In this segment ofMotley Fool Answers,Alison Southwick and Robert Brokamp, along with Motley Fool Wealth Management's Sean Gates and Joe Perna, talk about the pros and cons of whole life insurance, which is the most expensive type of life insurance. And financial advisors have a mighty compelling incentive to push it to their clients: huge up-front commissions. But for the wealthy, there are actually a few conditions under which those policies make sense.
A full transcript follows the video.
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This podcast was recorded on Sept. 6, 2016.
Alison Southwick:The next question comes from Patrick. "I am currently 46 years old with a net worth of approximately $4 million. In addition, I have two term life insurance policies. Over the years, both my insurance rep and my financial advisor have tried to convince me to consider purchasing or converting to whole or universal life policies. I have yet to hear a convincing argument to justify buying very expensive permanent life insurance policies, overtaking the annual premiums and investing them myself." Can you walk me through the difference between whole and universal? What's going on in Patrick's life right now?
Joe Perna:The most basic breakdown is going to be term versus permanent. Term is as long as you pay the premiums, there's a specified term that's going to cover. The most common is going to be something like a 20-year term policy. You pay the premium every year for 20 years. Once that's done, the insurance goes away unless you try to renew that.
Permanent insurance, as long as you pay the premiums, the policy is going to stay in force until you pass away. Term insurance policies are going to be much less expensive than something like a whole life policy, which is a type of permanent insurance. That's going to be the most expensive type of policy.
The one thing I'm going to say is it's not a surprise that they're trying to push him to do permanent insurance, because here's a tip: They get paid on the first-year premium of those policies. So when you convert that policy -- if it's $10,000 for that new permanent insurance policy, they're going to get paid close to $10,000 in commission. So one thing to be aware of is they do have some incentive -- I would say misaligned incentives in this case -- for trying to sell you on that permanent insurance policy and trying to convert that term.
That being said, there are some times that I think permanent insurance makes sense for someone's financial plan. One thing in particular has to do with estate planning. So with Patrick's example, if he lives in New Jersey, which has a pretty terrible estate tax (it's a bad state to die in, unfortunately) but with $4 million in an estate, you'd be subject to about $350,000 in estate taxes that your family would have to pay New Jersey at your current net worth.
That's a lot of money that goes to just pay taxes. So if you have a life insurance policy set aside for your family to just cover those costs in a tax-free manner, it might be a better way to transfer those funds rather than paying Gov. Chris Christie, at least at this time.
Sean Gates:And New Jersey is not just a bad state to die in, by the way. It's also a terrible state to live in.
Southwick:That's not true.
Southwick:Zing?Come on. Listen to our show where I ream South Dakota every five seconds.
Brokamp:That's true. But generally I would say Patrick's instincts are correct. It's better to get with term and save the money or invest the money rather than buy whole life. Part of the issue with whole life is you get insurance and an investment component where you're building up the cash value, but it doesn't often build up very well. As an investment, it's often not very good.
Southwick:Can I ever buy life insurance without someone getting a kickback? Or is that just how it's set up? If you're going to buy insurance, someone's trying to sell you something where they get the most kickback out of it.
Brokamp:For the most part, that's true. Even if you go online to a website and get the policy through the website, you'll find that behind the website is actually an insurance agency and someone is getting a commission. It's just that term commissions are much lower than whole life policies, or universal, or variable life.
Gates:Significantly lower, so I think that's the key. If you see a $200,000 term policy, the agent might get $150 to $250, so just in terms of comparison to the permanent insurance, that's where the misaligned incentives can come in. But I think there's always a commission associated with it, because in order to sell insurance, you have to get licensed, and there's a whole system involved that costs money.
Southwick:And I don't want to make it sound like selling insurance is like a charity. It's not like I expect an insurance salesman to do it out of the goodness of his or her own heart; but if they are always incentivized, and if A is better for B for them, then naturally they're going to be recommending A and it is always the case that they're going to have that struggle.
Gates:Yes, I think so.
Brokamp:I think so.
Perna:I just ran across a client the other day where I actually had a phone call with the insurance rep that sold them the policy. Basically, he converted $1 million of term into $1 million of whole life, which is a $36,000-a-year premium. It's an exorbitant amount, but [for] the insurance salesman it was, do we convert $500,000 or $250,000? That didn't cross his mind. It was like this easy, convenient, seamless sale for me to do. But how did it fit into the guy's plan? To me, that was not a part of his logic when making that decision or recommendation.
Southwick:So, be extra careful. Way to go, Patrick, for being skeptical.
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