Should you use life insurance instead of traditional investments? Let’s see.
Is It an Investment or Not?
A lot of people will tell you life insurance is not an investment. In some jurisdictions it literally cannot be described as an investment under the law.
Nonetheless, what you do with your cash value can easily be colloquially conceived as an investment so I’ll set aside the semantics and address this cash value feature and what can be done with it.
What Is Cash Value?
As a matter of regulation, whole life insurance products must accumulate a refundable cash value over time. The amount accumulated with each monthly premium is typically very small, particularly in the first couple years of the policy, and if you turn in the policy for its cash value sooner than ten years after you bought the policy, there are typically steep penalties.
However, insurance companies found ways to get creative with what they do with the cash value in order to compete with each other. They have also created ways to access the cash value that don’t require termination of the policy, which, structured right, have the effect of “withdrawing” cash without having to cancel the policy. Many policies also let you use the cash value to pay your premiums if you find yourself unable to pay them.
Insurance companies often allow policy holders to overpay premiums to directly contribute to the cash value and take advantage of policy features
Interest on Cash Value
The most basic thing that occurs with cash value is the application of an annual interest rate to it. In recent years, given the low interest rates in banking, the interest rates on cash value are often high by comparison.
One type of policy, the IUL, has a variable interest rate that roughly matches a chosen stock index. If the index does well one year, your interest rate will be as high as the policy maximum interest rate. If the index performs poorly, the policy credits you whatever the minimum interest rate is, usually zero or one percent.
Direct Investment of Cash Value
Some policies allow you to directly invest the cash value, which carries the same risks and rewards of any investment. These policies became less popular as a result of major market pull backs.
Why Bother with This over More Traditional Investment?
I’ve read the opinions of many financial advisors on this subject. A lot of them say the best investment strategy over the long term is to buy term life insurance to cover your life insurance needs and invest the rest of your money directly through a Roth or traditional 401(k), or another IRA. I’ve seen the math on it and I understand the conclusions they have come to.
The primary advantage to using this method is that the “withdrawals” you make from these policies are non-taxable if you follow the rules for them because they are treated like loans.
I’ve seen the models and traditional investing will usually be the better direction to go—certainly when talking about the normal VUL policies where you are still assuming much of the same risks. However, with IUL, you do not directly invest the cash value; they just vary your interest rate between the policy minimum and maximum depending on the performance of the index.
That means, even if the market tanks altogether, your cash value does not drop.
Why is that important? Because if your goal is to accumulate money for retirement, knowing that the economy tanking a couple years before you intend to retire won’t wipe out your “investment” provides a pretty good sense of security. Mind you, many models still predict that you will be better off with traditional investments, but we can’t predict now with any accuracy what the market will do five years from now, let alone 20 or 30 years from now.
It really comes down to how risk-averse you are. If you don’t particularly trust the market, it can be a decent alternative.
Always Read and Make Sure You Understand before You Buy
Not all policies are alike. Read everything before you make a decision and make sure you understand it before buying. The cash value component, if you intend to use it as a savings vehicle, is a long-term commitment to get out of it what it’s being marketed for. It is insurance, which means you are paying for insurance first with every premium you pay.
Read Ashton Rooks’s comment on, “How Life Insurance Stacks up against Traditional Investments” on Quora.