It’s really hard to understand insurance products with the information available on the internet, and you are right that it is extremely unfriendly to online research. When I investigated whole life vs. term a few years ago, I came to the conclusions that there are a lot of problems with whole life and I wouldn’t touch it with a ten foot pole.
For one thing, the extra cost for whole is mostly retained by you, nearly as if you had never spent it, which make it questionable how much of that extra cost is really a cost.
Actually, there is something far weirder and insidious going on. By “extra cost,” I assume you are referring to the extra premium that goes into the insurance company’s cash value investment account, beyond the amount of premium that goes towards your death benefit (aka “face amount,” aka “what the insurance company pays to your beneficiary if you die while the policy is in force). Wait, what? Didn’t I mean your cash value account, and my words the “insurance company’s cash value account” were a slip of the tongue? Read on...
Let’s take a look at the FAQ of the NY Dept. of Insurance which explains the difference between the face amount of your policy (aka “death benefit” aka “what the insurance company pays to your beneficiary if you die while the policy is in force):
The face amount is the amount of coverage you wish to provide your beneficiaries in the event of death. The cash value is the value that builds up in the policy. The minimum cash values are set by the Insurance Law and reflect an accumulation of your premiums after allowances for company expenses and claims. When you are young, your premiums are more than the cost of insuring your life at that time. Over time the cash value grows, usually tax-deferred, and the owner may be allowed access to that money in the form of a policy loan or payment of the cash value. The face amount of your policy will be higher than your cash value especially in the early years of your policy. If you surrender your policy you will receive the cash value not the face amount. If you die your beneficiaries will receive the face amount.
So, you have a $1 million face amount insurance policy. The premiums are set so that by age 100, “your” cash value investment account will have a value of $1 million. If you die right before turning 100, how much money will your beneficiary get?
If you guessed $1 million face amount + $1 million cash value account = $2 million, you guessed wrong. See the last quoted sentence: “If you die your beneficiaries will receive the face amount.” Your beneficiary gets the $1 million face amount, but the insurance company keeps the $1 million investment account to offset their loss (which would instead go to your beneficiary if you had done “buy term and invest the difference).
This is because the cash value account is not your money anymore. The account belongs to the insurance company; I’ve read whole life policies and seen this stated in the fine print that people don’t read. Now, you may think you can access this account, right? Yes and no. It’s true that the money in it grows tax-free, but getting your money from the account isn’t as simple as you might think.
You can’t just take money out of a cash value account. If you want to take money out of the cash value account without surrendering the entire policy, it is not usually a withdrawal, it’s a loan.The reason it’s called a “loan” is because, as we’ve established, the account is not really yours, it’s the insurance company’s! According to the FAQ, here is what happens when you try to take a loan on a cash value account (emphasis mine):
There may be a waiting period of up to three years before a loan is available. If the policy owner borrows from the policy, the cash value is used as collateral, and interest is charged at the rate specified or described in the policy. Any money owed on an outstanding policy loan is deducted from the benefits upon the insured’s death or from the cash value if the policy owner surrenders the policy for cash.
As it says, you can get the money out of the cash value account by surrendering your policy… but then you have no life insurance anymore (whereas with buy term and invest the difference, taking money out of an investment account may incur taxes if they are not already paid, but you don’t have to cancel your life insurance to do so). See the penultimate sentence of the first quote: “If you surrender your policy you will receive the cash value not the face amount.” Your coverage (the “face amount”) is gone if you surrender your policy to get the cash values. Here is what happens when you surrender the policy:
When a policy is surrendered, the owner is entitled to at least a portion of the cash value. The actual amount that the owner receives will depend whether there are any outstanding loans or unpaid premiums that can be deducted from the cash value.
With “buy term and invest the difference,” if you take money out of your investment account, it doesn’t decrease the death benefit of your policy. Another article claims that you can do a partial withdrawal from the cash value account without it being a loan, but it can decrease the death benefit:
You can also make a full or partial withdrawal of your cash value. Depending on your policy and level of cash value, a withdrawal might reduce your death benefit. Exactly how much varies by policy, but in the case of universal life insurance your death benefit would be reduced on a dollar-for-dollar basis. For example, if you had a $100,000 death benefit with a $20,000 cash value and you withdrew $10,000, your resulting death benefit would be $90,000.
In some cases, partially withdrawing your cash value could decimate your death benefit. For some traditional whole life insurance policies, the death benefit could be reduced by more than the amount you withdraw.
The cash value surrender values will be spelled out in a schedule in a whole life contract. And for the first 3-5 years, they can be dismal (and would be less than if you had invested the difference and withdrew it paying taxes). From the insure.com article (emphasis mine):
Also important to note is the fluctuating rate of return on cash value in this particular whole life insurance policy. Your first year’s premium disappears into fees and expenses without a penny into your cash value account. Only at year 4 does the cash value rate of return go positive. That means if you drop this policy within the first few years, you’ve made a terrible investment.
[...]
The chart at the right summarizes the estimated average rate of return if you kept this particular life insurance policy 5, 10, 15 or 20 years. Even if you held this policy for 10 years, your estimated cash value average rate of return works out to only 2 percent because you’re still making up ground for those expensive first few years. You should be prepared to hold a whole life insurance policy for the long haul in order to make a potentially good investment.
That whole article is a good read. Notice that even though a cash value account can match a “buy term and invest the difference” strategy that accumulates 4.6% a year, your beneficiary does not get the cash value investment if you die:
You may be looking at this example and adding up cash value plus death benefit, but remember: With ordinary whole life insurance policies like this one, your beneficiaries do not receive the cash value when you die; they receive only the death benefit.
