Is a whole life insurance IRR comparable to other assets? Using the Funding calculator, we can actually show why the comparison takes more time and nuance than you might expect, as well as the additional benefits of a life insurance policy.
Since this case study is going to use the Funding calculator, it involves loading data from Life Insurance Values. To learn how to upload your own data, view our earlier post on copy and pasting illustrations or view our “Life Insurance Values” category in the blog,
Once you’ve got the values you want to use, you’ll open Funding and load them in with the “Load Life Insurance Data” button on the left-hand side. Once you do that, you’re ready to start using the Funding calculator.
Cash Value Internal Rate of Return
To start, we’re going to look at a life insurance illustration of a 9-year-old. After loading in that data, we’ll toggle off the “Legacy” button, which represents the Death Benefit, and the “ROR” button on the top-left in the red bar for simplicity’s sake.
When we do this, we can clearly see that in the first year, there’s $44,000 going in, but we only end up with $28,925 of cash value, so we have a loss. Yet if we look at the Internal Rate of Return (up in the red bar) of this life insurance policy over 30 years, we see that it says it’s 4.04%.
You’ll want to note that the above information is from an estimated illustration from the insurance company, based on the 2023 dividend scale with no changes.
Now, “internal rate of return” is a pretty confusing term. Many people misunderstand how to interpret rates of return because they’re used to thinking of them annually. In actuality, it’s a bit more than that: the Rate of Return is happening annually and over time.
Whole Life Insurance IRR Compared to Another Asset
The easiest way to understand IRR is to first look at if we had the choice of putting money into a life insurance policy or putting it in another account.
What would happen if we put it in an alternate account and we earned 4.04% every single year? On the right-hand side, we’ll toggle the “Alternate Account” button. We know that a life insurance policy doesn’t work that way, but down at the bottom, what we see is that this account would grow to $1,940,085, assuming the same annual inputs.
Well, if we earned 4.04% on the same cash flows going in every single year, we would end up with the same $1,940,085. Now, clearly, in this example, this alternate account is earning 4.04% every year. The life insurance policy, on the other hand, is earning the equivalent of 4.04% every year.
And what do I mean by that? Well, let’s look at the life insurance policy again, and let’s look at the actual Annual Rates of Return, by toggling on the ROR button in the red bar. What we see is in the life insurance policy, we actually have a negative 34.38% in the first year, a negative 17.7% in the second year, and a negative 10.9% in the third year.
The next is a negative 3.75%. How in the world do we get to a place where we’re earning 4.04% every year? Or the equivalent of it? Well, it’s because as we move down through this, we can see that we’re actually earning more than 4.04% in the later years.
In fact, from the 11th year down, the annual rate of return is more than 4.04% every single year. So that at the end of this timeframe of 30 years, we earn the equivalent of 4.04% every year.
Not an average rate of return, but an actual rate of return, because that’s where we end up with the same $1,940,085 as the account that is earning 4.04% every year.
What’s the Difference Between RORs?
Now when we’re looking at this return, a life insurance policy shows the ROR net of all fees and costs because they’re pulled out before the cash value increases. On the other hand, alternative assets show their ROR as a gross number, because the fees, commissions, taxes, and other costs are taken out after the account increases.
You can’t truly compare a gross ROR to a net ROR. So you’ve got to take those things into consideration with the alternate account. So even if you could earn 4.04% on this alternate account, it would feel like less once the costs are accounted for. You’d actually have to earn a much higher ROR in order to get the net 4.04%.
For example, if you were able to somehow earn 4.04% at a bank, you would still have to pay taxes on it. Based on a 32% marginal tax bracket, every dollar of that growth would have to be taxed at 32%.
So let’s toggle back to the Alternate Account, and click “Alternate Account Inputs” on the left-hand side. Then, right-click the 4.05% rate in the red bar and select “copy Rate to Alternate Account Rate.” Finally, click “Income Tax Bracket” and input 32%.
What we see is we’d have this string of payments in the coral-colored column that would have to come out of this account to keep this account going. And so at the end of this timeframe, we’d only end up with $1,505,456 rather than the $1,940,085 we had in the life insurance policy.
And that’s because the 4.04% was gross earnings and the taxes had to be paid out of the earnings. Now in order to have this keep up, we can see up there at the top, it tells us that we would have to earn 5.94% every year to be equivalent to the 4.04% that we’re seeing in the life insurance policy.
You can further test this by copying the 5.94% rate into the Alternate Account Rate, and you’ll see that the account finally ends up in the same place as the whole life insurance. Once proven, the real question is, what taxable account can you even earn 5.94% every year?
If you want to get really into it, add management fees. Suddenly you’re needing to earn 7.56% every single ear to keep up with the life insurance.
Visualizing the Difference with Charts
If you click the chart button in the top right section (represented by an image of a chart), you can actually see the two assets side by side on a line graph. The gold line is the alternate account. The blue line is the Life Insurance policy cash value.
You’ll see that if we did not put money into the life insurance policy over the 30-year timeframe, we can see that the alternate account would be ahead of the life insurance policy along the way by a little bit. Yet at the 30-year mark, they actually become the same amount.
Now let’s take that timeframe out another 20 years, for a total of 50 years, and see what it looks like. In the 41st year, the cash value crosses over and becomes more than the alternate account. Note that this is for a 9-year-old, so 41 years out is age 50. With this timeframe, we can see that we would end up with more in the life insurance policy. And this is just the cash value being represented.
So here in this comparison, we can see our alternate account, at the end of the year value of a little less than $5 million, ($4,987,000), and the life insurance policy at $5.7 million. So the life insurance policy actually has $766,000 more dollars in it at that point in time. Even though on the front end it was a little bit behind.
What’s the Benefit of the Death Benefit?
Part of what pulls the return down, on the life insurance policy, is the fact that it does have a death benefit with it. There’s a cost for having that incorporated. Now, this blue line is all net of those costs. But I think we need to look at what that benefit is, to see what we’re getting as well as this cash that’s in here.
So if we toggle on the legacy button (top left, in the red bar), what we see now is this purple line. So if death were to occur at any point in time, this is the coverage that would be in place for the heirs over that timeframe.
And let’s take this out to a more reasonable life expectancy. So let’s go out 80 years. And so that would be age 89. At that point in time, this is the difference that we would see if we didn’t put money in the life insurance policy and we could earn 7.56% per year every single year with no down years–no fluctuations in what the market did, and we stayed at that 7.56% the whole time frame.
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