Life Insurance Has Shortcomings as Investment

Anyone who has a checking account and is over the age of 21 has probably been approached by an agent who wanted to sell them on the many benefits of life insurance policies.

The pitches can be impressive. In addition to death benefits, life insurance can provide consumers with safe, tax-deferred investment earnings, they’ll say. And, with charts full of projections, they can show how relatively small investments can multiply.

But there are often a lot of caveats that the sales people forget to mention. First and foremost is that life insurance is not for everybody.

Who should have life insurance? People with dependents, assets and debts. For someone who wants and needs insurance to protect the family’s assets and living standards against the wage earner’s unexpected death, life insurance has no equal. But it is a waste of money for those with no one who relies on them for financial support.

Doubtless, life insurance agents will bicker with this assessment. Most agents maintain that anyone can benefit from the “investment side” of a whole life policy, which can allow tax-deferred earnings to build up much like they would in an individual retirement account.

But many experts maintain that life insurance policies fall short when you evaluate them solely as investments, which is what anyone who doesn’t need the death benefits should do. To understand why, you have to consider one of the most basic tenets of investing--risk versus reward.

The reward for holding a life insurance policy is usually similar to the reward for holding a 10-year Treasury note. Right now, policies written by many major companies pay between 5.5% and 7% interest. Yields on Treasury notes vary daily, but they’re comparable. Neither is terribly generous.

What do you get with a life insurance policy that you don’t get with a Treasury note? The ability to defer federal tax on your interest earnings.

What do you get with a Treasury that you don’t get with life insurance? Plenty. You get government backing, which translates to total safety of your principal. You get an interest rate guarantee that lasts the length of the contract. And you get the ability to sell the Treasury note in the open market at any time. Although the price of your T-note may vary a bit with interest rates, there’s no set penalty for selling before maturity.

Not so with a life insurance contract. Most insurers impose hefty penalties on anyone with the temerity to cash out in the first seven to 10 years. These fees, called “surrender” charges, vary from insurer to insurer but generally amount to between 7% and 10% of the cash value of your policy in the first few years. The surrender fees usually decline in subsequent years.

Some insurers also impose “market value adjustments” on those who cash out before their policies mature. The adjustments generally benefit the customer if interest rates have dropped, but hurt the policyholder if interest rates have risen.

The surrender fees essentially lock investors into long-term arrangements with their insurer, but the interest-rate promises that they get in exchange are usually short term. Most insurance policies allow insurers to adjust their interest rates at regular intervals--say, once a year--to respond to current market conditions.

Interest rates are usually guaranteed not to fall below certain thresholds, but those thresholds are low. Right now, most insurers are offering guaranteed rates of just 3% to 4% per year.

If the rate on the policy drops below market rates and the consumer wants out, he or she has to pay the surrender fee.

Finally, while the safety of your principal is guaranteed by the federal government when you buy Treasury securities, it is guaranteed by an insurer, and then a state-operated guarantee fund, when buying life insurance. There’s a huge difference.

Consumers who have policies with a failed life insurance company know that the guarantees offered by these state funds vary dramatically, depending on where you live. And payoffs can be delayed for years.

In the case of Executive Life Insurance Co., which failed more than a year ago, those who have insurance contracts and annuities worth more than $100,000--the cash-value guarantee limit in most states--are not expected to get back all their principal.

(The exact amount they’ll receive is uncertain, but it should be between 75 and 90 cents on the dollar.) And all policyholder accounts have been frozen since April, 1991, when the company was seized by regulators.