Q&A Hot Topic: Cash Value in Permanent Life Insurance

Here we go again discussing hot takes on permanent life insurance and its uses as an investment vehicle. Today I tackle one of the best questions I have received in a long time on the topic, and I think it is so important to understand.

[00:00:43]
Welcome to another episode of the Retired-ish Podcast. I'm your host, Cameron Valadez, financial planning connoisseur and tax super nerd of sorts, where every two weeks I discuss hot-button topics for pre-retirees and retirees over age 50 about investing, taxes, retirement income, divorce, widowhood, and more.

Occasionally, I decide to piece together some interesting questions that I've received from listeners of the show, casually amongst friends and colleagues, and even from prospective clients looking to hire our firm. And I like to address some of these common scenarios and questions head-on, publicly, because I find that so many people are being convinced one way or another into making certain financial decisions that they probably shouldn't be making, and I think I can help you avoid falling into some of the traps out there when it comes to building wealth.

And I think it's kind of cool. You get to learn from mistakes that I hear from other people or that I've personally seen in practice, simply because of what our firm deals with on a daily basis. Typically, your friends and family aren't going to admit to you at the next party or dinner about the financial moves and mistakes that they may have made. People generally like to keep that stuff a secret. So for today's show, I picked what I think is a very controversial topic, but also a very misunderstood one, which is the use of permanent life insurance as an investment, or pseudo-investment, because of its cash value component.

[00:02:21]
Just a heads up, I can go on for days about this topic. In fact, we have an older podcast episode that covers some other aspects of permanent life insurance and how we feel about it as a firm in general, and I'll link to that in the show notes. But today, I'm addressing the nuances of this specific question. So if this, phew, over your head, go back and listen to the previous episode we did on permanent life insurance.

This question was from a fellow tax professional, actually, that I was having a conversation with a couple weeks ago at a tax conference. Her question was, isn't it true that the portion of the premiums you pay for a permanent life insurance policy that go towards the cash value can actually end up adding a significant amount to the actual cost of the permanent insurance? Because if you die, your beneficiaries don't get both the death benefit and the cash value. If so, why doesn't anyone talk about this?

Yes! Yes! I love this question, and thank you for this. I have the same question. Why does it seem like nobody ever mentions this? Here's my best answer. This is one of the least understood and most glossed over, I might add, aspects of permanent life insurance policies, like whole life insurance, variable life insurance, and the different forms of universal life insurance. Again, I am so happy that she brought this up because I find myself having this conversation so, so much with people privately, usually after they have recently met with a life insurance agent or their old financial advisor really wanted to get them a permanent life policy. Or maybe they just asked ChatGPT if permanent life insurance was good, and they got some sort of biased answer and went down that rabbit hole.

[00:04:30]
Before I get into this, I want to caveat really quick. Permanent life insurance in and of itself isn't necessarily all bad. There are some use cases, absolutely. It's just that they are usually, most of the time, bought and sold for the wrong reasons. And sometimes it's simply because the agent selling them or the professional selling them may not actually fully understand how the policy works, even though their intentions may have been good. So I just wanted to throw that out there. And for those of you who, unfortunately, may have been sold a permanent policy already for the wrong reasons, you might hate me when I tell you these things, but you need to hear it. But hey, why wouldn't you want to know the truth, even if it hurts a little?

[00:05:18]
The hidden truth in most cases is your beneficiaries don't get both the death benefit and cash value built up in the policy, at least by default. That's why I said in most cases. Most permanent life insurance policies are structured so that when the insured dies, the beneficiary only receives the death benefit, not the death benefit plus the cash value that you may have built up or that quote unquote investment bucket that's inside the policy. That means the cash value reverts to the insurance company unless you've elected, and paid for, either a death benefit option or rider that allows both to be paid. Usually they call this like an Option 2 or an Option B death benefit payout, and for some types of policies, they actually don't have those and you have to have some sort of enhanced death benefit rider that you add on to the policy.

