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Life insurance is a notoriously scammy industry, made more confusing by the fact that there are legitimate forms of life insurance that aren’t a total waste of money. So which ones are legit, and which ones should you avoid?

Reminder: I am not a certified financial professional and this is not financial advice; please do your own due diligence.

Our show is a production of Morning Brew and is produced by Henah Velez and Katie Gatti Tassin, with our audio engineering and sound design from Nick Torres. Devin Emery is our Chief Content Officer and additional fact checking comes from Kate Brandt.

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Mentioned in the Episode

• Average life insurance rates (Nerdwallet)

• Cash value life insurance (MarketWatch)

• The estate tax (SmartAsset)

• “Is IUL a Scam? Yes” (Personal Finance Club)

• Income tax on life insurance policies (IRS.gov)

• Historical stock market average returns (Trade That Swing)

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Zoey:

I can get a baby out of a woman in under a minute by cutting through and both of them end up alive at the end, but I can't figure out why my money is going away into this thing that I never needed.

Katie:

Look, in a region of the financial universe where we get swindled into accepting a healthcare system that invents things like premiums and deductibles and out-of-pocket maximums to avoid ever having to pay a dime for our care, it feels a little silly to delineate between elaborate insurance scams, but as you'll hear today, there are levels to this game and it's a highly sophisticated one.

The reason this particular form of insurance is so dangerous is because the most vulnerable targets are relatively unknowledgeable people trying to make positive financial strides. On one of my first calls with a “financial advisor” (financial advisor is here in scare quotes), I found myself spinning. He couldn't answer any of my questions about how much I should be saving or what I could afford for rent, but he seemed hellbent on redirecting my attention to life insurance. As a 23-year-old with no dependents and barely an income, it was not immediately clear to me for whose benefit we would need to ensure my life, but he was insistent and I ended up dropping the ball and never getting back to him. And now I'm really thankful for that forgetfulness and avoidant tendency. I'm not sure how much he would've charged me for a policy, but I know with near certainty that it would not have been the good investment that he promised.

Because as you'll hear, this is an intentionally murky part of the financial world that uses complexity and aggressive sales tactics to part you from your money. Of course, I'm not a financial advisor, but I am someone with a very low tolerance for financial bullshit and boy, this stuff stinks. But as always, do your own research and consult a professional, preferably a CFP who does not sell life insurance rather than a life insurance salesperson before you make any major decisions.

Welcome back to the Money with Katie Show, Rich People. I'm your host, Katie Gatti Tassin, and today we're talking about life insurance with someone who did take the plunge.

Zoey:

Hi, my name is Zoey, and two years ago I was sold a variable universal life policy from my financial advisor who I met through my parents.

Katie:

That's Zoey, a young doctor from California and she doesn't have any kids or dependents, but in 2022, her financial advisor worked for the insurance subsidiary of the financial services company Ameriprise called RiverSource, and she told Zoey that she needed this policy.

Zoey:

So my financial advisor and I would meet periodically about once every six months to go over the measly investments that would go into my retirement. And about two years ago is when she brought up the idea of purchasing term life insurance and whole life insurance and to consider something like a variable universal care like with long-term rider.

And that was kind of how she sold it to me actually in front of me. I still have my notes from that first meeting that I took. So it's really interesting going back and looking at what I wrote and exactly what she said to me to convince me that this is something that I needed.

Katie:

What was that? What did she say?

Zoey:

She told me that I do have the option to cash out at any time to use for supplemental retirement funding. She sold the long-term care rider, especially because I'm a physician. She really was like, you know how expensive it can be towards the end of life and all of those costs, so this is something that I know you know about. And then she really sold it when she told me this is the policy that your parents have. Your parents got this policy a couple of years ago and they really like it. And so in my financially illiterate way, I was like, oh, well my parents are doing pretty well financially from what I can tell, they're doing something right. Sure, sounds fine.

Katie:

What Zoey's describing will be a familiar tale to anyone who's been on the receiving end of such a sales pitch. But maybe we should back up a step. Why do you need insurance in the first place? Insurance can be a good thing. So how do we distinguish between this kind and the type you actually do need?

We'll dig into it after a quick break.

So why might you need insurance? Well, you typically buy life insurance as soon as someone else depends on your income. Most often this means kids and or a partner. And once you decide you need it, you have different options about the type you want to buy. And for most people, most of the time, there's only one type that really makes sense: Term life insurance. The only goal of term life is to supply a death benefit, aka money to your beneficiaries that will replace the income you would've earned to support them if you die within the defined period of years, like 10, 20 or 30.

