Universal Life Insurance as a Retirement Plan Is a Bad Idea
- Dominick Paoloni
- April 16, 2024
- 12:57 pm
Universal Life Insurance (UL) has gained popularity as a retirement planning tool, with promises of tax-deferred growth and tax-free withdrawals. However, when we examine the high surrender rates, disappointing growth, and high commissions paid to agents, it becomes clear that using UL as a primary retirement strategy is often a bad idea.
High Surrender Rates: A Symptom of Disappointment
One of the most telling signs that Universal Life Insurance is not well-suited for long-term retirement planning is the high surrender rate. According to industry data, between 20% and 30% of policies lapse within the first five years, and by the 10-year mark, around 40%-50% of UL policies have been surrendered. Many policyholders enter into these contracts with unrealistic expectations of cash value growth, only to find that the actual returns fall short.
Why Do So Many People Surrender Their UL Policies?
1. Low Cash Value Growth:
- The reality of UL policies is that they often deliver disappointing returns. With traditional UL, cash value typically grows at 2%-4% annually, which is not enough to generate meaningful retirement savings over time. Indexed UL (IUL) offers some market participation, but often comes with caps on gains, meaning policyholders are locked out of the full market upside.
2. High Fees and Costs:
- UL policies are notorious for their complex fee structures. Administrative costs, mortality charges, and other expenses significantly reduce the growth of cash value. Additionally, as the policyholder ages, the cost of insurance increases, further depleting the policy’s cash value over time.
3. Complexity of Loans:
- One of the major selling points of UL as a retirement strategy is the ability to borrow from the cash value tax-free. However, this benefit is often misunderstood and can turn into a financial trap. While loans against the cash value are tax-free, they are not free of interest. Policyholders must pay interest on the loan, and if they fail to do so, the loan interest is added to the balance, which can erode the cash value. Over time, this reduces both the cash value and death benefit and can even cause the policy to lapse if left unchecked.
- This practice of “borrowing your own money” with interest is often seen as a shell game: although the income appears tax-free, it comes with hidden costs. If policyholders aren’t diligent, the policy can collapse, leaving them with neither the death benefit nor the retirement savings they planned for.
High Sales Commissions Drive Misaligned Incentives
Another problem with UL policies is the high commissions paid to insurance agents, which often incentivize them to push policies that are not in the client’s best interest. Agents can earn 6%-8% of the first-year premiums, which encourages aggressive sales tactics. Policyholders are often presented with optimistic projections of cash value growth, but these scenarios rarely come to fruition due to the high costs embedded in the policy.
To offset these hefty commissions, insurers often impose surrender charges in the early years of the policy. These charges make it costly for policyholders to exit their policies if they realize early on that the product is not performing as expected. Unfortunately, many policyholders only become aware of the true costs when it’s too late.
Why Cash Balance Plans Are a Superior Alternative
In contrast to Universal Life Insurance, cash balance plans provide a more stable and predictable method of saving for retirement. Cash balance plans are defined benefit plans that offer participants a fixed annual growth rate, funded primarily by employer contributions. Here’s why they are a better choice:
- Guaranteed Growth:
- Cash balance plans guarantee a fixed interest rate, typically between 4%-6%, which provides stable and predictable growth over time. Participants don’t have to worry about market fluctuations or underperformance, as the employer is responsible for ensuring the promised growth.
- High Retention Rates:
- Unlike UL policies, which face high lapse rates, the majority of individuals who start cash balance plans retain them through retirement. These plans are designed for long-term savings, and participants can choose between taking lump sum distributions or annuitizing their benefits upon retirement, providing them with flexibility in how they receive their retirement income.
- No Sales Commissions or Hidden Costs:
- Cash balance plans are employer-sponsored, which means there are no high commissions paid to agents for selling the product. Additionally, participants do not face the same high administrative fees or mortality charges that are associated with UL policies. This results in a more cost-efficient retirement savings vehicle.
- Higher Contribution Limits:
- One of the biggest advantages of cash balance plans is the higher contribution limits, especially for high-income earners. These plans allow individuals to save significantly more on a tax-deferred basis compared to 401(k) plans or IRAs, making them an ideal solution for professionals or business owners looking to maximize their retirement savings.
Conclusion: Universal Life Insurance Falls Short as a Retirement Strategy
While Universal Life Insurance may appear attractive due to the promise of tax-free loans and death benefits, the reality is that high surrender rates, low growth, and complicated loan structures make it an unreliable tool for retirement planning. The idea of borrowing against cash value without paying taxes is tempting, but in practice, the need to pay interest and the risk of policy lapse can turn it into a financial nightmare.
In contrast, cash balance plans offer stable growth, lower costs, and higher retention rates, making them a far better choice for individuals looking to build reliable retirement savings. If you’re serious about securing your retirement, a cash balance plan is a more dependable and transparent alternative to the unpredictable world of Universal Life Insurance.