So where do your premiums go? Well, when you pay premiums on a permanent policy, they generally break down into a few different subsections or tranches. The first one is the cost of the insurance. This is pure insurance, the actual risk the insurer is covering. You have to pay for that. This is what you are to pay for when you buy life insurance to protect your beneficiaries financially. For instance, when you buy term insurance, the cost is primarily based on the pure cost of the insurance. There's some for administrative expenses, but usually not that much.

[00:07:04]
The second piece of the premium is administrative fees. Like I just mentioned. Number three is for some sort of cash value accumulation, or again, that quote unquote investment bucket that is a part of the policy. A portion of your premium is set aside to grow in this tax deferred account attached to the policy that's held by the insurance company. When these policies are sold as an investment vehicle, they are referring to this cash value component. Depending on the permanent policy you get, the cash value and the underlying investments can and do vary. To really build this cash value up over time, sometimes you have to - what we call - overfund it, which means put a ton of money into this policy.

So what's the problem here? Well, the cash value is effectively building up equity for the insurance company, not just for you. Unless you, One: surrender the policy, which means you get the cash value minus any potential surrender charges and taxes if applicable, or Two: you take a loan or a withdrawal while you're from the policy, which reduces the death benefit if that loan isn't paid back with interest, or number Three: buy the option or add a rider to increase the death benefit to include the cash value. Now that's that exception I mentioned earlier. I will say most people don't do this. It's not very common in reality because guess what? It costs more. You essentially have to a higher premium for your beneficiaries to get your own money back, aka the cash value that you built up in the policy over time.

[00:08:57]
To better illustrate this, here's a basic example of your typical permanent policy. You have a policy with a $250,000 death benefit and $80,000 in cash value so far. If you die without any specific Option 2 or Option B death benefit or enhancement rider, your beneficiary gets $250,000 and the cash value, the $80,000, disappears. With a return of cash value death benefit option or rider on the other hand, your beneficiary gets 330,000 or slightly less depending on the exact terms of the policy, which would be the $250,000 death benefit plus the 80,000 that you had in cash value. But remember, that option-slash-rider costs more money and most people don't realize that they have to pay more to get the full value of what they've built up. When a policyholder pays extra premiums to build cash value in one of these permanent policies and that cash value is forfeited to the insurer at death unless they pay even more for an enhanced death benefit option or rider, the true cost of the insurance policy is potentially magnitudes higher than it initially appears.

But this quote unquote forfeiture is not counted in the traditional cost of insurance tables or agent sales pitches. It's basically a stealth cost. And if you take a loan from the policy and plan not to pay it back, which is common for those trying to use permanent insurance as an investment vehicle, it will also reduce the death benefit by the loan amount plus the ongoing net interest owed that you don't pay back, which can compound significantly over time if your policy doesn't perform well enough. This is called negative amortization. It's like your balance growing over time instead of decreasing. Plus, when you take that loan, your premium and particularly the portion that goes towards the pure cost of insurance will still be the same, even though if you die with that loan outstanding, your beneficiaries don't get the full amount of the death benefit that you've been paying for the whole time because it's going to get reduced by unpaid loan plus the interest. In that case, you'd essentially be overpaying for the pure cost of insurance too.

[00:11:37]
While we're on the topic of policy loans, if you don't make any payments, the amount you owe could eventually exceed your policy's actual cash value. If this happens, your policy will lapse. In other words, it'll terminate and the insurer will use the cash value to pay off your loan. You'll also owe income tax on the amount of your cash value proceeds that exceed your total premium payments or your cost basis. And this is true even though the entire cash value is used to pay off your loan. There can be some exceptions to this for some universal life policies structured in certain ways and by certain carriers, depending on how they define and calculate their net amount at risk. But it's rare to see these exceptions.

Wild, isn't it? Again, most people don't talk about this anywhere. That's why these policies can end up being way more expensive than they initially look because you're funding something that may never benefit your heirs unless structured properly. They don't show the built up projected cash value as a potential cost on the illustrations for the contract.