Term life insurance can still be profitable for companies; most policies expire before the policy holder passes away, thus collecting 10, 20 or 30 years of premiums without ever needing to make a payment. And per NerdWallet, the average cost of term life insurance is $26 a month based on data for a 40-year-old buying a 20-year $500,000 term life policy, which is the most common term length and amount sold. This means that if this 40-year-old with dependents were to pass before age 60, which is coincidentally around retirement age, their policy would pay out $500,000 to their dependents.

This works like most insurance types you're probably already accustomed to. Take your car insurance for example. Your car insurance is not an investment, it's to protect you if something really expensive happens to your vehicle or because of your driving, it's to underwrite the value of the asset. With life insurance, the asset you're underwriting is…you, it's your human capital. This means that another way to think about life insurance's purpose is to consider it a source of replacement income. If you pass away before you have enough time to build up the adequate investments to provide for those who are dependent on you or if you have a pension that your partner relies on that would go away if you did.

Term life insurance is straightforward, it's cheap, and importantly it is not and does not pretend to be an investment, because that's where we get into trouble.

So did the financial advisor who sold you this, it sounds like they framed it as an investment, but I want to confirm that, and I'd love to know a little bit more about how they described the product you were buying. It sounds as though they positioned it to you as your parents have it and they like it and oh, long-term care is so expensive. But what were some of the other particulars that they noted about how this product worked?

Zoey:

They really sold the fact that there would be a great rate of return on the investment and that this would be yet another source of income for me in my retirement and how it would be super beneficial to my family as well in case I don't make it to retirement. All the while they knew that I am unmarried, no children don't have any dependents, but that it was really important, especially while I was young and healthy to get a policy like this.

I think I remember that she also talked a lot about how this would be beneficial from a tax perspective, like an income tax perspective. I don't remember the details that she told me other than, well, we have to try to get your taxable income as low as we can and this would somehow help. And I was just like, it's okay if you say I don't know that that's correct, but I don't know enough financially, unfortunately I know enough medicine, but finances are a little over my head, which is why I had her.

Katie:

The product that Zoey is describing is what's known as a permanent life insurance policy. That is, one that doesn't expire. It's a lot pricier.

How much did you pay in premiums each month for the policy? Can you walk us through some of the numbers?

Zoey:

Yeah. She had me paying $350 a month into the policy, so for the last two years I've been paying that much into the policy with the plan to, from her perspective, continue paying $350 a month or if I wanted to, I could pay more than that each month to help really grow it and have all that extra money for me to use later.

Katie:

So $350 a month, but she said you could do more than that.

Zoey:

Correct. Almost in the way that you would pay more for instead of sticking with your minimum payments on your student loans, you could pay more into this policy and then it would reach its maximum benefit sooner than what she had planned.

Katie:

Insurance products that attempt to combine your desire to ensure yourself and invest do both…at great expense to you. When you combine these two intentions, you introduce a level of complexity that makes it much easier for the person working at the firm to rip you off.

You may have noticed that Zoey noted that her advisor emphasized that her youth and her health were key. This is a common tactic when selling a permanent policy to young people emphasizing that your premiums will be lower. It's kind of meant to suggest that you're getting a bargain.

Permanent life insurance policies come in at least five flavors, all of which have something called a cash value. This phrase cash value is a little like the scam dog whistle. It's the signal that they're trying to combine your insurance needs with your investment needs and overcharging you for the pleasure.

In practice, a permanent life insurance policy has two components: the death benefit which your term life policy has and a savings component. This is what the permanent policies add and is the part that's purportedly a good investment.

You might be offered one of the following: a whole life policy in which everything from the premium you pay to the death benefit is fixed and guaranteed, making it the most simple and straightforward of your bad choices. Then you have things like an indexed universal life policy, a variable universal life policy, a variable life policy, or a universal life policy; like take your pick, combine the words in any order you want.

Universal life policies are often considered to be the most predatory types because they require a constant stream of cash to fund which pays the necessary boatload of fees and if you stop funding it or paying the fees, the balance just gets collected from your cash value, which is then slowly bled dry.

Unlike a regular investment that you can make early in life, forget about it, put some money in one time and then revisit it 40 years later to find a bigger sum, this is the opposite. You must keep dumping money into it in order to preserve it and grow because the fees are substantial.

