There are a lot of things to know when you are doing this.
Firstly, if you are buying life insurance, it’s usually going to be better to work with a “Mutual” insurance company rather than a stock insurance company. Mutual insurers are owned by the policy holders and stock companies are owned by whoever bought stocks in them. If there is money left over after they have paid their expenses (“dividends”), mutual insurers return it to the people who paid premiums and stock companies pay it to the people who own stocks. All things being equal, it’s better to be able to get some of your money back.
Secondly, what I strongly suggest for most people is a blended policy. These are a mix of different combinations of insurance that have all the benefits and none of the drawbacks. They are harder to setup and harder to understand, but IMHO the payoff is worth it.
The plan I would generally suggest is starting with a low death benefit whole life policy of maybe $50 per month. Then add a level premium term rider of another $50 per month. Scale those numbers as appropriate for your financial position. Then add a Paid Up Additions (PUA) rider that lets you pay extra to immediately add completely paid off whole life insurance any time you want. With your dividends, I would suggest having them offset the premium cost of the policy and if there is more than enough to completely pay for the policy then use it to buy more Paid Up Additions.
Why I suggest this course of action over others:
- As anyone in the financial world will tell you, you get a lot of bang for your buck with Term life insurance. This helps ensure that you can pass more to your beneficiaries in case you die too soon. It also goes a long way towards preventing your policy from becoming a Modified Endowment Contract (MEC) which you don’t want to happen.
- The Whole Life basic portion of this policy will ensure that you get to pass money to your heirs if you live the long and healthy life that we hope you do. Level premium Term will go down in death benefit every year and the Whole Life will go up in death benefit every year. Ideally, this will cancel out early on and when the death benefit of the whole life portion gets high enough (or you become uninsurable) the term life coverage will drop off and you will still have a sizable death benefit to pass on to the next generation or for use in an act of charity.
- With Paid Up Additions, you can pay a lot more money than the minimum into this policy if you want to. This increases your death benefits and the yearly dividends you receive. Doing this will cause the amount of yearly dividends to surpass the yearly premiums much more quickly.
- This allows for maximum flexibility. The minimum premiums for this policy are very low as compared to basic permanent coverage with the same death benefit. This can be very helpful with cash flow management. You are able to pay maybe 4x the minimums and buy PUAs with the overage if you want to.
- This sort of policy allows for diversification across asset classes and risk management. Both of those are helpful for financial planning and aren’t present when you concentrate within a single asset class.
- The maximum amount of stuff is completely guaranteed. Your low minimums can’t go up, they can’t cancel on you, and stuff like that. What isn’t guaranteed probably has a pretty consistent every year for 100+ years history
- You can borrow using the policy as collateral. You could do the same thing with some stock accounts or your house if you are a home owner. Theoretically, it would be the same in any of those cases. However, if you borrow from the insurer directly, the loans are no questions asked. If you choose the right insurer, they will even pay you dividends as if you hadn’t borrowed.
- You can do interest rate arbitrage. Your dividend rate will probably be pretty stable. If you are able to borrow at a lower rate than that, you can do some interesting financial stuff. Learn a lot of stuff before trying to do any of this.
- You minimize profits to the insurers/agents by structuring things this way. The agent that you work with on this policy will probably get 80%ish of the $50/m of whole life, 25%ish of the $50/m Term, and 2%ish of the PUAs. This is far less than the same premium 100% in whole life and about the same as 100% of the premium in Term. The more you go in on the PUAs, the lower that percentage is.
- The dividends really aren’t that bad. When the average person is in control of their stock accounts, they often try to “time the market” or, in other words, they buy high and sell low. This pushes the average person’s stock performance way down compared to stock performance on paper. That makes blended policies a lot better in relation to stock accounts.
What you need to know before you consider this:
- Getting advice from somebody that is not trying to sell you a specific thing is a good idea. Fee only financial planners might be an example. I am not paid by any financial company and I don’t have any licenses to sell financial products. Please have them look over this page and see if they agree with the concepts therein before purchasing anything. At the very least it might help give you confidence in what is being suggested here.
- Most of the people you might get advice from regarding this probably haven’t investigated the upsides and downsides of structuring things this way and therefore cannot competently advise either way regarding this.
- If somebody says one component of this insurance is bad therefore everything must be bad, they might not know what they are talking about.
- This requires a serious commitment. You should think about this as if it’s similar to a mortgage. Indeed, this should be more mortgage-like (until death, in French) than an actual mortgage is. Please do not buy this unless you will see this though until your heirs/your favorite charity receive(s) the death benefit check.
- The minimum payments on this will be pretty low, but you absolutely must commit to them. Please do not let this policy get behind or lapse because you aren’t holding up your end of the deal.
- This should not be your whole plan. You absolutely should probably also get a mortgage on a house and you should absolutely also spend at least as much in a 401k as your employer is matching. If you have enough money to fund both of those things, this insurance policy, and you have some left over, I would suggest using a Roth IRA. Do diversify across asset classes.
- Going heavy into the PUAs early is strongly advised. The PUAs are where most of the effectiveness of this policy structure comes from. They help the policy pay for itself more quickly, they keep the minimum payments low, and they reduce the commission percentage you are paying to someone else.
- This is all very complicated. It’s potentially hard to wrap your mind around. That is neither good nor bad, but it does require more work from everybody.
