Annuities are, too. And yet, insurance salespeople love to prey on parents trying to juggle college, retirement and other savings priorities. Claims that “It’s better for financial aid since you don’t have to report it on the FAFSA!” and “You don’t have to decide whether to save for retirement or for college because you can use it for both!” have unfortunately resonated with too many parents. I have even seen insurance salespeople encourage a high-income family to cash out their child’s 529– in a FAFSA income year– and pay the taxes and penalties and use the money to fund a life insurance policy “to get more financial aid.” Whole life, universal life, annuities and other insurance products are insurance products, not savings vehicles. Here are 6 reasons why life insurance is a terrible choice for your college savings.
- Financial aid: While it’s true that the FAFSA doesn’t require insurance policies to be listed as assets, the CSS Profile does. Unfortunately for families who choose insurance for financial aid purposes, the colleges that are most generous with financial aid tend to require the CSS Profile. So that insurance policy will ultimately be reported.
- Flexibility: While it’s true that you could take tax-free policy loans to pay for college or retirement, if you use the policy to pay for college, there won’t be much left for retirement. You only get to use each dollar once, and if you spend it all, it’s not available for retirement or for insurance purposes.
- Cost: A typical cash value insurance policy– whole life, universal life or annuity– has annual expenses that get paid every year. Those include account fees (usually a flat fee of between $50-$150 per year, depending on account size), mortality & expense risk charges (usually around 1.25-1.5%), subaccount fees (depending on the underlying investments, these can range from around 0.25%-3%), rider fees (depending on riders selected, these can range upwards of 1% each, and policies are often sold with multiple riders; products sold to parents for college purposes often have riders allowing for larger-than-standard withdrawals), and surrender charges (these usually start around 7-10% and are assessed if the policy is terminated within a certain period after purchase, usually between 5-10 years, because the insurer has already paid the salesperson their commission). All in, it’s not at all uncommon to be assessed as much annually in account fees as the total assessment of an asset on the FAFSA. The main difference between paying account fees on an ongoing basis and having your asset show up on the FAFSA is that in the former case, your money is being taken away every year. In the latter, you still keep your money but the college deems you able to spend 5.64% of it every year for college. Which is what you intended to do anyway.
- Value: Because of the cost of the underlying insurance, it takes multiple years of large contributions to build up enough cash value in the policy to pay for a large expense like college. A whole life policy with a $500,000 death benefit would require 18 years of annual premiums in the $4,000+ range in order to have about $65,000 in cash value. Depending on underlying investments, a universal life policy might have more cash value. Put that same amount into an age-based portfolio in a 529 and you’d have almost $150,000 available for college.
- Inaccurate comparisons: One of the biggest problems that we as advisors see is insurance companies provide apples-to-bananas comparisons of insurance products and investment products. One way they do so is misrepresenting investment indices. Two common investment index measures are total return or net asset value (NAV) return. Total return includes both price appreciation and dividend payments; NAV is strictly price return. When you invest in a mutual fund in a 529, your dividends are reinvested, generating compound growth. This is a significant portion of a fund’s appreciation, especially over a long time horizon. In fact, according to Hartford Funds, more than 80 percent of the total return of the S&P 500 index between 1960 and 2016 is attributed to the compounding of reinvested dividends. In a 529 portfolio, Vanguard Total Stock Market fund, a common holding in a 529 plan, has a dividend yield of 1.6%. That means that pays out about 1.6% annually in dividends, so $1,000 invested in it will generate $16 of dividends every year. But those reinvested dividends are only part of total return, not NAV, because when the dividend is paid out, the fund price adjusts to reflect the payout. Insurance companies love to compare their products to NAV, not total return, because the comparison is more favorable. But it’s not an accurate comparison and understates investment returns, particularly 529s where dividends are automatically reinvested.
- Insurance: The whole “choose life insurance because it meets all your needs” breaks down when you actually pull the cash value out of the policy. Doing so reduces the remaining insurance benefit, potentially leaving parents underinsured if the cash value insurance policy was their only form of life insurance.
Life insurance is an important component of a family’s overall financial health, but life insurance is for insurance, not for investment. Don’t be fooled by salespeople who try to convince you that you’ll get more financial aid by using insurance instead of a savings account. It might get you more financial aid, but it does so at a very high cost.