A reader, Arlene, recently asked a question in my article “investing on behalf of kids” about obtaining “Whole Life Insurance” for their young children. A financial planner suggested that obtaining permanent insurance for their children is a good idea to invest in their future.
Here is the question:
Hello! A financial planner thinks it’s a good idea to get whole life insurance policies for our three children, each $100,000 policies. Is this a good idea? I know this doesn’t necessary pertain to their education future however it is still in regards to their future and I’m really struggling to know if this is a good path to take. We will be paying $1500/yr per child for twenty years.
After that we no longer have to pay into the policy and the policy itself keeps growing and compounding. If they don’t touch it all their life and they go to retire they will each have around one million dollars to use. I just don’t know if these whole life insurance policies are legit or if they should be avoided? I am definitely not a financial expert like some of you in here, I’m a stay at home mom trying to make the right decisions for my kids. Any insight would be appreciated!
What is Whole Life Insurance?
First lets start with a little background for new readers – what exactly is whole life insurance? In terms of life insurance, there are basically three types: Term Life, Whole Life and Universal Life.
Term insurance insures an individual for a chosen number of years (which is the term). For example, our family has purchased Term 20 insurance which means we have coverage for 20 years, with a pre-determined death benefit and set premiums paid annually.
At the end of the 20 years, we can either apply for new coverage, renew our current insurance for another set number of years (without medical proof), convert our coverage to permanent insurance, or stop coverage altogether. Term life insurance is known as the lower cost insurance of the bunch.
Universal and Whole Life insurance, on the other hand, will pay a death benefit when you pass away regardless of when it happens (ie. not based on a term).
The other major difference is that Universal and Whole Life premiums are MUCH higher. This is because in addition to providing life insurance, there is an investment portion of the product. While the investment portion can grow tax free within these policies, they are also subject to very high fees (MERs).
Why Buy Insurance at All?
In my eyes (and many others), insurance is all about mitigating financial risk. To mitigate against the cost of a major fire or flooding within your home, you buy home insurance.
If you need regular income to pay the bills, then you can mitigate against disability through disability insurance.
If other people (like your children) depend on your income to support expenses and would cause hardship if you were to pass away, then you buy life insurance.
Buying Whole Life Insurance for Your Kids?
So back to the situation at hand, should Arlene follow her financial planners recommendation to buy whole life insurance to insure her three young kids?
To sum up my thoughts – Not a chance.
As I mentioned, insurance is to mitigate against financial risk. The only real financial risk when it comes to her children passing away is the cost of the funeral when they are young. If this cost is a real concern, they can purchase a cheap term insurance to cover potential funeral costs (some providers offer $20k death benefit for around $30/year).
If Arlene does purchase whole life for her kids, once they are old enough, the insurance policy would be likely be assigned to a new beneficiary – like the child’s future spouse and/or children.
The argument that whole life and universal life insurance is a great retirement product is simply not true. Even if the child accumulates a large sum within the investment portion of the insurance policy, the child cannot simply withdraw the amount. The investment portfolio can only be used to pay the premiums (which will no long exist after 20 years), or used it as collateral for a loan from the bank.
Mind you, I really don’t know a lot about Arlene’s situation so I’m making the assumption that her children are financially dependent on them. If her kids are child TV stars and generating a lot of income to support the whole family, then maybe some insurance would be prudent. Another reason why it may make sense to insure children is for future insurability reasons. That is if Arlene anticipates that her children will have issues obtaining life insurance due to a future medical condition.
What Should She Do?
So it appears that Arlene wants to do something for the future of her children and I can relate with that. What can she do instead of purchasing whole life insurance? Here is what I would do:
- Start or maximize an education fund for the children. In Canada, that would be an RESP, with the government adding 20% to your contribution up to $500. In other words, if you contribute $2,500/child/year, then the government will add $500/child/year to your RESP account. I would pick this option over whole life insurance for children any day of the week. We opened a family RESP with TD using their e-Series index mutual funds.
- Consider an informal in-trust account. If the RESP’s are maxed out, the next thing I would consider is to open an investment account on behalf of the children – an informal in-trust account. This account can be turned over to the child once they reach the age of majority, which could be used for life milestone expenses like a wedding, down payment on a first home, graduate studies, or even a dream trip. There are a few considerations (taxation and portfolio selection) with this account which can be read here.
It would cost Arlene and her spouse a total of $4,500/year (for three children) for 20 years for a $100,000 death benefit (each) that doesn’t adjust to inflation and a high fee investment portfolio (that’s not really accessible).
Can she do better? I believe so. Assuming that RESPs are already maxed out, investing the $4,500 annually in an informal in-trust account invested in a low cost indexed portfolio (assuming 5% return) would result in $168k after 20 years. Let the account grow for another 20 years, and now the account is worth $445k ($1.18M after 40 years) with the added bonus that it is 100% liquid.
I can’t say that whole life insurance doesn’t have a place out there. I can see some benefit to adult wealthy people who have all of their own accounts maxed out (RRSP, TFSA, RESP, mortgage paid off), have dependents, and looking for more tax deferral (and perhaps a way to pay off large capital gains tax upon passing). However, this may benefit only very small percentage of the population.
Most people are better off buying lower cost term insurance and investing the rest with the goal of eventually becoming self-insured through your own accumulated wealth.
Whenever I hear these stories about recommending big insurance for children, my “rip off” alarm tends to sound. It may sound a little harsh, but whole/universal life insurance products are generally overpriced products that only benefit a very very small percentage of the (adult) population. What makes it worse is that there is a conflict of interest as insurance agents are paid a higher commission selling whole life/universal life insurance rather than selling the more sensible term life insurance.
Moral of the story? Avoid whole/universal life insurance for children; invest in their education instead. If you’ve already maxed out their education fund, consider an informal in-trust investment account (available at most discount brokers) and invest the premiums in a low cost portfolio. When the children become adults and require their own insurance, they can purchase lower cost term life insurance to help financially protect their dependents.
Thoughts, comments, or arguments?
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