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 the needs of the individual and their 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.
I recently sat down with a client who had a similar dilemma, and after taking time to break down the options, we came up with a solution that was best for the client’s needs. The client chose a term insurance approach, but that might not be right for you. See how your situation compares with these available options.
How Much Can You Spend on Insurance?
Your research starts with knowing how much coverage you need and how much you can afford to spend. Based on the client’s budget, there was between $2,500 and $6,000 available to spend annually for insurance. The client needed a $400,000 death benefit. Granted, this situation is a little particular given the range in their budget, but they had already covered all of their financial needs and still had a significant amount of discretionary income available for insurance, so we plugged in some numbers to see what their money can buy. We looked at term life, whole life, and a relatively new option called return of premium term insurance (more on that below).
Term Life vs. Whole Life Insurance Options
I discussed with this client the two most basic types of life insurance: term and whole life, also referred to as permanent insurance, and noted that while term life insurance is cheaper, it goes away after the term is up, whereas a more expensive whole life policy is permanent until you pass away and it is dispersed to beneficiaries, or you take the cash value. Within term insurance, we also addressed a relatively new option called return of premium. This client was not interested in hearing about universal life, variable life, variable universal life or indexed options. (In my practice I generally stay away from these options mainly because I like to separate investing from insuring).
Comparing Available Insurance Quotes
After running different quotes from different providers using the client’s annual budget range of between $2,500 and $6,000, we came up with the following options:
Death Benefit $2,000,000
Term 30 Years
Annual Premium $2,500
Return of Premium Term
Death Benefit $2,000,000
Term 30 Years
Annual Premium $4,000
Whole Life (two providers)
INSURANCE COMPANY A
Term 30 years
Death Benefit $426,665
Cash Value $198,852
Annual Premium $6,000
Death Benefit $554,885
Cash Value $277,831
INSURANCE COMPANY B
Term 30 years
Death Benefit $403,197
Cash Value $190,406
Annual Premium $6,000
Death Benefit $539,105
Cash Value $271,410
Using the quotes above we reviewed what options the client had to determine what may be in their best interest. Keep in mind that we have someone with a lot of flexibility regarding how much death benefit they need and how much premium they can pay. They were shopping in order to find out what they could get within the range of $2,500 to $6,000 per year.
The client already covered all their other financial planning needs. They needed a minimum $400,000 death benefit over the next 30 years, but with their available spend could purchase $2,000,000 insurance or more. After 30 years they decided they won’t need an insurance death benefit for heirs because there will be other assets to distribute.
Term Life Insurance, the Cheapest Option
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 the coverage and peace of mind that comes with it. You just rented your insurance and hopefully 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 time frame it is needed for, such as the period of a mortgage, 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.
Return of Premium Term Insurance
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.
Comparing Term Policy Types
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.
Comparing Term and Whole Life
For this comparison, 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 within 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 pass away (even after 30 years) and it is dispersed to beneficiaries, or you take the cash value.
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 with a $400,000 death benefit, which would only cost approximately $600.
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.
Which Insurance Is Best for Your Financial Plan?
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 time-frame 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!
If we use a return assumption greater than 6%, let’s say 8%, you are going to end up choosing the regular term policy and you will invest the difference. When compared to the return of premium policy and the whole life policy you would end up with a greater account balance/death benefit after 30 years.
Even with knowing these numbers there still can be an argument made for whole life. With this type of policy you are forced to save; that is you must make the higher premium payments in order to keep the insurance. You are also putting the investment risk on the insurance company. For people that have a difficult time keeping a disciplined savings plan or who lack the ability and the risk tolerance to invest intelligently or find a good investment manager to do so, this is a good alternative.
So, what did my client do? The client chose the regular term policy and wanted to invest the difference. They were comfortable with accepting the investment risk and they believed with a slightly more aggressive asset mix they could earn a higher than 6% return over the next 30 to 50 years.
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