When you’re talking about whole life insurance, you’re talking about guarantees. Guaranteed death benefits, guaranteed premiums, and guaranteed cash value growth. What comes up a lot of times is people asking, what growth can I expect within the policy? Is it 3%? Is it 4%? I know there was a law that changed. How does that affect me today? Today we’re going to unravel all of this.
So let’s dive into the guaranteed 4% that we hear about all over the internet.
It’s not 4% anymore.
From the year 2000 to basically the year 2022, interest rates were held low by the Federal Reserve. Consequently, companies and individuals who were saving were not earning the interest rates they were used to. Insurance companies that had life insurance policies guaranteed at 4% struggled to meet that number.
Here’s the key. The guaranteed 4% does not mean your cash value is going to grow at 4%. That was never the case.
During COVID, the rules changed, and insurance companies were allowed to use a lower guaranteed rate. That rate is typically somewhere between 3% and 3.75%, although some policies have guarantees as low as 2%. It depends on the policy and the insurance company.
So what do these percentages actually mean for the policyholder?
Most people think of this guaranteed rate as a perfect compound interest curve where you put your premium in and it grows steadily over time. But that is not how it works.
When you pay your premium, the insurance company first deducts mortality charges. Then they deduct expenses required to run the company. Only the remaining portion is credited with interest based on the guaranteed rate.
So it is not as simple as paying your premium and having all of that money grow at 3.5%.
The insurance company uses that guaranteed rate as a discount factor to meet its second promise. The first promise is to pay the death benefit as long as the policy is in force. The second promise is that at the age of maturity, typically age 100 or 121, the cash value will equal the face amount of the policy.
For example, if you purchase a $50,000 policy, the insurance company must ensure that by age 100, there is $50,000 of cash value available. They calculate how much must be set aside each year using that guaranteed rate to ensure they meet that obligation.
This is why, in the early years, whole life policies have little accessible cash value. Mortality costs, expenses, and underwriting costs are highest at the beginning. As the policy matures, those costs decrease, and the policy becomes more efficient.
These policies are actuarially designed to have minimal cash value early on and then grow exponentially over time.
To improve early cash value, policies can be structured with a paid up additions rider. This rider allows you to purchase additional paid up insurance that has immediate cash value attached to it.
By using paid up additions, you are essentially front loading the policy to increase early liquidity and access to capital. This helps bridge the gap until the policy becomes naturally efficient on its own.
Any available cash value within the policy can be accessed through the loan provision. That is a key feature of whole life insurance.
When you contribute additional money through paid up additions, that amount is also discounted using the guaranteed rate. For example, if you put in $1,000 and it purchases $2,000 of death benefit, the insurance company ensures that the $2,000 will be available as cash at maturity by applying that same discounting process.
So why would someone choose a lower guaranteed rate versus a higher one?
A lower guaranteed rate gives the insurance company more flexibility to generate higher dividends. It is a lower hurdle for the company to overcome, which means more potential profit can be distributed to policyholders.
On the other hand, a higher guaranteed rate provides stronger contractual guarantees but may result in lower dividend potential.
It ultimately comes down to how you plan to use the policy. If you intend to use it earlier, higher guarantees may be more attractive. If you are focused on long term growth and potential dividends, a lower guarantee might make more sense.
Another factor is that lower guarantees often result in lower death benefits, which can allow for more premium contributions before reaching MEC limits.
One of the biggest misconceptions is that the guaranteed rate equals the return you will earn over the life of the policy. That is not true. The guaranteed rate is simply a calculation tool used by the insurance company. Your actual performance may be higher or lower over time.
So what should you actually expect?
There are three key milestones to focus on.
In year one, you can typically expect around 50% of your premium to be available as cash value. For example, if you contribute $10,000, you may have about $5,000 available.
Between years four and seven, you can expect an annual break even. That means your annual premium contribution is roughly equal to the increase in cash value for that year.
Between years ten and thirteen, you can expect a cumulative break even. If you have contributed $100,000 over time, your cash value may be at or near that same amount.
These benchmarks are much more important than focusing on a single interest rate.
In conclusion, the guaranteed interest rate on a whole life policy does not represent the return you will earn. It is simply the rate used by the insurance company to ensure they can meet their long term obligations.
These policies are actuarially designed to grow cash value year after year.
If you would like to learn more about how to put a whole life insurance policy to work for you, your family, and your business, visit our website www.tier1capital.com and click the “Schedule Your Free Strategy Session” today.
Thanks for reading, and remember it’s not how much money you make, it’s how much money you keep that really matters.