By: Dennis Ho
Published in October 2020 by The HumbleDollar (original article may be viewed here).
As I’ve written in a past article, term insurance is typically the best fit for people who need life insurance with permanent policies being appropriate for only a few situations. But one of the questions I get frequently is does it make sense to purchase a whole life policy for a young child? While their children don’t have any financial dependents, these parents want to know if it’s worthwhile to lock in insurance pricing early on or if this is a good way to help their children get started with retirement savings. If you’re a parent considering such a purchase, here is a framework to help you evaluate the pros and cons.
To consider the first question — is whole life a good way to help my child lock in life insurance costs — we can use a hypothetical case study. Let’s say parents of a 10-year-old girl (we’ll call her Katelyn) assume she’ll need to purchase $500,000 of life insurance at age 35. One strategy is to purchase Katelyn $500,000 of whole life insurance today to guarantee she’ll have coverage. The best price I could find for this coverage was a premium of $2,040 per year, payable for life. By the time Katelyn reaches 35, she and her family will have paid in 25 years of premiums totaling $51,000 and will be required to continue paying $2,040 per year for the rest of her life. In contrast, if she waits until age 35 to purchase a 30-year term policy, the cost today is $370 per year for a 35-year old woman in the top health class (super preferred) and $675 if she’s of average health (standard). Despite locking in pricing 25 years ago, the whole life policy will still likely be 3–5x more expensive than the average 30-year term policy for Katelyn at age 35. Even if Katelyn has some major health issues in the future, it would be difficult for the premium on a 30-year term life policy to exceed the $2,040 per year of the whole life policy, let alone offset the $51,000 of past whole life premiums. We tested this with a few other scenarios and the results were similar. If your goal is to ensure that your child has access to life insurance in the future, purchasing a whole life policy is a very expensive way to do it. Yes, there is always the chance that your child has health issues that make life insurance not available at all, but when comparing the odds of that situation to the $51,000 of premiums in the scenario above, I would tend to say most people are better off not purchasing the whole life policy. Many of you will rightly point out that comparing whole life to term is not completely accurate given the opportunity for cash value build up, so that brings us to our second topic — is whole life a good way to help a young child save for retirement?
Using the quote for Katelyn at age 10, we can look at how the cash value of her policy builds up over time. With whole life, you have a minimum guaranteed cash value at each age plus you also receive annual dividends based on the performance of your insurer’s life insurance business. In general, higher interest rates will lead to more investment income, which increases dividends. Lower interest rates will do the opposite. Similarly, less than expected death claims will increase dividends and higher than expected death claims will reduce them. So with a whole life policy, you are participating in the performance of the insurer’s business but have a minimum guaranteed cash value to protect you if things go really bad. Let’s say Katelyn’s parents want to build cash value in the whole life policy for her to age 65 at which point they expect her to use the cash value to cover retirement expenses or perhaps purchase an income annuity or long-term care insurance. In the quote we got for 10-year old Katelyn, the company provided for a guaranteed cash value of $214,175 at age 65 vs. total premium contributions of $112,200 over 55 years. Using Excel’s nifty Internal Rate of Return (IRR) formula, this translates into a guaranteed annual return of 2.2%. The quote also provided for an estimated non-guaranteed cash value at age 65 which includes dividends based on the insurer’s current dividend scale. This value was $521,026 which results in an IRR of 4.8%. Actual cash values will certainly be different from this projection, but the $521,026 is a good proxy for what you might expect to earn on such a policy. When compared to other investment options, an expected IRR of 4.8% and a minimum IRR of 2.2% doesn’t sound too bad in today’s environment. But there are caveats. First, the whole life policy is highly illiquid, meaning to get these returns, you need to hold it to 65 and can’t make any changes to the premiums you pay. Second, your return is driven by the performance of a block of life insurance business which might not be a risk everyone is comfortable with. Finally, you will be exposed to a single insurer’s counter-party risk for several decades. I suspect folks who are comfortable investing their funds in the market or other higher-yielding asset classes won’t find these whole life returns attractive, but for those who want a simple investment and are comfortable with the caveats above, I would say, in this case, the whole life policy wouldn’t be a terrible way to put some money away for Katelyn. Because of the caveats above though, I would limit the allocation to less than 15% of Katelyn’s savings. Note, since pricing can vary, please don’t assume that Katelyn’s numbers apply to all whole life policies for children. This was meant to provide you with a framework for how to evaluate a policy and not a blanket recommendation, so please make sure you review any quotes you receive to confirm the guaranteed and expect returns under the scenarios you care about before finalizing any purchase.
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