In some of these options, you'll encounter things like flexible interest rates with a floor, which means they're going to cap your losses. For example, your cash value might be invested so that it'll track an index, but it'll cap losses at 2% such that you can never earn less than 2%—and that sounds good on the surface if you can invest and have your losses capped—but it also means they're going to cap your gains such that you are not going to benefit from the full strength of bull markets either and anything above the ceiling they keep. In Zoey's case, her floor was 0%, but her cap was only 6.5%, which means in a year when the S&P 500 returned 30%, she would only see 6.5% gains.

But honestly, don't concern yourself too much with remembering all of these different names and types and variations because it's not important. The simple way to remember it is: If a policy has any of these words associated with it or there's any mention of a cash value, most people are probably better off running in the other direction, straight into the arms of term life and investing the cost difference on their own.

In these more convoluted policies, the premium is paying for two things, the payout that your family would receive if you passed and the cash value where some of your payment is going to grow tax deferred at either a defined or variable rate. This supposed tax benefit is a big selling point for those who stand to make large commissions on these products.

Zoey:

So she definitely mentioned the fact that it can be tax deferred. She mentioned the fact that the cash grows over time that I can pay until whatever age I want into this policy and that it becomes income that is tax free for my future financial goals.

Katie:

Can you tell me more about what she told you with respect to taxes?

Zoey:

The other notes I have are actually from the meeting that I had with her two days ago when I told her I just don't want this policy is that there's an opportunity for a tax-free future and that it's the quote, she said, “only way to grow a tax-free retirement bucket.” I wrote that down specifically when she said it because this sounds insane. So I'm writing this down.

Katie:

Unlike the tax benefits that accompany legitimate investment vehicles, these benefits are a little less compelling. Think about how a taxable brokerage account works: You can access your principal at any time tax-free, but you’ll pay taxes on capital gains, if you have them. 

A life insurance policy’s cash value tax treatment can be similar, with one difference: The funds are growing tax-deferred within the vehicle (a little like how funds grow in a 401(k) or IRA). As you likely know, you can’t tap the principal in a 401(k) early without paying taxes or penalties unless you know the crafty-but-legal workarounds we espouse in our “pay no taxes in early retirement” episode, so often salespeople will focus on this supposed benefit to make the point that this product is “better” or that the 401(k) is “a scam.” But the tax-deferred growth is nowhere near impressive enough to offset the egregious fees you’ll pay, which we’ll unpack shortly.

There's another tax benefit that's often touted your policy will pay out to your heirs tax free. Tax free, but here's why that's a red herring. Unless you're passing down an estate worth more than $13.61 million per person, your estate is already going to be passed down tax free because that is the estate tax exemption limit and if you're in that position passing down an estate that'll bequeath your heirs with an amount in excess of $13.6 million. I will assume that you are working with a wealth manager who can guide you through the decision to buy life insurance for tax benefits.

We will continue this breakdown after a quick break.

In case it's not obvious yet, this stuff is complicated, really complicated. The manuals that accompany these policies can be a hundred pages long. You get the impression that they don't want you to understand what you just purchased and these sales tactics thrive in the obfuscation.

I asked Zoey if she would send me her paperwork because I wanted to dig into it too. It was “only” 33 pages long and there were three pages of key terms to know in order to understand the policy.

Zoey:

So two years ago when she first brought up this policy, she sent me the 33 page, almost like a manual that I sent to you, and I distinctly remember downloading it, putting it on my computer desktop, which is my note to myself, come back and review this in detail someday. And then every time I would try to open it and read through it and process it, I couldn't. So that was the bulk of the information that she gave me at the time.

Katie:

Inside this packet, you'll often find dozens of charts that purport to show how your policy of guaranteed income is going to outperform the S&P 500. Jeremy, the founder of Personal Finance Club, bought an indexed universal life policy, read all 91 pages of the paperwork and debunked some of their most egregious claims in a post called, “Is IUL a Scam? Yes.” that we will link to in the show notes and he points out the way in which the comparison between S&P 500 average returns and a policy with a floor and a cap conveniently ignores the existence of dividends in the S&P 500, thereby intentionally misrepresenting the outcome one would've achieved had they just invested in a simple index fund. Having gone through the sales process himself in order to conduct this exercise, he also noted another major thing that was suspiciously absent from the pitch that he received.

