What is the Internal Rate of Return of a Whole Life Policy?
“Little by little I will drive them out before you, until you have increased enough to take possession of the land.” (Exodus 23:30)
Historically, the Internal Rate of Return (IRR) of Whole Life insurance has been very strong and yet, pinpointing the IRR is not as simple to answer as you would think and is the source of much confusion when it comes to Whole Life Insurance. In the beginning, the rate of return is non-existent, and then it grows stronger and stronger over time, so it works completely differently than simple one dimensional investments.
Because you get lifetime benefits that become stronger and stronger over time, you have to measure them with a long term perspective. Remember that by purchasing a Whole life policy (through a strong Mutual company) you are becoming an owner of that company. As with any profitable business which is started, there must be capital invested in the beginning which does not bring immediate profits. However, over time you expect greater and greater profits from the policy. Again, the first couple years (each policy/company is a little different) buys you these long term benefits. Every year after this initial start up phase, you basically see the money that you put into the plan go immediately to cash value and then some.
The amount of this growth over time will be dependent upon dividends and is impossible to accurately predict. However, to give you an idea of what to expect, we’re going to look at it in a few ways. This won’t give you an accurate crystal ball to know exactly what will happen in the future, but it will hopefully help you understand the range of possibilities. Unlike the stock, real estate, or other turbulent markets, the range of possibilities does not include negative outcomes, but instead a range of positive outcomes.
Let’s first look at what the insurance company itself will tell you about how it will perform. Mutual Life Insurance companies are not like Mutual Fund companies who will point to the best period of history that its had and talk up how wonderful the future possibilities are (with a discreet disclaimer that past performance is no guarantee of future results). The insurance companies do pretty much the opposite of this. Instead of showing you their past performance, which is very strong as we’ll see below, they only talk about what they are doing now, along with two worse case scenarios.
So they will show you an illustration of what your policy will perform like if the dividend rate that is currently being paid never changes. They will also show you what will happen if the policy never receives a dividend (remember, if you’re with a good company, they have ALWAYS paid a dividend since before you were born, so the idea that they would never pay one is extremely conservative). And they’ll show you a mid-point in between these two. It is our opinion that the best case scenario that these companies will show you is a worst case scenario for your life. The low dividends are based on the extraordinarily low interest rate environment that we’ve been in recently. Expecting this to continue forever is not realistic.
That being said, the performance predicted by the policy is still pretty good. It will usually tell you to expect between 4-6% IRR. Remember, this is tax advantaged, so to equal this growth in a taxed plan such as your savings account, CD, or Money Market, you would have to achieve between 5 to 8.1% IRR depending on where in that range your policy fell and your tax bracket (soon to increase). Even though this is an extremely conservative projection based on today’s interest rates, it is far higher than you can achieve with any other Guaranteed growth/Safe Money Vehicle.
If we break down the different components and benefits of the whole life insurance policy as we have been discussing, the results begin to look a lot better. Perhaps that can best be explained by looking at a real policy that has been in force for a while.
We’ll do that tomorrow.
This is Part 6 in a series on Whole Life Insurance. You might want to read the introduction to this series which will link to each post in the explanation of whole life and Ben’s story showing how whole life is used in a variety of ways in his life.
Photo credit: Smelter Mountain