At first glance, permanent life insurance policies and annuity contracts have almost polar opposite goals. Life insurance is there to help your family if you die unexpectedly or prematurely. Meanwhile, annuities act as a safety net, usually for those in their senior years, by providing a guaranteed stream of income for life. Life insurance annuity.
However, the companies that market these products try to convince customers that both are prudent investment alternatives to the stock and bond markets. And in both cases, the tax-deferred growth on any underlying assets is a key selling point.
As it happens, insurance and annuity contracts also have a similar drawback: Steep costs that have the tendency to weigh down returns.
To be clear, there are certain cases when virtually any financial product can make sense for a particular purpose. But those instances are less common than some salespeople are inclined to let on. Let's look at the pros and cons of both instruments as investments.
Insurance: The Pros
The primary reason to take out life insurance is to safeguard your dependents in the event of your passing. But unlike simple term life policies, which just pay a death benefit, permanent life policies (also known as cash-value policies ) add a savings component. For that reason, their premiums tend to be quite a bit higher than they would be with a term policy of the same face value.
In the case of whole life products – one of the more popular forms of permanent life insurance – the company credits your cash account based on the performance of a relatively conservative investment portfolio. Other types, such as variable life insurance, increase your potential growth (as well as your risk) by allowing you the choice of investing in a basket of stock, bond and money market funds.
The money in your cash/investment account grows on a tax-deferred basis. So unlike ordinary investment or savings accounts, you don’t have to pay any tax on investment gains until the funds are actually withdrawn. As a result, you don’t have that drag on your earnings that taxable accounts bring with them.
These policies also offer a certain degree of flexibility. For example, if your cash balance is high enough, you can take out tax-free loans to pay for unexpected needs. As long as you pay yourself back – including interest – your full death benefit remains intact.
Insurance: The Cons
But life-insurance-as-investment strategy has its downsides, too. Not least of them are the hefty fees that often accompany such policies. With many plans, roughly half of the premiums you pony up in year one pay the commission for the sales rep. As a result, it takes a while for the savings component of your policy, also known as its cash-surrender value, to start gaining traction.
Term life ins rates
On top of the upfront costs, you face yearly charges for administrative and management fees, which can counteract the benefits of your funds' tax-sheltered growth. Often, it’s not even clear what the exact fees are, making it hard to compare providers.
It’s also worth pointing out that many policies lapse within the first few years because the sizable premium payments become just too steep for policyholders to maintain. As a result, these individuals may see little, if any, return on their investment.
Insurance: The Best Strategy
Quoting the adage, "Buy term and invest the rest," many fee-based financial planners recommend that investors purchase a lower-cost term policy for insurance coverage and use "the rest" – that is, the additional amount that a permanent life premium would've cost – to fund a tax-advantaged plan such as a 401(k) or IRA. Most of the time, you’ll face dramatically lower investment fees this way, while still enjoying tax-deferred growth in your accounts.
However, if you’ve already maximized your contribution to these tax-advantaged retirement accounts, cash-value policies might start to make sense. Even then, you’ll be better if you select a low-fee provider and have a long timeframe to let your cash balance grow.
In addition, high net worth individuals sometimes put a cash-value policy inside an irrevocable life insurance trust in order to reduce estate taxes. Technically, the trust pays the premiums – not you – so the policy isn’t considered part of your estate when you die. Considering that the top federal estate tax rate in 2018 is 40%, beneficiaries usually end up with a much bigger inheritance this way. For more, see 7 Reasons To Own Life Insurance in an Irrevocable Trust .
Annuities: The Pros
Most of us hope to live until a ripe old age, but longevity can have perils. Among them is the risk of outliving your money.
Annuities were developed to help mitigate that concern. Basically, an annuity is a contract with an insurer whereby you agree to pay the company a certain amount, either in a lump sum or through installments. In turn, it makes a series of payments to you now or at some future date.
Sometimes those payments last for a specific time period – say, 10 years. But many annuities offer lifetime disbursements. As a result, the fear of exhausting your assets starts to subside.
As with permanent life insurance policies, the number of annuity products has exploded over the years. Now, you can choose between “fixed” contracts that credit your account at a guaranteed rate and “variable” annuities, in which returns are pegged to a basket of stock and bond funds. There’s even an indexed annuity, where the performance of your account is tied to a specific benchmark, like the S&P 500. For more details, see Variable Annuities with Guaranteed Income Options.
Annuities: The Cons
Unfortunately, the same problems that often come with permanent life insurance policies also hold true for annuities. For instance, if you sign a contract with a traditional insurance company, you can expect to pay a big upfront commission fee that’ll cut into your long-term gains.
Perhaps even more troubling are the surrender fees that can tie up your funds for as long as 10 years. The numbers vary from one provider to the next, but it’s not unusual to take a 7% hit on any excess distributions you take during the first couple years of the contract.
Another concern is the tax treatment. Sure, your earnings grow on a tax-deferred basis. But once you start withdrawing funds – you can do so penalty-free when you are 59½ years old – any gains are subject to ordinary income tax rates. If you had bought stocks and bonds instead, you’d be taxed at a more favorable capital gains rate.
Annuities: The Best Strategy
Do high costs mean you should steer clear of annuities altogether? Not necessarily.
Some folks simply need some protection for their old age, especially if they come from a long-lived family. If you don’t have enough assets to live until age 90 or 100, a lifetime stream of income might make sense. But experts say you should only get as much coverage as you really need.
First, determine how much money you’ll need in order to live comfortably in retirement. Then, deduct any other sources of income, like 401(k) withdrawals and Social Security payments. As retirement draws near, you can purchase an immediate payment annuity that covers the difference.
If you're a younger investor, variable annuities might be an alternative if you've already maxed out your 401(k) and IRA contributions, and could still use some tax-sheltering. Just make sure your assets are encumbered by unnecessarily high fees. These days, companies such as Vanguard, Fidelity and Jefferson National offer low-cost annuities whose fees won't take a big bite out of your return on investment. Life Insurance vs. IRA for Retirement Saving discusses this in more depth.
Cigna health insurance
The Bottom Line
Some financial advisors maintain that insurance is insurance, and investing is investing, and never the twain shall meet. That's not necessarily so. While fees and administrative costs can hurt the returns you get from a permanent life policy or an annuity, these vehicles can have their tax-advantaged uses, especially for the risk-adverse and those with high net worth.
If you think one of these products might be a good fit for your specific needs, just Beware of Annuity Salespeople and Their Tactics. Consult a financial advisor whom you know isn’t working for an insurance company – or on commission from one.
For related reading, see "Life Insurance vs. IRA for Retirement Saving."