Whole life as an investment: what the returns really are

Whole life can work as a conservative, long-term asset, but it is not a high-return investment, and its return depends heavily on how long you hold it. Over the first several years the return is typically negative because of up-front costs. Over several decades it is usually modest, in the range of a high-quality bond rather than a stock portfolio, with the added value of a death benefit that you cannot get from a bond. How you judge it depends on whether you treat the death benefit as part of the payoff.

How the return is built

Whole life cash value grows from three sources:

• Guaranteed growth. The contract includes a schedule of minimum cash value by year, based on a guaranteed interest rate and mortality charges.
• Dividends. On a participating policy, the insurer may pay dividends when its investment, mortality and expense results beat what it assumed. Dividends are never guaranteed. Dividend scales are set annually; see whole life dividends: how participating policies pay.
• Paid-up additions. Dividends or extra premiums can buy additional paid-up coverage with its own cash value, which compounds.

The insurer invests premiums mostly in a general account of high-grade bonds, mortgages and other fixed-income assets, which is why dividend results track bond-like yields over time. See how life insurers invest your premiums.

Why the early years look bad

Premium dollars do several jobs before they reach cash value: they pay the cost of insuring you, the agent's commission, and the insurer's expenses. So the guaranteed cash value in year 1 is typically a small fraction of the premium paid, and it takes years for cash value to catch up with total premiums. A rule of thumb many consumer guides repeat is that break-even on guaranteed values takes 10 years or more; the exact year is on the policy ledger, so use the actual number for the policy in front of you. Surrendering before then means a loss. See surrendering a life insurance policy: what you get and what it costs.

How to measure the return

A fair test uses the internal rate of return (IRR) on the cash surrender value (see cash surrender value) at a given year:

1. List every premium paid, year by year.
2. Take the cash surrender value at the end of the year you want to test, for example year 10, 20 or 30.
3. Compute the annual rate that turns the premium stream into that value. A spreadsheet's IRR function does it.
4. Do it twice: once with guaranteed values only and once with the illustrated, non-guaranteed values. The gap between the two is the part you are betting on. See guaranteed vs non-guaranteed values in a policy illustration.
5. Repeat on a death-benefit basis: compare premiums paid with the death benefit at death in year 20, 30 or 40. The longer you live, the lower this return becomes, but the earlier you die, the higher it is.

The IRR on cash value is usually negative or near zero in the early years and rises over time. The IRR on the death benefit is high if you die young and low if you live long, which is exactly the insurance trade.

The case for treating it as an investment

• Low volatility. Cash value does not fall when stock markets fall; the guaranteed values cannot go down as long as the policy stays in force.
• A guaranteed floor with potential upside from dividends.
• Tax advantages. Growth is tax-deferred, and dividends are generally treated as a return of premium until they exceed what you have paid in, according to IRS Publication 550. Loans from a policy that is not a modified endowment contracts and the 7-pay test are generally not taxed while the policy stays in force. See how cash value is taxed: withdrawals, loans and surrenders. The death benefit passes to beneficiaries generally income-tax free.
• Forced discipline and access. Some buyers value an asset they will not raid or panic-sell.
• Possible creditor protection in many states, under rules that vary by state.
• Bond-substitute for high earners who already max out other accounts.

The case against

• Low early returns and long break-even. Most of what you pay in the first few years does not become accessible cash.
• Modest long-run growth. Over long periods, diversified stock portfolios have historically outpaced the growth in conservative insurance cash value, with much more volatility along the way. Past performance does not guarantee future results either way.
• The cost of the insurance is bundled in. You cannot separate the protection charge from the investment, so it is harder to see what you pay. Compare with buy term and invest the difference: does it hold up, and the buy term and invest the difference calculator lets you test assumptions.
• Illustrations can mislead. Projected values rest on dividend scales that may not hold. Read the guaranteed column separately.
• Opportunity cost and liquidity. Money in the policy is not available as flexible investable capital, and loans carry interest.
• Lapse risk. Many policies do not last. If you stop paying, you may get back less than you put in.
• Commissions create sales incentives. See how life insurance agents are paid.

A hypothetical comparison

Say two 35-year-olds each have $400 a month to spend beyond their budget. Anna buys whole life with that money. Ben buys a term policy for the same death benefit at a much lower price and invests the difference. After 30 years, Anna holds a cash value and a death benefit that is guaranteed to last as long as she pays, and Ben holds whatever his portfolio became, with no coverage once the term ends. If Ben's investments earned a good return and he kept investing every month, he would probably have more money; if the market had a poor stretch, or he spent the difference, Anna would be ahead. Neither outcome can be known in advance. The example is invented and uses no market rates.

Who might reasonably use it as part of a plan

• People with a permanent insurance need who would pay for permanent coverage anyway, where the cash value is a by-product
• Savers who already use tax-advantaged retirement accounts and want a conservative asset
• Buyers with a long horizon who can pay premiums reliably for decades

It is less suitable for anyone who may need to cancel within a few years, for those with an inadequate emergency fund, and for people who are underinsured and could buy more protection with the same money. A fee-only financial planner can run your numbers. For a broader view, see is whole life insurance worth it? and the keep, surrender or sell your policy? if you already own a policy.

Key takeaways

• Whole life cash value earns a conservative, bond-like return that is usually negative in the early years and improves with time.
• Measure it with the internal rate of return on cash surrender value, using guaranteed and projected values separately.
• The case for: stability, a guaranteed floor, tax advantages and permanent coverage; the case against: high early costs, modest long-run growth and bundled, hard-to-see charges.
• It fits long-horizon buyers with a permanent need; it is a poor fit for short horizons and tight budgets.
• Compare against term plus investing the difference before buying, and read the guaranteed column first.