Whole life insurance receives its name because it provides the owner with a death benefit for the whole lifetime. It is a form of permanent life insurance. Whole life also includes an accumulation and savings component through its cash value. Whole life insurance may be viewed as a fixed-income investment vehicle that incorporates a permanent death benefit as well. When structured properly, a whole life policy provides a tax-free death benefit and tax-deferred growth for its cash value. There are ways to access the cash value on a tax-free basis as well, as will be discussed. Whole life policies include provisions that guarantee the amount and duration of premium payments. The policy endows at the point that the cash value has grown to equal the amount of the death benefit. Whole life policies are typically designed to endow at either age 100 or age 121. If the policy also matures at one of these ages, then the cash value is paid to the policy holder, with gains in the policy being taxable. Policyholders may prefer to have the policy endow rather than mature, which allows the policy holder to maintain the policy until death so that the cash value can be received as a death benefit without having to pay taxes.
Before digging into the details about how whole life insurance can fit within a retirement income plan, it is worth beginning this discussion with a simple explanation about how to calculate premiums on a whole life policy without extra features. As with term life insurance, the costs for the death benefit are structured as a lifetime series of one-year term policies. But there is one important difference related to cash value accumulation that helps to reduce the insurance costs within a whole life policy over time relative to term insurance.
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Exhibit 7.2 provides the mechanics for a whole life policy designed to endow at 100. The death benefit is available when death occurs before age 100. At age 100 the cash value has grown to equal the death benefit and the policyholder could receive the death benefit if still alive, but any gains in the policy would be taxable. If left untouched, the cash value and death benefit can continue to grow with interest and the death benefit could be received at death without triggering a taxable event.
With whole life insurance, there is as a policy cash value that provides a portion and eventually all of the death benefit. The cash value represents the amount that the policy holder could receive by surrendering the policy before death. This is a feature not provided with term life insurance.
The cash value represents an asset for the policy holder and the cost to the insurance company of providing the full death benefit is not the full amount of the death benefit. Rather, it is the difference between the death benefit and the cash value. This is an aspect that helps to reduce the costs of insurance implicit inside the whole life policy over time relative to a term policy. When death occurs, the insurance company only needs to cover the difference between the death benefit and the cash value.
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For those needing life insurance for human capital replacement, the ability of whole life to reduce insurance costs through the cash value helps to make cash value growth more competitive relative to buying term insurance and investing the premium difference in bonds. With “buy term and invest the difference,” the outside investments have no impact on the cost of insurance. With whole life insurance, the portion of the premium that goes into the cash value is working double-duty by accumulating a return and by helping to offset the future costs of the life insurance by reducing the portion of death benefit at risk for the insurance company. A single-premium whole life policy would grow the cash value most quickly to reduce the subsequent costs of insurance within the policy, while policies that extend premium payments out for longer periods would have relatively less prefunding and higher relative insurance costs.
Moving now to Exhibit 7.2, the first four columns are the same as with term life insurance in Exhibit 7.1. The fifth column in the exhibit is different. With term insurance, the insurance company must always support the full death benefit. But with whole life insurance, the insurance company only needs to support the amount of the death benefit that exceeds the cash value in the policy. This column reflects the $500,000 death benefit less the cash value accumulated at the end of the previous year. Now, the amounts shown in the discounted cost of one-year term insurance are impacted by four factors: rising mortality rates with age, the declining number of surviving policy holders, the discount factor on the amount set aside today to fund that future insurance cost, and the declining value of the net death benefit.
This leaves two remaining columns to be explained: premium and cash value. They are interrelated. The cash value is an asset of the policy holder. Any premiums paid are first used to pay for the cost of insurance, and the remainder is accumulated as cash value. With our assumptions, cash value also grows at the same economy-wide assumed 3 percent interest rate. The policy in this exhibit is designed to allow premiums to stop after twenty-five years at age sixty-five when the individual is anticipating retirement. The costs of insurance must still be paid; they are deducted from the cash value that is still otherwise growing at 3 percent each year. In this example, the $6,873 premium is specifically chosen so that the cash value grows to match the value of the death benefit at age 100 even after paying all insurance costs. A smaller premium would leave the cash value falling short of the death benefit at age 100, and a higher premium would cause the cash value to reach the death benefit amount too soon.
Though not shown in the exhibit, separate calculations indicate that a single premium of $119,662 at age forty would support the same whole life policy with $500,000 of death benefit coverage and with cash value growing to the value of the death benefit at age 100. Again, the reason the whole life single premium is less than the permanent term insurance premium (which was $164,927) is because of the role the cash value plays in reducing the net amount of the death benefit the insurance company must cover.
Exhibit 7.2 Pricing a Whole Life Insurance Policy for a Forty-Year-Old Male
Retirement Researcher
Exhibit 7.3 provides a visual representation for the numbers in this whole life example. At the top, the exhibit shows a steady death benefit of $500,000 from age forty to 100. Next, the cash value grows to equal the value of the death benefit at age 100. This example includes premium payments until age sixty-five. By sixty-five, the cash value of $107,380 is higher than the $85,925 of cumulative premiums paid. But it took twelve years for positive returns net of insurance costs to manifest for the cash value. Whole life insurance is not designed to be a short-term strategy. After age sixty-five, the cash value continues to grow net of the continuing insurance costs until the policy endows at age 100.
Exhibit 7.3 Whole Life Insurance Policy Values for a Forty-Year-Old Male
Retirement Researcher
*This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon
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