Permanent life insurance is an umbrella term which covers several policy types, such as whole life and indexed life, and making a decision between the two can be confusing.
If you try to research the subject, much of the information available is biased and tries to promote one over the other.
Other times, the information is too complex to be understood, or too simple to provide any value.
In this article, we will present an unbiased guide of the similarities and differences between whole life and indexed life to help you make a better decision.
While both policies can help you protect your loved ones and build up tax advantaged cash value that you can use during your life, the way they do this differs.
Whether you are putting your money in whole life or indexed life, it isn’t a short term vehicle, and for the best results you should be prepared to keep your policy in force for life, which is why it is so important to understand the respective risks and potential rewards upfront.
While it is entirely possible to switch an indexed policy for a whole life policy, or vice versa, as we learned in our 1035 exchange article, it is easier to make the appropriate decision from the start.
For the rest of this article, we will understand the basic differences in how whole life functions differently from indexed life, the differences in risk, and what policy is best for you.
The Basics Of Whole Life
Whole life is the most conservative policy within permanent life insurance, and has the strongest guarantees and security.
With a whole life policy, you are guaranteed to have level premiums over the time that you pay up the policy, meaning that they are guaranteed not to increase.
Similarly, you are guaranteed a minimum dividend - usually around 4 % - on the cash value that you build up in the policy.
In excess of the 4 %, you are eligible to receive a non-guaranteed additional return, which these days usually adds up to around 6 %.
Most whole life policies are issued by mutual insurance companies which are owned by their policyholders, which means that building up a cash value in a whole life policy is similar to building up equity in the life insurance company that issues it.
There is a couple of ways that the life insurance companies generates the guaranteed and non-guaranteed dividend for its policyholders:
- It makes an operating profit by taking in more premium payments than it is paying out in death benefit payments and running the company cost-efficiently
- It manages the money at hand conservatively in strategies like government bonds, corporate bonds, and policyholder loans
Whole life insurance is the first type of life insurance that was sold, before other types like term and indexed life, and has a very solid track record of delivering both guaranteed and non-guaranteed returns since the 1800s.
The Basics Of Universal Indexed Life
Universal life insurance is a more modern invention that came around in the 1980s, which has weaker guarantees and security, but offers the potential for higher cash value accumulation or cheaper coverage.
With an indexed life policy, your premium is flexible, and you are able to pay more or less premium each month.
While a flexible premium can sound convenient, it is also a fact that the charges of the policy can increase over time, and there is a risk that a policyowner might be required to pay an increasing amount of premium for the same coverage.
Most indexed policies do not have a minimum return guarantee, but are instead guaranteed against loss, meaning that the lowest return they can make over one year is 0%.
The returns that indexed policies can make are usually linked to the S&P 500, and policies will generally make the same return as the index, up to a cap, or max return, which today generally is around 9-11 %.
Most indexed life policies are issued by stock companies, which are owned by external shareholders, and do not generate returns for its policyholders in the same way that mutual insurance companies do.
Instead of having your cash value represent ownership in the insurance company, indexed policies generate a return for you by:
- Putting the majority of your money in fixed interest accounts which earn you a relatively low but dependable return
- Putting the remaining money in options that provides you with exposure to the upside of the stock market without the downside risk
The variability of both returns and potential cost makes indexed life a more risky proposition than whole life, but for someone who’s primary intention is to build up cash value for retirement or other purposes, indexed life might present a good alternative.
For both indexed and whole life policies, it is possible to enjoy dividends and loans from the cash value during your life, and to keep your loved ones protected with life insurance coverage that never expires.
In the next section, we will go into more detail on the risks and results to be expected from the different types of policies.
Differences in Risk and Results
As we already mentioned, indexed life is generally more risky than whole life, but there are several factors to consider, and many times things are not black and white.
In this section, we will mainly compare structural differences between the policies, but there are additional risks with any policy if your agent recommends the wrong policy for your needs, or designs it in a suboptimal way.
