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The Worst of Both Worlds

In the ever-changing world of finance, some old standards just don't cut the mustard anymore.

Take whole life insurance, for example. It wasn't that long ago that people flocked to whole life policies as simple ways to combine the protection of a death benefit with a method for saving a nest egg for themselves or their family. Now, though, with more sophisticated types of life insurance such as universal life and variable policies, plain-vanilla whole life is no longer the only game in town.

You can still buy whole life from many companies, including Metlife (NYSE: MET  ) , Prudential (NYSE: PRU  ) , and Allstate (NYSE: ALL  ) . But for most people, whole life just doesn't make much sense. It's the worst of both worlds -- whole life ties you into a long-term investment, but its returns are generally lackluster at best.

Iffy returns
Many critics of whole life complain that it's expensive. Certainly, when you compare whole life with term insurance, you'll find that whole life premiums are quite a bit higher. But that's because whole life includes a savings component -- part of each payment you make goes toward building cash value.

The main problem with traditional whole life policies is that they're invested too conservatively. Permanent insurance is often marketed toward young families who'll pay into them for decades. However, with such a long time horizon, it makes sense to invest aggressively in higher-risk assets like stocks.

But whole life doesn't work like that. Instead, it usually offers modest guaranteed returns that usually track bond yields fairly closely. In the 1970s and 1980s, when interest rates were high, whole life was quite popular, as the returns were relatively high. As rates dropped, however, so did the pace at which savings accumulated within whole life policies. That meant that in many cases, illustrations based on those higher rates turned out not to be correct.

Buying term
It's because of the inflexibility of whole life that the maxim "buy term and invest the rest" is so powerful. As long as you have the discipline to invest the money you save by buying a cheaper term policy, you can choose whether to seek much higher returns by investing aggressively or settle for the more modest returns available from a mix of assets.

It's true that life insurance policies offer some special benefits. Earnings inside a policy are tax-deferred, while buying a term policy and investing the rest will likely leave you with a tax bill every year. But with the wide variety of tax-protected accounts available to most investors, including IRAs and 401(k) plans, you can usually lessen the impact of taxes on your investments.

Forcing yourself to save
Moreover, whole life isn't the best choice among so-called permanent insurance. If you don't trust yourself to invest your savings when you buy term, then you might want to take a closer look at permanent insurance. But in that case, variable insurance policies whose returns are tied to the stock market are a better bet for most people. For a long-term investment, bond-like yields are just too low to make sense.

Even though you can still find whole life policies, they're mostly a relic from a simpler time. Before you buy whole life, take a look at your other options -- odds are, you'll find one that's better for you.

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