So if you die with the cash value account, your beneficiary gets $100,000, but if you die with the term strategy, your beneficiary gets $100,000 + the value of the investment account. If you die in year 20, that is $28,000 (don’t know if those dollars are taxed yet or not, but the difference is still stark), making the total gain by your beneficiary $128,000, instead of $100,000 with whole life.
So, what’s the deal with cash value accounts and why are they so wacky? To understand, realize that the cash value account is not an investment vehicle for you; it is a protection for the insurance company. From this article:
Whole life was the name of the original policy form. Premiums were payable for the whole of life (hence the name) or some shorter premium paying period (e.g., to age 65 or for 20 years). Regardless of the premium paying period, a guaranteed cash value was built up such that, at the terminal age of the policy (typically age 95 or 100), the cash value would equal the face amount. Thus, as policyholders got older, the “net amount at risk” to the insurance company (the difference between the cash value and the face amount) would decline while the reserve built up tax free. The true objective was not to build up a “savings account,” but rather to create a reserve against a known future claim.
Cash value accounts are for mitigating the risk of insurance companies, so they can make money even though they are insuring you your “whole life” (well, up to age 95-100). In contrast, the way term life insurance policies make money is that a certain percentage of policies expire and are not renewed before the insured dies, so the insurance company keeps those premiums… but this is how insurance in general works, and it’s far more straight forward. You can always get a guaranteed renewable term policy, and then actually renew it.
It’s very dangerous to bundle life insurance and investments in whole life policies.
It’s really hard to understand insurance products with the information available on the internet, and you are right that it is extremely unfriendly to online research. When I investigated whole life vs. term a few years ago, I came to the conclusions that there are a lot of problems with whole life and I wouldn’t touch it with a ten foot pole.
Actually, there is something far weirder and insidious going on. By “extra cost,” I assume you are referring to the extra premium that goes into the insurance company’s cash value investment account, beyond the amount of premium that goes towards your death benefit (aka “face amount,” aka “what the insurance company pays to your beneficiary if you die while the policy is in force). Wait, what? Didn’t I mean your cash value account, and my words the “insurance company’s cash value account” were a slip of the tongue? Read on...
Let’s take a look at the FAQ of the NY Dept. of Insurance which explains the difference between the face amount of your policy (aka “death benefit” aka “what the insurance company pays to your beneficiary if you die while the policy is in force):
So, you have a $1 million face amount insurance policy. The premiums are set so that by age 100, “your” cash value investment account will have a value of $1 million. If you die right before turning 100, how much money will your beneficiary get?
If you guessed $1 million face amount + $1 million cash value account = $2 million, you guessed wrong. See the last quoted sentence: “If you die your beneficiaries will receive the face amount.” Your beneficiary gets the $1 million face amount, but the insurance company keeps the $1 million investment account to offset their loss (which would instead go to your beneficiary if you had done “buy term and invest the difference).
This is because the cash value account is not your money anymore. The account belongs to the insurance company; I’ve read whole life policies and seen this stated in the fine print that people don’t read. Now, you may think you can access this account, right? Yes and no. It’s true that the money in it grows tax-free, but getting your money from the account isn’t as simple as you might think.
You can’t just take money out of a cash value account. If you want to take money out of the cash value account without surrendering the entire policy, it is not usually a withdrawal, it’s a loan.The reason it’s called a “loan” is because, as we’ve established, the account is not really yours, it’s the insurance company’s! According to the FAQ, here is what happens when you try to take a loan on a cash value account (emphasis mine):
As it says, you can get the money out of the cash value account by surrendering your policy… but then you have no life insurance anymore (whereas with buy term and invest the difference, taking money out of an investment account may incur taxes if they are not already paid, but you don’t have to cancel your life insurance to do so). See the penultimate sentence of the first quote: “If you surrender your policy you will receive the cash value not the face amount.” Your coverage (the “face amount”) is gone if you surrender your policy to get the cash values. Here is what happens when you surrender the policy:
With “buy term and invest the difference,” if you take money out of your investment account, it doesn’t decrease the death benefit of your policy. Another article claims that you can do a partial withdrawal from the cash value account without it being a loan, but it can decrease the death benefit:
The cash value surrender values will be spelled out in a schedule in a whole life contract. And for the first 3-5 years, they can be dismal (and would be less than if you had invested the difference and withdrew it paying taxes). From the insure.com article (emphasis mine):
That whole article is a good read. Notice that even though a cash value account can match a “buy term and invest the difference” strategy that accumulates 4.6% a year, your beneficiary does not get the cash value investment if you die:
So if you die with the cash value account, your beneficiary gets $100,000, but if you die with the term strategy, your beneficiary gets $100,000 + the value of the investment account. If you die in year 20, that is $28,000 (don’t know if those dollars are taxed yet or not, but the difference is still stark), making the total gain by your beneficiary $128,000, instead of $100,000 with whole life.
So, what’s the deal with cash value accounts and why are they so wacky? To understand, realize that the cash value account is not an investment vehicle for you; it is a protection for the insurance company. From this article:
Cash value accounts are for mitigating the risk of insurance companies, so they can make money even though they are insuring you your “whole life” (well, up to age 95-100). In contrast, the way term life insurance policies make money is that a certain percentage of policies expire and are not renewed before the insured dies, so the insurance company keeps those premiums… but this is how insurance in general works, and it’s far more straight forward. You can always get a guaranteed renewable term policy, and then actually renew it.
It’s very dangerous to bundle life insurance and investments in whole life policies.
I believe “buy term and invest the difference” is the slogan of the Amway-like Multi Level Marketer (MLM, legal pyramid scheme) Primerica.
That’s how I first encountered it, too. But it seems to be mainstream and widely accepted advice that is confirmed independently.