To avoid this risk, and always get the best policy for your circumstances, get your policy through our simple digital platform where industry veterans can help you through the whole process of getting the optimal policy.
Returns on Your Cash Value
With whole life, you will generally produce a return each and every year that you own that policy, which you will not with indexed life.
With indexed life, however, you might have some years where the return is greater than with whole life.
In other words, we could say that whole life is more of a savings vehicle, while indexed life is more of an investment like vehicle.
Whole Life Return Risk
With whole life, dividends are very dependable, and the life insurers on White Swan’s platform have delivered steadily on both their guaranteed as well as their non-guaranteed dividends for more than 100 years.
What makes whole life unique is that the cash value represent a part ownership in the issuing insurer, and as these companies are owned by their policyholders they act in a more prudent way than companies that are held by external stock investors, as you can learn more about in this article.
In fact, the whole life carriers available through our platform have the same credit rating as the US government, and have consistently outperformed other savings vehicles.
As an illustration of this, the chart below shows the hypothetical historical results of having $100 invested in a 10 year government bond versus having it in the cash value of one of the whole life policies offered through our platform.
The great thing about whole life insurance is that it can provide an extremely stable base pillar for your investment portfolio, which can support loans and other higher risk investments by always providing rock steady returns through virtually any situation.
While the returns are stable, and far above what you could get with other savings vehicles, they have been trending downwards in correlation with the increasingly lower interest rates over the past decades.
In fact, the pressure of decreasing interest rates recently caused the government to change its laws on permanent life insurance to allow them to offer whole life insurances with weaker guarantees.
While this law does make it easier to build cash value in permanent life insurance policies, as you can learn about in this article, it does also allow insurers to take away a part of the strong guarantees usually associated with whole life.
It is however still possible to purchase a whole life with the old and strong guarantees, which is simplest done by getting a quote from White Swan’s platform.
Indexed Life Return Risk
While indexed life does carry more risk than whole life, it carries less risk than a traditional direct investment in the stock market.
With the guarantee against loss, the cash value of indexed policies will not lose in value during market crashes but can still participate in the ensuing recovery of the market.
To understand this, let’s imagine a hypothetical market crash, and how it would play out for someone having $100,000 invested directly into the market through for example an index ETF, versus someone who had the same money in the cash value of an indexed policy with a cap of 11 %.
In the first year, the index drops 30 %, and while the direct index investor now has gone from $100,000 to $70,000 in the market, the indexed life investor still has $100,000 in his cash value.
The second year, the market starts recovering, and produces a 15 % return, which takes the direct index investor back up a bit to $80,500, but still puts the indexed life investor at a lead by bringing the cash value up to $111,000.
In essence, the downside protection allows the indexed life investor to “reset” when the market produces losses, and start earning money from the new lows as soon as the market starts recovering.
This protection is ever more important the larger the crash is, as the percentage gain you need to recover after a crash becomes larger the bigger a crash is.
To illustrate this effect, the table below illustrates how many percent gain you need to make to breakeven on an investment with different levels of losses.
While it can seem unlikely that the stock market drops 90 %, it did actually happen in the great depression, when it took direct index investors 25 years to breakeven.
In essence, the greater the drop, the more advantage an indexed life investor would have over a conventional direct index investor.
Granted, this protection does not come for free as the index life insurance is limited in returns by the cap, and by not getting dividends on the shares since the exposure is based on options, which are not eligible for dividends like direct stocks are.
Still, over the long run indexed life insurance tends to average out to a similar or slightly better end result than a direct index investment.
Those differences become even bigger when the direct index investing was done through a vehicle without tax advantages, which is another big factor that makes indexed life appealing.
As an illustration of these principles, the graph below shows the hypothetical results of having $100 in the cash value of one of the indexed life policies available through the White Swan portal versus having it invested directly in the index, with and without tax advantages.
