The only thing more difficult than committing to a life insurance policy is deciding what kind to buy. Is it better to buy term insurance, or whole life? Should you pay less and invest more, or choose insurance that pays your premiums back or holds value no matter how long you live?
The answer will be different depending on your needs and your level of investment discipline. However, with a little knowledge, a calculator, and an eye toward sound financial planning, the hazy differences between term, whole life, and other insurance options can become clearer.
Let's assume for this exercise that our budget is between $2,500 and $6,000 available to spend annually, for at least a $400,000 death benefit. For pricing purposes, we will use a healthy 40-year-old male, because that is what I am and it is easy to get quotes for myself.
Granted, this situation is a little particular given the spending range, but we will assume all other financial needs are covered and there is still a significant amount of discretionary income available for insurance. We will look at term life, whole life, and a relatively new option called return of premium term insurance.
The two most basic types of life insurance are term and whole life, also referred to as permanent insurance. While term life insurance is cheaper, it goes away after the term is up. A more expensive whole life policy is permanent until you die and your death benefit is disbursed to beneficiaries, or you take the cash value while you're still alive.
Within term insurance, we will also address a relatively new option called return of premium. We will not review universal life, variable life, variable universal life, or indexed options, as I prefer to separate investing from insuring.
After running different quotes from different providers using an annual budget range of between $2,500 and $6,000, I came up with the following options
Running the numbers
Term insurance is the easiest situation to calculate. You spend $2,500 per year for 30 years, meaning at the end you have spent $75,000 and you have zero to show for it, except for peace of mind during the insured period. You just rented your insurance and thankfully you didn't actually need it because, hey, you are alive!
For me, term insurance is the best option for most people. It is inexpensive, it can be aligned with the exact timeframe it is needed for, and most importantly, it allows any additional money not being spent on premiums to be invested for other financial goals. However, there are occasions when it may not be the absolute best option for some.
The option to buy return of premium coverage makes things a little more interesting. In this case, you pay $4,000 per year for 30 years, which amounts to $120,000 in premiums. The big difference, though, is that at the end of 30 years you get all of your premium back — if you are still alive. That is a lot of money. The downside is that when you do get the money back, it has not grown at all. Because of inflation, it has lost purchasing power.
Let's stop for a minute and compare these two term life insurance approaches and see what options we have.
Instead of buying the more expensive return of premium option, we could buy the regular term insurance and invest the difference between it and the more expensive return of premium option. What would that look like?
Well, if we take the $1,500 annual difference between the $4,000 and $2,500 premiums and earn 6% over 30 years, we end up with an account worth $118,587.27. That compares to the $120,000 we would have received from the return of premium policy. So, in this instance, we should have bought the return of premium policy.
But what if you are an astute investor and you can earn 8% instead of 6%? Well, then you should have bought the regular term and invested the difference because your account would now be worth $169,924.81 after 30 years.
Obviously, the biggest factors here are the rate of return and the discipline of the individual, i.e. will they actually save/invest the difference or simply spend it. Just missing one of these $1,500 annual payments ruins the outcome.
Now we have to compare term to whole life. We are going to assume that we first buy the regular term policy at $2,500 annually and we take the difference between this amount and the whole life cost, $6,000 annually, and we invest it.
Remember that the main factor that defines "whole life insurance" is that not only does it pay a death benefit, it accumulates cash value. Also, it does not disappear after 30 years; it will always be there for you as long as the life insurance company doesn't go out of business.
In this comparison, if we invest $3,500 over 30 years and earn 6% we would end up with an account worth $276,703.65. This account would be worth more than the guaranteed cash values for both whole life examples and close to the non-guaranteed ones.
The downside to this, of course, is that it is less than the death benefit on both whole life policies. This difference will diminish each year, though, as a diversified portfolio outperforms the growth rate of the cash value of the whole life policy.
Also remember that term life insurance goes away after the term is up. If you live past the 30 years, you are left with zero cash value. A whole life policy, although more expensive, is permanent as long as you keep paying premiums. It holds value until you die (even after 30 years) and it is disbursed to beneficiaries, or you take the cash value while you're still alive.
It's important to point out that the term cost in this example is based on a $2,000,000 death benefit; this is why this comparison is close. If we really want to compare apples to apples, we should use the actual cost of term life with a $400,000 death benefit, which would only cost approximately $600 annually.
If we invest the difference between $6,000 and $600, $5,400 annually, at 6% over 30 years, the money would grow to an account worth $426,914.20, which is similar to the death benefits for guaranteed values and less than the non-guaranteed values; again, this difference will diminish over time as a diversified portfolio outperforms the returns on the insurance.
So which insurance is best for you? Like many other decisions in financial planning, what type of insurance you choose depends on a lot of factors, including your budget, risk tolerance, and discipline as an investor.
As you can see from our analysis, if you use a return assumption of 6% and, most importantly, are disciplined enough to save the difference in the premiums for the policies, you should choose the return of premium term over the regular term, $120,000 after 30 years as opposed to $118,587.27, if you invest the $1,500 difference in premiums.
The term and whole life choice is a little more difficult because the death benefit is very similar for the whole life and what your account balance could be worth if you simply chose term and invested the $5,400 difference on your own over 30 years. By investing, you hold onto value even after your insurance disappears in 30 years' time.
What will really help you decide between these two policies is estimating how long you are likely to live. This obviously can only be an educated guess, but the longer you live past that 30-year timeframe we used for the analysis, the greater the difference will be between simply having an account you are investing on your own and having a whole life policy.
For example, after 50 years, the guaranteed death benefit on Policy A does not change compared to 30 years; it is still $426,665. The non-guaranteed death benefit could be $853,590. But if you continued paying in, your investment account could be worth $1,567,813.88!
Even knowing these numbers, there still can be an argument made for whole life. With this type of policy, you are forced to save; you must make the premium payments in order to keep the insurance. You are also putting the investment risk on the insurance company.
For people who have a difficult time keeping a disciplined savings plan or who lack the ability and the risk tolerance to invest on their own or find a good investment manager to do so, whole life insurance is a good alternative.
Charles Weeks is the founding partner of Barrister, a registered investment advisor, which provides financial planning, investment management, and risk management for individuals, along with retirement plan and insurance solutions for business entities.
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