. With the investment portfolio, even though it was hit by both the dot-com bust and The Great Recession, it still performed way better than the whole life insurance estimates.
In the end, my insurance agent was just blowing smoke to try to keep me as a client. I can’t say I blame him, but I’m even more confident now about cancelling my policy.
As planned, I cancelled my whole life policy. Now I can take those $200/month and put them towards investments that will do more for me.