Before you apply for an indexed life policy you can access information on how it is expected to perform, and historically much criticism has been directed towards these result predictions.
These predictions generally assume a flat return over time, which is not realistic, as some years will provide a higher return while others will provide a lower return.
The root of much of the critique that has been directed at these predictions in the past is that they were based on rates that were unreasonably high, which set people up with unreasonable expectations.
This is however not an issue anymore, since new regulations called AG-49 have been put in place which restricts the rate that can be assumed in making result predictions for indexed life policies.
While policy predictions before this law tended to overstate the expected performance of an indexed policy, policy predictions after this law change tend to slightly understate the expected performance.
Another part of this regulation is that it is no longer allowed to show expected results from a certain policy using actual historical data, as these tend to show better results than the new predictions after the law change.
In general, it is a good law to help set reasonable expectations, but it is important to understand that it might slightly underestimate the results that you could expect over time.
One risk that could make the indexed life perform worse than predicted over time, however, is an extended period of negative return years.
This is however not a big risk, as is evident by examining historical returns of S&P 500, where we can see that since 1937 the market has gone up 76 % of the years, and there has only been two instances where the market has gone down three years in a row (1939-1941 & 2000-2002).
It is said that the market takes the stairs up and the elevator down, meaning that it grows slowly but falls quickly, which implies that most falls are quick and followed by gains which can help indexed policies get back on track with their growth.
Another factor that could make the indexed life policy perform worse than expected is that the issuing insurance company could lower the caps (ie. the maximum returns), as these are not guaranteed.
The underlying reason why carriers might have to decrease caps is twofold: on the one hand, it could be because the interests rates are lower than expected, which leaves them with less money to buy options, and on the other hand, it could be because perceived volatility in the financial markets are high, and options are priced higher than usual.
While these two conditions could cause caps to go down, it usually only happens in small increments, since insurance companies need to stay competitive.
This is because if your caps gets changed past what you are comfortable with, you can do a 1035 exchange to switch your policy for another one with higher caps, as we learned more about in this article.
This same competitiveness can also cause caps to go up if the options strategy becomes easier to do.
The one risk to acknowledge here however is that the risk for a disadvantageous cap change is higher with lower rated, less financially stable insurance companies.
The best way to avoid this risk is by shopping your indexed life insurance through White Swan’s platform, where smart technology and industry veterans help you pick and design the best policy for you as well as monitor it over time to make sure you’re always keeping your money in the policy where you can get the best results.
Cost of Insurance Risk
Generally, premiums paid into a permanent life insurance policy goes towards two things - building up cash value, and paying for your insurance, as we have learnt about in this article.
While many who buy permanent life insurance policies primarily for saving or investing purposes see the insurance as secondary, it is not a bad protection to have.
This is because with the insurance coverage, the cash value of the policy will be guaranteed a certain final value, if the insured person were to die before the cash value has grown to equal the size of the protection.
In this way, the cost of insurance isn’t as much of a “cost” as it is a cash outlay, which provides protection and can drastically increase the returns on a policy if the insured person dies prematurely.
Further, the cost of insurance is only paid for the difference between the cash value and the death benefit, as this is the only amount at risk to the insurer.
Thus, in a policy that quickly builds cash value, the total cost of insurance will go down as the cash value will be able to cover much of the value at risk from the death benefit.
It is however important to take into account how much of the premium is going towards paying for the insurance, as it can be more or less with different policies in different circumstances.
With a lower cost of insurance, a larger part of the premium is able to go towards building up the cash value, which will boost the saving or investment performance of the policy.
As we will see, the cost of insurance works differently in whole life versus indexed life policies.
Whole Life Cost of Insurance Risk
With whole life insurance, the cost of insurance is the same in all the years that the policy is paid for, which is a feature of the guaranteed level premiums.