[00:12:55] And to answer the last part of the question, which was essentially, why don't any of the top financial minds and academic researchers who talk about permanent life insurance address this? Well, there is some stuff out there, but definitely not a lot. The topic is dense. The mechanics of life insurance level death benefits versus increasing death benefits, internal policy expenses, riders, et cetera, they're technical and often skipped in any public facing discussions. Most academics don't focus on life insurance to begin with. Financial economists focus more on investments, retirements, spending, taxation, or annuities. Permanent life insurance is often a niche subtopic.

There's also industry initiatives. The insurance industry has a powerful marketing arm. Financial professionals who call them out sometimes face a lot of backlash. And lastly, the cash value illusion is very effective, unfortunately. People see growing cash value and think they're building wealth efficiently. And they hear that there's little to no risk with these, which is wildly untrue, by the way...topic for another day. And then the fact that the cash value often disappears on death is a tough pill for clients and even agents to acknowledge. But as I said, some do acknowledge these things. You've got Michael Kitces on his Nerds Eye View blog, Dr. Wade Pfau in his book, Safety First Retirement Planning. PWL Capital out of Canada has looked at this numerous times. And another financial professional, Alan Roth, has also addressed this, I think in articles in the past. And there's probably many more that I'm forgetting, but those are some of the more prominent ones I can think of. So there's some out there. They just take some serious digging to find, and you know, they're not in the limelight because they're not being advertised and pushed out there by big insurance companies, obviously.

[00:14:58]
However, if you think permanent insurance is needed for your situation, and you want the death benefit to include the cash value, then make sure you do a couple things. First, ask about an Option B or Option 2 type of death benefit or some sort of rider with an increasing death benefit. You'll want to run projections of different policy structures and types that compares costs and payouts with and without those options or riders and for differing death benefit amounts. Or if you truly have a need for the permanent coverage. So maybe this is for like a buy sell agreement for business owners or something. And you don't want it at all for investment purposes, you can try and structure a policy with as little as possible going to cash value, and again, compare it to the cost of other structures available from the various insurers that are out there.

[00:15:56]
That does it for today's show. If you haven't already subscribed to and follow the show on your podcast app, that way you can get notified each time a new episode drops every two weeks. Also be sure to check out our free monthly video newsletter to get more useful information on retirement planning, investments and taxes once a month straight to your inbox. The newsletter often dives deeper into some of the topics discussed on the show, as well as offer some useful guides and charts available for download. As always, you can find the links to the resources we have provided in the episode description right there on your podcast app, or you can head over to Retiredishpodcast.com/73. Thanks again for tuning in and following along. See you next time on Retired-ish.

[00:17:02] Disclosures
The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.

Variable Universal Life Insurance/Variable Life Insurance policies are subject to fees and charges. Policy values will fluctuate and are subject to market risk and to possible loss of principal. Guarantees are based on the claims paying ability of the issuer.

This material contains only general descriptions and is not a solicitation to sell any insurance product or security, nor is it intended as any financial or tax advice. For information about specific insurance needs or situations, contact your insurance agent. This article is intended to assist in educating you about insurance generally and not to provide personal service. They may not take into account your personal characteristics such as budget, assets, risk tolerance, family situation or activities which may affect the type of insurance that would be right for you.

In addition, state insurance laws and insurance underwriting rules may affect available coverage and its costs. Guarantees are based on the claims paying ability of the issuing company. If you need more information or would like personal advice you should consult an insurance professional. You may also visit your state’s insurance department for more information.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

Cameron Valadez is a registered representative with, and securities and advisory services are offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC.

Neither LPL Financial nor its registered representatives offer tax or legal advice. Always consult a qualified tax advisor for information as to how taxes may affect your particular situation. Tax and accounting related services offered through Plan-It Business Services DBA Planable Wealth. Plan-It Business Services is a separate legal entity and not affiliated with LPL Financial. LPL Financial does not offer tax advice or tax and accounting related services.