Like many young adults, I inherited permanent life insurance policies that my parents bought for me when I was a kid. They purchased one when I was a newborn (the universal life policy of this post) and the other when I was six (a variable appreciable life policy–post coming soon). Now that I am an adult and my wife is the beneficiary, I am paying the premiums. Since joining the financial independence (FI) movement, I’ve learned that these cash value life insurance policies are not optimal for life insurance or investing purposes. But once you’ve had a policy in place for several decades, the low (often negative) investment returns usually turn into OK returns. To see whether I should ditch the universal life policy, I analyzed the policy as both an insurance product and an investment.
Disclaimer: this post is only an example and is intended to be educational and not specific or individual advice. You should evaluate your life insurance and investment needs with a trusted adviser.
Details of the universal life policy
Here is a summary of the policy as of the most recent annual statement. The statement came in the mail, but is also available online through the provider’s website.
- Starting value: $5,635
- Deposits to cash value: $172 (these are taken directly from the “premium” payments)
- Charges + deductions: $203 (these are the remainder of the premium payments)
- Interest: $261
- Dividend: $83
- Ending value: $6,151
- Credited interest rate for period: 4.50%
- Guaranteed credited interest rate: 4.00%
My other life insurance coverage
I have a term life insurance policy that covers 6.7x my salary, and an employer group policy for 2x my salary. I also have the universal life policy detailed above and a variable appreciable life policy (also inherited–post coming soon). These policies cover 0.9x and 0.4x my salary, respectively. Between these four policies (covering 10x my salary in total), our saved assets, and our shortened timeline for FI, I feel I have enough coverage. (You must decide how much coverage is appropriate for you–I am not recommending 10x coverage).
It is important to point out that the universal life policy I am evaluating is very likely beyond my needs due to the term and group policies. Before making any decisions to change or cancel an existing policy, make sure you have other policies in place that provide adequate coverage. The last thing you want to do is drop or reduce coverage and then not be eligible for replacement coverage. This could happen for example if a medical condition develops before you secure a new policy.
Now that I’ve laid out the life insurance aspect of this policy, let’s look at three ways I evaluated it as an investment.
Case 1: I actually need the permanent life insurance and am happy to pay the premiums
In vast majority of scenarios, permanent life insurance isn’t necessary. For now, that generalization certainly holds for me. But I also haven’t ruled out all of the appropriate uses for permanent life insurance. Specifically, we haven’t had kids yet, and can’t know for sure that we won’t have kids with special needs. Since we also haven’t achieved FI, that means we haven’t self-insured against this risk and the cost of maintaining their welfare after we pass. So for now it may make sense to keep to this policy.
How well does the cash value investment perform if I was happy to keep paying the premiums? The charges and deductions are just the cost (premium) of buying the permanent insurance and are not considered in the investment calculation. The deposits into the cash value account ($172 from the premium payments) are equivalent to putting money in a savings account. Using the RATE() function in Excel, the first argument is 1 for one year of investing. The second argument is -172 for $172 deposited into the account during the year. The third argument is -5635 for having built up a starting value of $5,635 from previous deposits, interest payments, and dividends. The fourth argument is 6151 for the balance of $6,151 after one year of growth from 2018 to 2019.
=RATE(1, -172, -5635, 6151) = 6.1%
The formula is simplified because I have just looked at the year in aggregate. In reality, the cash value deposits are made from the monthly premium payments, the dividend is deposited once per year, and the interest is calculated daily. These facts slightly change the actual rate of return, but the simplification is close enough for me.
The total return (6.1%) exceeds the interest for the period (4.50%) because of the dividend payment. In fact, the returns on this policy have been OK over the last decade. The interest rate has varied from 4.5% to 6%, but the dividend has only shown up in the last few years.
Since I’m not 100% ready to ditch the coverage just yet, the 6.1% rate of return is decent. But what if I was absolutely sure I didn’t need permanent life insurance?
Case 2: I am sure I don’t need the permanent life insurance and hate paying the premiums
Many people don’t need permanent life insurance. Without dependents, you may not need any life insurance. If you have dependents, but have achieved FI and can cover your obligations, you also may not need any insurance. If you have dependents but are still working towards FI, a term life insurance policy can most likely cover your needs until you reach FI.
In any of these situations, the charges + deductions that pay for the permanent life insurance are essentially wasted; they are paying for insurance you don’t really need. Here I adjusted the RATE() calculation by counting the $203 charges + deductions against the returns in the second argument:
=RATE(1, -(172+203), -5635, 6151) = 2.5%
The inefficiency of paying for unneeded coverage really eats into the returns. But is this a fair way to look at the policy?
Case 3: I am willing to accept the permanent life insurance as a small inefficiency
I think Case 1 is a little too rosy, since I don’t believe I actually need this universal life policy. Conversely I think Case 2 is a little too hard on the policy, since it completely ignores the value of the life insurance provided. To account for the value of the universal life insurance, I have compared it to my term policy by determining the cost (paid via premiums) per dollar of death benefit:
cost for coverage = annual premium / death benefit
with the caveat that for the universal life policy I don’t include the portion of the premium going directly into the cash value account as a true “premium.” In other words, the annual premium for the universal plan is just the charges + deductions amount of $203.
Running the numbers (not shown for privacy reasons) indicates that my term policy costs only 60.5% of what the universal policy costs. This means 39.5% of the universal policy’s premium (charges + deductions) is lost to inefficiency. In contrast, Case 2 used a 100% inefficiency. Here the rate of return is calculated as:
=RATE(1, -(172+0.395*203), -5635, 6151) = 4.7%
where the $203 charges + deductions have been multiplied by 0.395 to account for the higher premium of the universal policy compared to my term policy. As expected, this approach yields a rate of return in between Cases 1 and 2.
What I’ll do with this policy
I think the comparative approach of Case 3 is the most accurate way for me to view the policy. Since it uses term insurance–my preferred form of coverage–as the benchmark, I can more easily determine how to reduce my coverage as we approach FI. For example, if I don’t need permanent life insurance and am otherwise over-insured, I would preferentially drop this policy instead of my term policy. Conversely, if we do have a need for permanent life insurance, I could always dial back or cancel my term policy.
So for now, I’m comfortable keeping the universal life policy. The investment returns are OK and having a death benefit beyond the end of my term life insurance policy still provides some value.
A final comment on permanent life insurance
The WhiteCoatInvestor is the best resource I have found for information on permanent life insurance. I don’t have the expertise or desire to dig in as thoroughly as he has. So if you are looking for more information on a permanent life insurance policy, I recommend reading through his site. One pertinent article I found strongly recommends against buying life insurance for children. Point #5, “Nobody Knows What To Do With an Inherited Life Insurance Policy,” is more or less the reason for my post..
Anyways, to repeat the disclaimer from above: this post is only an example and is intended to be educational and not specific or individual advice. You should evaluate your life insurance and investment needs with a trusted adviser.