In reality, the risk that a certain person will die in a given year naturally goes up as that person becomes older, but with the design of a whole life policy, that risk is averaged to be the same each year.
The upside to this feature is that it guarantees that the cost of insurance will not go up over time, which is good for security and predictability.
The downside, however, of averaging the cost of insurance in this way is that the cost in the first years will likely be higher than they would have been if the costs had been decided on a year-by-year basis.
In essence, the cost of insurance with whole life ensures that you don’t have to worry about increasing insurance charges as you get older, but implies that you will pay more for the cost of insurance in the first years, which will build up less early cash value.
Indexed Life Cost of Insurance Risk
Unlike whole life, indexed life does not guarantee the same cost of insurance in all years, and will have a cost of insurance that increases in cost per unit as the insured person gets older.
What happens in an indexed life policy is that the cost of insurance is decided on a year-by-year basis, by using the amount that the insurance company is risking along with the probability that the insured person will die in the coming year.
For cash value accumulation purposes, this can be a good thing as the cost of insurance will be lower in the first years than it would have been with an equivalent whole life policy, which allows a larger part of the premium to go towards building cash value.
While it does pose the risk of increasing cost for the insurance, this risk is usually counteracted by the growing cash value, which puts less value at risk and thus lowers the total potential cost of insurance.
This allows you to build more early cash value in an indexed policy than in a whole life policy, which helps the policy compound better over time.
If the policy is not funded to the max or the cash value greatly underperforms the expectations, however, the increasing cost of insurance can become a problem in the later years of the policy, when premiums could increase to an unsustainable level.
If this happens, however, it is always possible, both with whole and indexed life policies, to decrease the death benefit to be closer to the cash value of the policy, which will lower the cost of insurance and the premium.
Further, there is additional risk with buying indexed policies from lower rated or less financially stable insurance companies, who might increase the cost of insurance over time by tweaking the levers available to them.
By doing this, these insurers would increase the cost of insurance beyond what has been predicted at the onset of the policy, which would make the policy more expensive, and allow you to build less cash value than expected.
This is however rare, and most high rated insurers never increase their cost of insurance, while the lower ones who have done it have never done it to the max allowed level.
This is because increasing the cost of insurance on a policy that is already in force creates legal hurdles for the company doing them, in addition to decreasing their competitiveness.
If someone did have a policy where the insurer increases the cost of insurance beyond what was projected at the onset of the policy, it is relatively easy to switch the policy for another, as we learnt in our article about 1035 exchanges.
So, while there are some risks associated with the non-guaranteed cost of insurance in an indexed policy, most of them can be alleviated by picking the right policy and max funding it in the first 5-7 years.
The easiest way to do this is through White Swan’s platform where we offer both whole and indexed policies from some of the best insurance companies and help you easily find, design, and monitor your policies for optimal performance.
It is popular to use the cash value of permanent life insurance policies as a security for low interest loans, which could be used to fund other investments or your lifestyle, and for example provide retirement income.
Just like taking loans against your house, it is important to do this responsibly, so that the loan balance doesn’t grow past the collateral value.
Unlike real estate, however, whole and indexed life policies can not lose in value from one year to the other.
With an indexed life policy, however, the cash value could grow 0 % from one year to the other, but with a whole life policy, the cash value will always be guaranteed to grow at least 4 %.
This means that while both indexed and whole life are safer to use as collateral for loans than your house, whole life is one notch more secure than indexed life is.
In general, however, it is advisable to keep the value of your loan against your cash value lower than 90 %.
If you do this, and pay the loans back when needed, the risk is not a whole lot bigger with indexed life policies than with whole life policies.
For practitioners within trends like Banking on Yourself and Infinite Banking, whole life is usually preferred, largely because of this reason.
Whenever you put money with an insurance company, you have a counterparty risk, which means that the insurance company that sold you the policy might go bankrupt in the future and might not be able to live up to the promises it has made to you.
