Fred’s car engine is dead. The mechanic tells him it will cost $2,000 to fix it, but that the car will only be worth $1,000 once it’s fixed. He shouts out the first thing on his mind, “I just spent $500 to replace my air conditioning, I have to fix it!”
Fred just learned the concept of a sunk cost the hard way.
While the timing is unfortunate, the fact that Fred recently put $500 into his vehicle should have no real bearing on the decision of whether or not he should get his car fixed. The air conditioning is a sunk cost. All that matters now is that it will take $2,000 to fix his engine and make his car worth $1,000. If Fred were rational, he would not fix his car but instead would spend the $2,000 on a better car that’s road-ready, or spend more to upgrade.
So what does this have to do with life insurance?
Sunk Costs & Life Insurance
Because of this same sunk cost principle, a previous decision to invest in whole life insurance should not affect your decision to keep the policy going forward. Just because you put money into a policy in the past does not mean that you must or should continue to do so. In fact, often it is the case that owners of whole life policies are better off selling their policies, even though it means foregoing some of their up-front payments on the policy, which typically get disproportionately allocated to commissions and other fees.
I’ll put my cards on the table (if it wasn’t already obvious): while whole life insurance policies can sometimes find a place in an investment portfolio, I am generally in favor of foregoing whole life insurance, purchasing term insurance, and investing the difference in premiums into other investment vehicles.
Whether or not you should keep an existing policy or cash it out depends on a number of variables and data-driven assumptions. Yet the decision to hold or sell should be based on just that – data- and evidence-based assumptions – not on the sunk cost of whatever you’ve put in or any emotional attachment to it.
What Is Whole Life Insurance?
Backing up a step, let me explain what whole life insurance is. It is a form of life insurance that, in addition to a death benefit, carries a cash value that typically grows over the life of the policy and as premiums are paid. The cash value can be accessed prior to the insured’s death via a loan or by surrendering the policy.
Disclaimer: There are many different types of whole life policies. This is a broad overview and not an attempt to explain every different kind exhaustively.
Whole life policies typically pay a commission to the person selling the product. This is the primary reason why, if you look at the policy’s growth projections, it often takes several years for the cash value to even catch up to the amount you’ve paid in (the cost basis). It’s during these early years that the opportunity cost of investing in a commission-free instrument, like an index fund, can amount to a big difference. Due to the power of compounding interest, the slow start in cash value growth that the typical whole life insurance policy experiences makes it hard-pressed to ever catch up to investments that start growing right out of the gate.
How To Make Your Decision
Deciding whether or not to keep an existing whole life policy depends on a few factors. Start by answering these questions:
What is the current cash value?
How much are the annual premiums?
What kind of benefits will you receive if you keep the policy in place? Tip: Ask your provider for an “in-force illustration” of your policy or policies and review carefully.
What are the quoted premiums for a term policy that insures you at an appropriate level? Term life policies offer the death benefit without the cash value and come at significantly lower premiums.
What would you do with the money you are currently using for premiums instead (the opportunity cost)? If an investment, what reasonable growth assumptions can be made? If the money would be used to purchase consumer goods or a fancy new car, then it may be better to keep the policy.
Once you’ve collected the information, it’s time to analyze and compare your options. How does the growth of your cash value compare to your alternative option?
I recently ran an analysis like this for a client who has had a whole life policy in place for six years. This client’s alternative was to use the savings in monthly premiums (less premiums for a new term life insurance policy) to make additional contributions to his Roth 401(k). This was a fairly “apples to apples” comparison in the sense that both are funded with after-tax dollars and grow tax-free.
In short, what we saw is that investing in an index fund with a 7% growth assumption led to a 75% higher portfolio value by retirement age. Here is a summary breakdown:
Whole Life Policy
$200k 30-Year Term With Premium Difference Invested
Death Benefit + Roth
What matters here is the expected future value, not what had been paid into the policy previously. That’s now a sunk cost! (However, the amount paid in, or the “cost basis” of the policy, does carry certain tax implications that should not be ignored.) This client was emotionally attached to the thousands of dollars paid into the policy, including the amount that went to commissions. Running the analysis helped him look forward, rather than backward, which is critical to making a rational decision.
How Risk Tolerance Plays In
Finally, consider one final factor when reviewing the analysis. How risk-averse are you relative to your time horizon?
One benefit of a life insurance policy is that the returns are guaranteed (to the extent the company remains solvent). Because of this, life insurance is considered to be relatively low-risk so long as it is purchased from a reputable company. Stock market investing carries more risk.
However, if you have a long time horizon before you plan to access the funds, it may be worth it. History has shown that stock market investors have been rewarded for bearing this additional risk and a diversified stock investment is likely to outperform life insurance returns in the long run. (Note: Past performance is not indicative of future results.)
Are you wondering what to do with your whole life policy? Guide Financial Planning can help you run this analysis and make sense of your situation. As a fee-only fiduciary advisor, we can offer unbiased recommendations based on your unique situation. To learn more about how we can help you, schedule a free introductory call today.
About Guide Financial Planning
Guide Financial Planning is led by founder Ben Wacek, who is a Christian fee-only Certified Financial Planner™ and Certified Kingdom Advisor®. He has a passion to help people of all income levels make wise financial decisions and steward their resources from an eternal perspective using Biblical principles. Based in Minneapolis, MN, he works with clients both locally and virtually throughout the country and abroad. You can follow the links to learn more about Guide Financial Planning and our team and the services we offer.