Zoey:

At no point in our conversation did she mention fees in the same way. At no point in any of our conversations did she mention like a commission that I have to assume that she's getting. And that's not to say I'm against people getting commissions, but I think the dynamic changes significantly when you're going to a car dealership and you're talking to someone that you know is going to get something out of your purchase, you come into it with a little bit more skepticism and I just did not have that wall when I spoke to my financial advisor and listening to what they were recommending that I do with my money. So I think the combination of never telling me about fees, never telling me about potential commissions, never providing more than a 33 page document, it just didn't bode well for my trust.

Katie:

Jeremy did the hard work of breaking down the fees in the policy he purchased, so hat tip to him for this breakdown though, keep in mind this is going to vary by policy, so what you find in your own packet might be different.

• First he found a premium expense charge of 6%. This is immediately taken out of the premium you pay every month.

• Then the monthly policy fee, his was $12. Next was the per unit charge of 59 cents a month where a unit is defined as each thousand dollars in death benefit coverage, and his policy had $100,000 of coverage, so he paid $59 a month for this.

• Next we have the surrender charge, which in his policy started at $24.91 cents a unit and started dropping at year 11 until it was gone after year 16. And an important note here per Jeremy, this means that if you want your money back before 16 years, you have to pay another fee. This generally means that you cannot get anything back for the first several years. In his case it was four.

• Last we have the index account charged for another 0.06% per month. After all of the fees above plus cost of insurance are taken, then this fee is assessed to the remaining cash value. And as he pointed out, 0.06% per month doesn't sound too bad, but that is about 0.72% per year.

But as you heard, there was no mention of any of these fees in the sales process. You'd have to read dozens of pages for that and even then, good luck making sense of it. If you understand how fees impact your investment performance, you probably can see the writing on the wall of where this is headed.

After combing through Zoey's paperwork, it seemed as though we reconciled some of the figures. The policy describes her net annual outlay as $2,700, which if you can divide by 12, you know that that's only $225 per month. And this tracks with what the premium stated on the first page of the policy. But since she was actually paying $350 per month or $4,200 per year, I think the word “net” is doing a lot of heavy lifting to obfuscate the fact that of the $4,200 she's paying, only $2,700 of it is going toward the cash value. Even then it's really befuddling.

One of the charts in her packet shows three different potential outcomes based on returns. And in the first scenario after year 10, the policy value is only $7,100. That is to say, after 10 years, she would've paid $42,000 for this insurance and the cash value to her was only $7,100. Now of course if she were to die, it would pay out $500,000, but $42,000 bucks is a lot of money to spend for coverage worth $500,000 and a piddly little savings account worth $7,000. The rosiest outcome on offer was scenario three in which she would slide into year 10—having paid $42,000, remember—with a surrender value worth $20,000.

If she surrenders the policy at any point in the first six years, it shows that her surrender value is zero. She gets nothing back, meaning she has to pay in at least $25,200 over the course of six years in order to have any surrender value in year seven worth between a whopping $739 and $8,374 depending on performance.

So what did you end up choosing to do? Do you still have the policy? Did you surrender it?

Zoey:

So as it currently stands, I still have the policy because when I told her I don't want it, she seemed as if no one had ever asked her that they didn't want this policy anymore and she didn't really know how to go about stopping it. And so her only suggestion really… [fades out]

Katie:

We ended up trying to work through how she could get out of this in real time together during this interview.

Zoey:

Certainly her advice at no point was to stop paying the premiums. I had to force her to stop automatically withdrawing monthly premiums from my bank account. And because again, when I was on the website for financial advisor about a month ago when I was trying to stop the payments myself, I could find nowhere on the website where I could click a button that said stop withdrawals. I attempted to disconnect my bank account from their website and it wouldn't let me.

And so then I thought to myself, okay, well let me wait until the email comes once a month that says, Hey, we're going to withdraw such and such amount from your, maybe that's the time that I can do this. I waited until that time the email came, I still couldn't find anything. I sent her an email at that point saying, I need you to pause payment until we have our next meeting.

Of course there was a delay in her response to me and when she finally did respond, it was, oh, unfortunately we can't make changes within five days of payment processing. I've stopped your future payments, but for this month it's still going to withdraw $350. And that's when I really got mad because I was like, do I call my bank and tell them to not allow this payment? But then I do that and now my bank is charging me a fee and I'm just like, this is insane. So at this time, the automatic withdrawals from my bank account, according to her, have stopped.

