Life Insurance: Family Protection, an Investment Vehicle, or Both?

By Wesley W. Lyon II, CPA, CFP®

Over the last 18 months, my company has tracked the progress of over 200 dentists with whom we have consulted. We found, on average, dentists are overpaying for life and disability insurance by more than $4,600 annually. Assuming a 7% investment return and 30-year dental career, this is a $434,000 mistake! How can so many dentists overpay? The answer is simple — a lack of meaningful information combined with predatory sales techniques.

Most dentists require life insurance for most of their careers. High student loan debt, combined with practice acquisition debt and real estate debt, can place a heavy burden on a surviving spouse. At the onset of your dental career, the life insurance need can commonly reach $8 million or more. In order to calculate your need, you must first calculate the amount of money needed to retire, and then add on your total outstanding loans. This number is different for everyone, as your spending habits will dictate the amount needed to retire.

Once your need is calculated, the difficult decision of how to obtain this insurance comes next. Unfortunately for dentists, most insurance companies have placed a target on their backs. While some insurance companies truly look out for your best interests, most are seeking to maximize profits. We often see agents go as far as selling life insurance policies on your children, who are financially dependent on you. Mathematically, this makes zero sense. However, the fear of losing one’s child can spark many emotions.

Insurance as an Investment

At this point in the process, you have a few different options, including permanent policies, such as whole life, universal life, variable universal life, etc., as well as term life insurance. Often, permanent life insurance policies are sold with additional benefits, such as being investment vehicles, acting like second retirement plans and generating tax-free income. On the other hand, term life insurance is very simple. You pay a set premium over the term of the policy, and, in return, you are insured for a specific amount. The downside? The premiums go down the drain if you don’t die during the specified period. While some might say this is a bad thing, I beg to differ. Term life insurance is the most cost-effective solution to protect your family due to the low premium costs.

Avoid Insurance as an Investment

As mentioned before, permanent policies offer investment components as well as insurance components. I recommend avoiding these policies. They contain high fees, low returns and poor income tax treatment. Since these policies are deemed insurance products, rather than investment vehicles, standard disclosures and performance reports escape Securities and Exchange Commission regulation, oftentimes leading to misled consumers.

The latest reliable published data on permanent life insurance comes from a 1979 report from the Federal Trade Commission. This report found that permanent life insurance policies had returns of -9% to -19% in the first five years, 1% after 10 years, and 2% to 4.5% after holding the policy for 20 years.¹ These returns were calculated after the cost of insurance was removed. I personally believe the return calculations were generous to the life insurance companies because they did not assume level insurance premiums, but the results are staggering nonetheless.

Fast forward to 2024, and the returns from these policies are largely hidden from public view. At McGill and Lyon Dental Advisors, we review about five policies per month. In our experience, almost all of these policies have negative rates of return on the investment portion.

Fees and Commissions

Having an investment account and insurance policy tied together doesn’t automatically make a poor product, but why would a company do this in the first place? The easiest answer is to make money. By combining the insurance and the investment product together, insurance companies make it very difficult to calculate exactly what the fees are. I recently reviewed a whole life insurance policy that had earned over $60,000 in interest for the year. However, the policy value did not increase year over year. This was because the administrative and insurance costs exceeded 4% of the policy value, leaving little room for investment returns. This left the doctor in a position where over $1 million was deposited into a whole life policy, and, 10 years later, they would receive less than $1 million if they withdrew their funds.

You might be wondering why someone would sell a product with such a poor return history. The answer lies with incentives. Insurance companies often pay over 50% of the initial premium to the agent in the form of a commission, a very lucrative business model for great salespeople. Due to high incomes, most insurance companies have these agents target doctors, dentists and lawyers first.

Lastly, insurance companies are allowed to present potential customers with “illustrations.” These illustrations show the hypothetical performance of a policy under a set of circumstances. Most agents will concentrate on the loftiest projections. However, the worst performing projections are closer to the truth. I recently had a client who was presented with an illustration of how a modest investment into a whole life policy could generate income for life. The presentation, however, ignored all other possible outcomes. What the agent didn’t concentrate on was, under the guaranteed assumptions, this policy would provide only five years of retirement income, leaving the client bankrupt in retirement.

Tax-Free Income or Tax Trap?

These policies are often sold as second retirement plans, mega Roth IRAs or tax-free income investments. While this may not be 100% false, it is misleading. Withdrawals from insurance products are taxed as ordinary income to the extent the value exceeds the tax basis. This means you will lose the tax-favored capital gains treatment that could be received by investing in low-cost, well-diversified index funds. What insurance agents should be explaining is that loans can be taken against the policy value tax-free, but you continue to pay the fees and expenses of the policy, which often reach over 4% of the policy value. Unfortunately, by the time many dentists figure this out, they are trapped. They can either take the loan and continue to pay the fees or suffer a large tax bill to exit the policy.

Recommendation

Instead, simply purchase a level term insurance policy for the necessary period and invest the remaining monthly amount in low-cost investments for higher returns. This simple strategy will dramatically increase your wealth and allow you to retire years earlier. I recommend obtaining a policy with a level premium through age 60 to ensure financial security for your family. Some dentists will obtain two policies to reduce premiums, one with a shorter term such as 10 years to pay off practice loans, and one with a term of 20 or 30 years to ensure financial security for family members. Once you have achieved financial independence, drop your term insurance since it is no longer needed. As a bonus, you can call your insurance provider and lower your insured amount as your net worth increases and your insurance needs decrease, saving thousands more in annual premiums.

Wesley W. Lyon II, CPA, CFP, is president and CEO of McGill and Lyon Dental Advisors. For more information on his firm’s comprehensive tax and business planning services for dentists and specialists, contact Janet Blair at 877.306.9780, or email consulting@mcgillhillgroup.com. To comment on this article, email impact@agd.org.

Reference

1. “Life Insurance Cost Disclosure: A Report to the President and the Congress on Life Insurance Cost Comparison Indexes.” Federal Trade Commission, 1979.