- You probably really don’t *need* 15 or 20 times your salary in insurance. You aren’t going to be ensuring your spouse (or whoever) won’t have to work ever again if you get only 6 or 8 times your salary, but it will still last a pretty long time most likely. At least long enough for a spouse to remarry or for kids to make it to adulthood. It would be nice to have more insurance rather than less, but less is probably OK if you really think about it and the blended insurance is much more likely to actually pay out.
- If the insurer you buy this from somehow goes under, another will very likely assume administering the policy more or less where the first one left off.
- In exchange for taking an approx 4.5% dividend per year rather than a maybe 8 or 12% per year stock market gain, you also transfer all of the downside risk of a stock market crash to the insurer for whatever portion of your assets are in the blended policy. A 4.5% per year expected return is not horrible by any stretch. If you still keep a large portion of your assets in high quality stocks (strongly advised), your overall portfolio yield should still be quite solid .
Why should I do this instead of something else? How does this compare against:
- Buying bonds with a percentage of your income?
This is probably what this insurance structure is most similar to. A lot of people buy bonds with a portion of their portfolio assets that they aren’t able to cash in until retirement (without steep penalties, at least). The yields and stuff are pretty similar to that. The bonds won’t require future investment to maintain, but they also don’t give you the best investment gains imaginable if you keel over tomorrow.
- Maintaining a large cash account.
This is probably what this policy is second most similar to. This policy can potentially be a really good place to keep assets you need to be able to spend on short notice but that you don’t want to leave sitting in a cash account.
Definitely do keep some in a cash account regardless of buying a policy like this or not, but you can slowly move cash to here over time so it will earn better interest rates.
This policy will be a lot better if you die quickly or if you die slowly, most likely. The time that a large cash account compares most favorably is if you need all the money in the first few years and it wasn’t because you died.
- Buy term and invest the difference?
Term insurance provides more insurance per dollar than this will in the short term. Buying term and investing the difference can potentially provide better returns than this plan all around IF the investments do really well.
In the year 2000, the S&P 500 (VFINX, for example) was at about 130. Currently 1/16, the S&P 500 (VFINX) is at 177.35. That is a 16 year compounded return of like 2% without counting fees. Keep that in mind if someone tries to convince you that you will get 8 or 10 or 12% returns per year in stocks.
I would absolutely advise everyone to put a great deal of their holdings in a diversified index fund. A diversified index fund is probably the best hedge against inflation that there is. However, I would advise against putting all your retirement eggs in this one basket.
- Universal Life (UL) Contracts
The policy structured as I described is a whole lot safer all around. A lot of UL products have a term insurance portion that renews each year and increases in price each year until the price for the insurance portion gets really really high. Investment gains are supposed to offset this, but UL contracts in general are at a greatly increased risk of crashing and burning compared to what I described.
A lot of UL contracts have flexible pay schemes that are similar to what I described. Most UL contracts guarantee next to nothing whereas there are a lot of guarantees in the blended policy I described. Risk of minimum performance is much greater with UL contracts than with a blended policy as I described written by a mutual insurer with a 100+ year track history.
UL contracts are similar but almost strictly worse than buying term and investing the difference, so anything else that applies there also probably applies here.
UL minimums are much more likely to come into play than the minimums from the blended policy are. UL minimums are often calculated once for the whole policy at the end rather than say 2% per year minimum. UL doesn’t mean you will get +2% in the year when stocks get -20%. Your UL portion for investment will almost certainly be affected by that whole -20% the same as the people buying stocks are affected by it.
- Buying only Whole Life + PUAs without the Term
You are much more likely to cause the insurance policy to become a MEC if you do this. You will also most likely be paying higher commissions to the insurer/agent. Term keeps the death benefit high and therefore the “insurance corridor” high.
Term is also a really good deal if you die early, which is possible. If you die early, you will be glad you have the term portion on there. A lot of the benefit of life insurance is just in case you do die too soon, and term is the best way to get over that roadblock. Buying the term insurance in a blended policy kills multiple birds with one stone.
The time when it’s most important for the policy to not be a MEC is if you need to get some kind of benefit while you are still alive. Because a lot of the benefit of this blended policy is in ways it can help you while you are alive (you can get a loan against it) you want to avoid the policy becoming a MEC. Moderate amounts of term are neither costly nor wasted.
- Buying WL only and neither Term nor PUAs
I can’t see any reason to do this. I don’t think that this can ever be a better strategy than the blended policy I described. The straight whole life will have greatly higher minimum payments, probably a lower death benefit, will result in greatly higher commissions for the insurer/agent, will take a lot longer to build up a cash value you can borrow against, will result in greatly lower dividends paid to you, and other stuff like that.
The only thing that might be in straight WL’s favor (that I can think of) is if you can’t understand the blended policy as described AND you can understand WL AND it would give you more peace of mind to be able to completely understand your policy.
I have spent hundreds of hours trying to find reasons not to get a blended policy along the lines I have described and the strategy has come through IMHO more or less unscathed. That being said, do not fall into any of these traps:
I have seen similar strategies portrayed as miracles (they aren’t).
I have seen people suggest that ALL your available money should be in such a policy (I would strongly advise against it).
I have seen people suggest borrowing the maximum against the blended insurance policy (know what you are getting into before trying this).
I have seen people suggest borrowing the maximum you can (cash out refinance house, second mortgage, loan against 401k, etc) in order to fund such a policy (most likely a terrible mistake).