Whole life insurance has received a bad rap in recent years. Some insurance agents may try to sell it to younger couples with children who are better served with low-cost term life insurance. And some people plan to withdraw the funds while living and face negative tax consequences or high loan interest rates. But in certain situations a whole life policy can make sense, particularly as a tax efficient way to accumulate a fund to pass onto heirs with the added benefit of protecting against the loss of a second social security benefit stream.
If you are planning to leave money to your children (or to charity), life insurance can provide a mechanism to accumulate funds with favorable tax consequences and a competitive rate of return. Recent quotes I have obtained for clients have returns on the death benefit in the 5% range for an investment with a risk profile that is low and very different from a portfolio of stock and bonds. The potential return is dependent on variables such as your age, health and the level of future dividends paid by the insurer. In addition, you get the benefit of the life insurance in the event something unfortunate were to happen early in retirement particularly in the case where a second social security benefit stream is lost.
I’ll use the example of a couple with two working spouses. Someone who had earnings near or above the social security max for a number of years (which right now stands at $118,500) would receive a social annual security benefit of around $40,000 per year in today’s dollars. A couple in which both with spouses had significant earnings would have a social security benefit of around $80,000 per year, which in and of itself could support a reasonably comfortable retirement lifestyle.
But if one of the spouses were to die early, the second social security stream would be lost, cutting social security income in half. This could have a significant impact on the quality of life of the surviving spouse. One strategy to protect against this risk would be to purchase a whole life insurance policy with a death benefit equivalent to the net present value of the stream of income from the second social security. This would make the surviving spouse whole from a financial standpoint.
If however, both spouses lived well into retirement, proceeds from the insurance policy would instead flow into their estate and to their children or to a charity. All of the increase in value would transfer with no income tax.
A question is how can an insurance company pay out death benefits that provide a return in the 5% range with relatively low risk? I’ll use the example of a mutual insurer, which is where I would typically turn to for a policy like this. Mutual insurers are owned by their policyholders not stockholders. So policyholders in participating dividend paying policies earn on average a return equal to the return of the portfolio of the insurer after expenses and reserves. But not all policyholders earn the same return. Some end up with lower returns because they do things such as borrow against a whole life policy (paying the insurer a high rate of interest) or incur surrender charges on an annuity. For every policyholder who earns a below average return, another policyholder earns an above-average return, which will be realized via the dividends paid. This is why it is possible for certain policyholders to earn a superior risk adjusted return making whole life a strategy to consider.
As always, feel free to reach out if you have any questions.