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TERM INSURANCE is typically the best bet for people who need life insurance, while permanent policies are appropriate for relatively few folks. Yet I keep getting the same question from parents: What about children? Does it make sense to purchase a whole-life policy for a young child?
No doubt influenced by Gerber Life Insurance’s relentless marketing, these parents want to know whether it’s worth locking in insurance pricing early on and whether this is a good way to help their children start saving for retirement. Intrigued? Here’s a framework to help you evaluate the pros and cons.
To see whether a whole-life policy is a good way to lock in life insurance costs, consider a hypothetical example. Let’s say parents of a 10-year-old girl—we’ll call her Katelyn—believe she’ll need $500,000 of life insurance once she reaches age 35 and potentially has a family who depends on her financially. One possible strategy: Purchase $500,000 of whole-life insurance for Katelyn today to guarantee she’ll have coverage later on.
The best price I could find for this coverage was a premium of $2,040 per year, payable for life. By the time Katelyn reaches 35, she and her family will have paid 25 years of premiums, totaling $51,000, and will be required to continue paying that $2,040 every year for the rest of her life. By contrast, if she waits until age 35 to purchase a 30-year term policy, the cost today is $370 per year for a 35-year-old woman in the top health class (super preferred) and $675 if she’s of average health (standard).
In other words, despite locking in pricing 25 years earlier, the whole-life policy will still be three to five times more expensive than the average 30-year term policy for Katelyn at age 35. Even if Katelyn has some major health issues in the future, it would be difficult for the premium on a 30-year term policy to exceed the $2,040 per year of the whole-life policy, let alone offset the $51,000 of past whole-life premiums.
I tested this with a few other scenarios and the results were similar. If your goal is to ensure that your child has access to life insurance in the future, purchasing a whole-life policy at a young age is an expensive way to do it. Yes, there’s always a chance that your child has health issues that means life insurance isn’t available at all. But when comparing the odds of that situation to the $51,000 of premiums in the scenario above, I’d argue most people are better off skipping the whole-life policy. Many of you will rightly point out that comparing whole life to term isn’t completely fair, given the opportunity to build up cash value in the whole-life policy. That brings us to our second topic: Is whole life a good way to help a young child save for retirement?
Using the quote for Katelyn at age 10, we can look at how the cash value of her policy builds up over time. With whole life, you have a minimum guaranteed cash value at each age, plus you also receive annual dividends based on the performance of the insurer’s life insurance business. In general, higher interest rates will lead to more investment income, which increases dividends. Lower interest rates will do the opposite. Similarly, fewer-than-expected death claims will increase dividends and higher death claims will reduce them.
The upshot: With a whole-life policy, you’re participating in the performance of the insurer’s business, but have a minimum guaranteed cash value to protect you if things go badly. Let’s say Katelyn’s parents want to build cash value in the whole-life policy up to age 65, at which point they expect her to use the cash value to cover retirement expenses or, alternatively, to purchase an income annuity or long-term-care insurance.
In the quote we got for 10-year old Katelyn, the insurer guaranteed cash value of $214,175 at age 65. That was after total premium contributions of $112,200 over 55 years. Using Excel’s nifty internal rate of return (IRR) formula, this translates into a guaranteed annual return of 2.2%. The quote also included an estimated non-guaranteed cash value at age 65, assuming dividends continue based on the insurer’s current dividend scale. This value was $521,026, producing an IRR of 4.8%. Actual cash values will certainly be different from this projection, but the $521,026 is a good proxy for what you might expect to earn on such a policy.
An expected IRR of 4.8% and a minimum IRR of 2.2% doesn’t sound too bad in today’s environment, especially compared to other investment options. But there are caveats. First, the whole-life policy is highly illiquid, meaning to get these returns, you need to hold it until age 65 and can’t make any changes to the premiums you pay. Second, your return is driven by the performance of a block of life insurance business. That might not be a risk everyone is comfortable with. Finally, you’ll be exposed to a single insurer—and the risk that it may fail—for many decades.
I suspect folks who are comfortable investing their funds in the stock market or other higher-yielding asset classes won’t find these whole-life returns attractive. But for those who want a simple investment and are comfortable with the caveats above, I’d contend the whole-life policy wouldn’t be a terrible way to put away some money for Katelyn. But because of the caveats above, I would limit the allocation to less than 15% of Katelyn’s savings.
This is not a blanket recommendation. Don’t assume that Katelyn’s numbers apply to all whole-life policies for children—and, based on the pricing I’ve seen, investigate policies other than Gerber Life, which I’ve found to be expensive. Before finalizing any purchase, make sure you review any quotes to confirm the guaranteed and expected returns under the scenarios you care about. Need help reviewing a quote or calculating IRRs? Shoot me an email at the address below.
Dennis Ho is a life actuary and chief executive of Saturday Insurance, a digital insurance advisor that helps people shop for life, disability and long-term-care insurance, as well as income annuities. Prior to co-founding Saturday, Dennis spent 20 years in the insurance industry in a variety of actuarial, finance and business roles. His previous articles include No Down Less Up, Questions I’m Asked and Retire That Policy. Dennis can be reached at dennis@saturdayinsurance.com or via LinkedIn. Follow him on Twitter @DennisHoFSA.
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Excellent discussion. With interest rates where they are how confident are you that the insurance companies can pay the current dividends? My assumption is that whole life pricing has built-in profits even without income from investments.
Thank you for the feedback. I would say given what interest rates have done this year, insurer dividends will most certainly go down for the next few years. Longer-term, insurer dividends “float” with interest rates, so if rates stay low then dividends will do the same, but if they rise, then dividends will recover. I can’t say I have any special insight into what interest rates will do, so I would just consider whether something a bit under the expected IRR is something I’d be happy with if interest rates stay relatively unchanged the next 40 years.
Great article. As a grandfather of a 7,5, and 7 month old, I’m interested in the “life cycle” of life insurance – what is needed at what age and what are the best products.
I was wondering if it would be fair to subtract out the term premium (say $375) from the $2040 premium, as that represents the price of the death benefit. Doing so improved the IRRs a little bit, to 2.75% and 5.24%.
Hi @Rick Connor:disqus – good observation and you are correct that the true expected IRR of the policy is slightly better than I showed because there is a small probability you pass away before age 65 and get the full $500,000 death benefit vs. the cash value at age 65. If this happens, the premiums stop as well, so you put less into the policy thereby increasing the IRR further.
The most accurate way to do it would be to calculate a “probability weighted” IRR that estimates the probability of dying each year vs. living to age 65, but that’s probably overkill for all but the most spreadsheet-addicted HumbleDollar readers out there :). I think what you did is a good estimate and the true IRR is probably even slightly higher.
My experience with a whole life policy:
MassMutual Whole Life. I made a one-time payment on 7/23/1987 at age 27 of $25,000 for an initial death benefit of about $273,000. Part of the cash value growth from that one-time payment was used to cover the annual $822 premiums.
I surrendered the policy on 1/9/2019 and received a check for the cash value in the amount of $186,027 for a pre-tax IRR of 6.6% annualized. Death benefit had grown to $426,525, a (happily unused) after-tax IRR of 1.4%. Basis on the cash value was $25,000 + (31 x $822) = $50,482, thus I was taxed at ordinary rates on a $135,545 gain.
@Langston Holland:disqus, thanks for sharing. Your timing worked out very well…while rates dropped over this 30yr period, it was a relatively slow decline. At the same time, mortality improvements led to lower death claims, so overall dividends held up relatively well over this period.