Katie:

As we alluded to earlier, if you surrender your permanent life insurance policy, you'll pay surrender fees and some of your funds may be subject to income tax. In order to get money back, you must first make it through the surrender period, which can be years. But this can be a tricky sunk cost calculation that you'll have to weigh: Is it better to keep sinking cash into this thing to get your money back—sometimes seen as throwing good money at bad money—or should you cut your losses now and just bail?

It usually depends on how long you've been paying in and how much longer you have to go and how much money is really at stake. In general, you'll only pay income tax on interest or earnings over the amount that you paid into the policy. The tax-free portion typically includes any money you paid in premiums over the life of the policy. So for example, if you paid $50,000 into the cash value via premiums and the surrender value is $60,000, you'll generally have to pay taxes on the $10,000 over what you paid into the policy.

And on that note, the cash value and cash surrender value are different. While they sound similar, they're not the same thing. Cash value is the current balance of your life insurance policy based on the amount of premiums that you've paid, and the cash surrender value is the amount of money you'll receive from the policy should you decide to surrender it, which will always be lower as it'll be your cash value less the surrender fees, which can be thousands of dollars.

Let's take a closer look at Zoey's policy to see the difference between it and investing in a simple index fund in just buying term life insurance. Since a permanent life insurance policy doesn't expire, we do have to arbitrarily pick a desired timeframe for our comparison. We also have no idea what the market is going to do in the future. So in the interest of being as unbiased as possible, I'm going to use the real S&P 500 returns with dividends reinvested over the last 30 years and compare it to the first 30 years of Zoey's policy with all of its fees, though I will note they are not explicitly disclosed anywhere in the 33 pages that I could find. We're going to use her floors of 0% and the caps of 6.5%.

We also need to estimate what term life insurance for $500,000 worth of coverage for a 30-year term would've cost Zoey so we can deduct it from her investment contributions in the term and invest route. Essentially, how cheaply can we get that same $500K of coverage in the event she passes away, but use another investment vehicle for this investment portion? For Zoey's age, zip code and health status, we were quoted $27 per month for $500,000 worth of coverage on a 30-year term compared to the $350, more than 10 times as much that her variable universal policy charged. We know the range of possible outcomes for Zoey after 30 years with this policy, all of which require the $350 per month payment to obtain. And I almost can't believe this to the point that I'm wondering if the charts in the policy paperwork are wrong, but her range of outcomes is between cash values worth $45,000 and $137,000 after 30 years. I don't think this is inflation adjusted, but just like the nominal payout figure now.

I wanted to use Portfolio Visualizer to run the simulation as accurately as possible and do a little back test. But the free tier limits you to 10 years of data and I'm a cheap bitch. So we're going to use average annualized returns instead. Assuming the real life returns over the last 30 years, the S&P 500's average annualized return is 10.52% per year before inflation. Assuming she pays $27 per month for her term life insurance and then invests that other $323 per month into a low cost S&P 500 index fund earning that average return of 10.52%, she would have around $710,000 after 30 years—or around five times as much as her best case scenario with the variable universal life policy while maintaining the same level of insurance.

Now, of course, it's possible that the next 30 years in the market could look nothing like the last 30, such that every single year is negative or less than her cap of 6.5%. But that's not a bet that I'm willing to pay $350 bucks a month on.

And the point is not that life insurance is bad, just that mixing insurance with investing probably spells trouble for most people most of the time.

Zoey says the worst part is that she knew going into this, that whole life insurance was a red flag, but that all of the different terminology tripped her up. She said she felt totally defeated by how complicated it became.

Zoey:

The fun of all of this is that I had always heard for years that I should avoid whole life insurance. I knew that the words whole life insurance were red flags that I should avoid it. So she very conveniently did not use the words whole life insurance. At no point. I had to really start looking into it and be like, wait, is a variable universal? Is that a whole life insurance? Wait, what did I buy into?

Katie:

And if you do have people who rely on your income, then by all means get a term life policy. It is significantly more cost effective, often provides higher coverage and for lower costs, and it can protect your income while you use the savings from not buying a whole life policy to invest in quality investments for your future income.

And that is all for this week. We'll see you next week on the Money with Katie Show.

Our show is a production of Morning Brew and is produced by Henah Velez and me, Katie Gatti Tassin, with our audio engineering and sound design from Nick Torres. Devin Emery is our chief content officer and additional fact-checking comes from Scott Wilson.