The good news is that a growing number of financial advisors are teaching their clients about the “living benefits” of Whole Life insurance. (I’ve given my own summary here.) The bad news is that a growing number of financial advisors are using faulty explanations to teach their clients about the living benefits of Whole Life insurance.
In this two-part series, I will focus on the popular marketing technique of touting the “uninterrupted compound growth” that one enjoys with a Whole Life policy. As we’ll see, this is certainly true, but it is often presented in a misleading way. In this first post, I’ll showcase how it is often presented poorly. In next week’s follow-up post, I will explain why Whole Life is still a great vehicle for cashflow management, even though this particular marketing point sometimes goes awry in the exposition.
The issue here flows from the ability to take out a loan from the life insurance company, with the underlying Cash Surrender Value of the Whole Life policy serving as the collateral. Because the policy loan is “on the side” and you never really took money “out” of the policy, it continues to chug along, earning both the guaranteed growth and non-guaranteed dividends that it would have even if you never borrowed a dime. (Note that even at this step, there is a complication of whether the carrier practices direct versus non-direct recognition, but we’ll ignore that subtlety for this article.)
In order to drive home the advantage of being able to enjoy “uninterrupted compound growth” inside a Whole Life policy even while using the money for something else, a financial professional will often explain to the clients that this strategy isn’t available to someone who saves in a bank account and then withdraws money in order to “pay cash” for items.
For example, if you are saving money in a bank account that earns interest, whenever you withdraw money from the account in order to “pay cash” for a major purchase, that money is forever gone. You are no longer earning interest on it; the bank is only applying the exponential growth to your now-smaller balance.
Everything I’ve said above is technically true, and the financial professionals who set up scenarios this way aren’t lying. But if they end the discussion here, they can mislead the reader or viewer into believing that this is a pure windfall to the person using the Whole Life financing approach, and only a fool would “pay cash.”
But hold on a second. One important thing is omitted from the discussion above: the interest the policyholder has to pay to the life insurance company. That also grows exponentially over time, unless the policyholder makes payments on it. But when you withdraw money from your actual bank account, there is no corresponding obligation to make future payments to anybody.
In the special case where all of the relevant rates were the same — namely, the internal rate of growth in the Whole Life policy, the interest rate that the life insurance company charges for policy loans, and the interest rate that the bank pays for deposits on its accounts — then the two financing approaches would be a wash, at least in terms of liquid cash value.
For example, suppose Alice has $100,000 in Cash Surrender Value in her Whole Life policy, which is growing at an internal rate of 4% annually. She borrows $20,000 against the policy at a 4% interest rate from the carrier to buy a $20,000 car. One year later, Alice’s gross CSV in her Whole Life policy will have risen to $104,000 because it keeps compounding the whole time. However, the outstanding policy loan balance will have grown from $20,000 to $20,800 because of the assumed 4% interest rate on the loan. That means Alice’s net Cash Surrender Value a year later is only $104,000 — $20,800 = $83,200.
In contrast, what about Bob? (Yes, people ask me that a lot.) He doesn’t understand how Whole Life works, so he saves his money in a conventional bank account that we assume earns 4% per year. He starts out with $100,000 in the account and then withdraws $20,000 to buy the same model car as Alice. He now has $80,000 in his account, which over the course of the year grows at 4% to reach $83,200.
In other words, if the relevant rates are all the same, financing with Whole Life versus a conventional bank account is a wash, at least if we are just considering liquid cash value. Now, to be sure, in practice, those various rates won’t be the same. Generally speaking, of the three rates, the interest you can earn in a bank account will be the lowest, the internal growth rate in the policy will be higher, and the interest rate charged on the policy loan will be a bit higher than that. With our Alice and Bob example, if we plugged in more realistic numbers, Alice would probably come out ahead. But the reason would be that the internal growth in the policy was much better than the yield in the bank account, not directly because of “uninterrupted compounding.”
For one final objection to this line of marketing, let me point out that Whole Life insurance (and other permanent life policies) is not unique in this attribute. For example, if you own a house and borrow against it, your house continues to appreciate at whatever rate it would have enjoyed, whether or not you took out the loan against it. Borrowing against your house wouldn’t have “interrupted” its long-run growth.
In conclusion, in this first post of a two-part series, I have illustrated some of the pitfalls in typical marketing of the “uninterrupted compound growth” available to Whole Life policyholders. To repeat, it’s not that this marketing is flat-out false. It’s just that it can sometimes be misleading.
Having said all of that, in my follow-up post next week, I will explain why it is still a great idea to use Whole Life insurance for cash management. In particular, I will show why it’s typically better than saving in a more traditional vehicle and then “paying cash” and why it is a much better asset than your house to serve as collateral for a loan.
NOTE: This article was released 24 hours earlier on the IBC Infinite Banking Users Group on Facebook.
Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together Whole Life insurance policies and digital blockchain-based issuance.
Comments