While this risk is actually very low, even lower than the risk with banks, as we learnt in this article, it is something worth considering.
In general, the type of insurance companies that sell whole life policies are different from the ones that sell indexed life policies.
While the companies selling whole life are generally so called mutual companies, which are owned by their policyholders, the companies that sell indexed life are generally stock companies, which are owned by external shareholders.
The difference between stock insurers and mutual insurers has many aspects to it, which you can learn more about in this article, but in general, stock insurers are less financially stable than mutual insurers.
This means that in general, companies selling whole life have better credit ratings than companies selling indexed life.
In fact, the companies behind the whole life policies available at White Swan’s platform currently have the same credit rating as the US government, AA+.
The companies behind the indexed life policies available at White Swan’s platform are not however far behind, with a rating one notch below at AA-.
This means that as long as you are shopping for permanent life insurance policies from the highest rated carriers, the counterparty risk is basically negligible.
Choosing the Best Policy For You
As we have learnt through this article, the main factor that separates whole life from indexed life is how the policies handle risk.
With whole life, the risk is lower as it has more guarantees, meanwhile with indexed life, the risk is higher, but the results also have the chance of being better.
For someone who is primarily using life insurance as a way to minimize financial risk, whole life insurance might be a good choice, and for someone who is comfortable taking a bit more risk, indexed life insurance can be a good choice.
While indexed life does carry risk both when it comes to returns and when it comes to the cost of insurance, those risks are not as significant as one might think if you apply the strategies we have touched on in this article.
As both whole life and indexed life have their own advantages and disadvantages, it might for some make sense to mix them together to balance out their advantages and disadvantages against each other.
One way of doing this is to simply buy separate policies, both whole and indexed life, from different insurers.
Another way of doing it is by using certain riders which can be used to tweak a whole life policy to work more like an indexed policy, or an indexed policy to work more like a whole life policy.
If you for example are looking to get the same types of cash value returns on a whole life policy as an index policy, you can use features like an index participation rider which allows you to allocate a percentage of your cash value to an account that works similar to the account of an indexed policy.
If you wanted to get the same type of cost of insurance in a whole life policy as in an indexed life policy you could do what is called blending, where you use a so called annual renewable term rider to cover a part of your death benefit, which lets you get a higher cash value growth in the early years.
The reason that blending a whole life policy can help you build cash value quicker is that regulations require that permanent life insurance policies have a certain level of death benefit in comparison to the premiums to maintain their tax advantages.
When you use a term rider with a whole life policy, you make the death benefit higher without making the premium as high as it would have been if the entire death benefit was a part of the base policy, which allows you to put more money towards the cash value.
If you have an indexed policy and want to get returns more similar to a whole life policy, you can allocate a part of your cash value to a fixed account, which yields consistent but lower returns.
To learn more about riders in general, you can read this article.
While this can all seem confusing, the experts at White Swan have decades of experience with these policies, and can help you get the best policy for your needs.
Whole life insurance and indexed life insurance are two types of permanent life insurance, which works in different ways, and carries different levels of risk.
Whole life insurance has more guarantees and less risk than indexed life insurance when it comes to return risk, cost of insurance risk, loan risk and counterparty risk.
Index life insurance does however have some benefits that whole life insurance doesn’t, such as the possibility of higher returns, and higher early cash value buildup.
While both index and whole life insurance has unique benefits, whole life is best suited for those looking to minimize financial risk, while indexed life has the potential to reward those who are prepared to take on a bit more risk.
In the end, the question might not be either or, however, and there are ways to combine the benefits of both.
Whether you are looking for whole life, indexed life, or something in between, White Swan has got you covered.
On our platform we offer both whole and indexed policies from some of the best insurance companies in the US, and by buying your policy through us you will be able to enjoy the best results possible through a simple digital application as well as human help from industry experts with decades of experience in the industry.
Getting started is easy - just press this link and we will help you sign up with the best policy for your circumstances.