Should You Cancel Your Whole Life Policy?

by Neal Frankle, CFP ®

Should you cancel your whole life policy? Here’s an e-mail I received that asks this very question:

I was wondering about a $5,000 whole life insurance policy that my wife’s parents took out for her nearly 30 years ago. We’re paying about $80 a year to maintain the policy that I guess has some cash value to it. At this point, should we just continue to pay the $80 a year, or would it make sense to try to close this thing out?Should You Cancel Your Whole Life Policy

These parents obviously believed in life insurance for children. But now the child is an adult. Does it make sense to hold on? To answer this question, you have to understand what whole life insurance is. ( It also helps to understand what term life insurance is too.)

Basically whole life insurance is insurance that has a savings element attached to it. When you make a premium payment, part of that money goes towards the cost of life insurance, just like term life insurance. But the extra amount goes into a savings account.

That is the part that is known as “cash value.” The cash value builds up, theoretically over time, because it is earning interest. I won’t try to hide the fact that I think whole life is not a good deal. Here’s the main reason:

The insurance and administrative costs are very high.

I’ve never seen a real-life example where the cash value builds up. That’s because the insurance and administrative costs eat up most of the earnings. The disclaimer is, of course, that this is just my experience over the last 26 years. It is hypothetically possible that there are people who do well on the investment side of whole life insurance. It’s just that I’ve never met anybody who has. So when you compare term life insurance vs. whole life insurance, term life wins in my book for most people.

We don’t have the numbers that detail exactly what’s going on in this example, but we have a pretty good indication that the charges are pretty high (as expected) on this policy too.

I say that because after 30 years, this person is still paying $80 a year to maintain the policy. If the cash value was high enough, it would generate enough money to pay the premium and then some. Since it’s not earning enough, it’s fair to assume that the charges are eating up too much. However, in order for this person to know what to do, he’d need to get an “in-force statement.”

This is a statement you can get from your insurance company. It tells you the exact cash value amount, total interest, how the cash value has increased from one year to the next and the premium. That’s really the only way to know what to do next.

Of course, you also need to know if you need the life insurance and if there are any health issues which might make it difficult to buy more insurance. But assuming there are no problems and we get an in-force ledger, the next step is to look at the numbers. Let’s look at an example.

Say the cash value is $3,000 but the death benefit is $5,000. In that case, the insurance is really only for $2,000…right?

The next number to look at is the actual earnings. The “in-force” ledger should tell you what the interest rate paid was. In fact, it’s the only way to know what you’re earning and what the cost of insurance really is.

Another number to look at is the taxable gain. You get that from the “in-force ledger” too.

This family invested $80 a year for 30 years so their invested capital was $2,400. If the cash value was $3,000, the average yearly return was about 1%. That would be about right for whole life insurance, and it does indeed stink.

Unfortunately, the numbers almost never work for whole life as an investment because the costs are extremely high. Rather than making premium payments to increase the cash value, most of the money goes to pay the expenses.

If that is the case, we need to ask if life insurance is needed and whether the current policy is the most affordable policy. If this person still needs life insurance, then they must calculate whether this is the lowest-cost method to obtain it. That of course depends on the person’s age and health at the time. The way to know that is to get a term life insurance quote and compare a new term insurance policy to the existing whole life insurance policy.

You can calculate the insurance cost by simply stripping out the return. So, if the in-force statement says the policy is earning 5%…do the math.

If the cash value was $2,950 last year and it earned 5%, the cash value should be a bit under $3,100. On top of that, you deposited $80. If you add up the 5% return on $2,950 plus the $80 you put in, you get to $3,180.

But since the cash value only went up to $3,000, the difference must be the cost of the insurance. So it cost this person $80 (in this example) for the $5,000 in life insurance. Knowing that number is powerful because with it you can compare the cost of the existing policy to that of a replacement policy. And then you’ll know if you should exchange the life insurance.

As you can see, there is no blanket answer. You have to determine how much life insurance you need and what the cost of the current insurance is. Whole life almost never works as an investment, but if you have a very old policy, you might be in the situation where it makes sense to hold on to it. Usually it doesn’t make sense because the costs are often very high.

In summary, here is a list of things to determine:

a. Do you need the insurance?
b. Can you get insurance elsewhere?
c. How much are you earning on your money?
d. What is the real cost of the insurance?

If you are earning a low rate and cost of insurance is high, it will be best to replace the existing policy with a better (and cheaper) term life policy.

 

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