by Mike Hohf, Financial Adviser and Smartvestor Pro
When we meet new clients for the first time, the topic of life insurance frequently comes up. After learning more about them and their situation, we’ll do an analysis to determine how much life insurance they need. Not surprisingly, most people are underinsured – particularly, those that have young families and little assets but good incomes.
When I let people know they are underinsured and should consider buying life insurance, the response I often get is: “I already have life insurance!” What is commonly the case, they have whole life insurance, which can be a costly mistake.
Whole life insurance is a permanent form of life insurance, meaning it covers you for your entire life, so long as the premium is paid. This doesn’t make sense for most people. Think about it. Why pay for life insurance when you’re in your 80s or 90s? It is highly unlikely that you’ll have dependents that are solely relying on you at that age.
There is also the problem with the cash value, which is a fixture of whole life insurance policies. In addition to the benefit that is paid upon the policyholder’s death, the policy has a savings component in the form of a cash value account, which grows during the policyholder’s lifetime. A policyholder can use the cash value as a tax-sheltered investment, or to borrow from, pay the premiums, or pass on to heirs.
Sure, the cash value gives the impression you will at least get some value out of the policy if you live a long and healthy life. Here’s what actually happens instead: you buy the policy in your 30s or 40s and pay the premium into your 60s. At that point, you realize you don’t need life insurance any longer and would prefer not to pay the premium. Since the whole life policy has cash value built up, you decide to use the cash value to pay the premium. However, as you get older the cost of insurance increases and the cash value whittles away. Eventually, there’s no cash value left and the policy lapses. So, what value have you received?
Maybe there’s a better strategy. Shop around for whole life insurance and term life insurance, and note the difference in premiums. You’ll see that whole life costs much more than term insurance. So, buy term life insurance and invest the premium difference in an investment account.
Consider the following chart showing the average annual premium for a 20-year, $250,000 term life policy purchased at various ages compared to a $250,000 whole life policy purchased at that same age. The cost difference is astounding.
|
Age |
Term Life Insurance Average Annual Premium |
Whole Life Insurance Average Annual Premium |
Average Premium Difference |
|---|---|---|---|
|
30 |
$334.54 |
$2,550.00 |
$2,215.46 |
|
35 |
$359.78 |
$3,126.84 |
$2,767.06 |
|
40 |
$432.36 |
$3,935.88 |
$3,503.52 |
|
45 |
$619.42 |
$4,990.32 |
$4,370.90 |
|
50 |
$918.91 |
$6,371.04 |
$5,452.13 |
|
60 |
$2,492.43 |
$10,377.36 |
$7,884.93 |
Source: https://www.valuepenguin.com/average-cost-life-insurance
There are two major benefits to this strategy. First, you can purchase a term policy for the period of time that you actually need coverage. If you select the correct term, you won’t be paying for insurance that you don’t need. Second, if you invest the premium difference in an investment account, you get to build your own cash value. When the term is over, you will have built an additional nest egg that can be used for retirement expenses, long-term care or other financial goals.
Here’s a real-life example of what I’m talking about. Let’s say you are age 35 and need $250,000 worth of life insurance coverage for a period of 30 years. This is how the math works out assuming a 7% annual rate of return on your investment account.
|
Annual Premium |
Total Cost of Insurance Over 30 Years |
Future Value of the Cash Value |
Future Value of the Investment Account |
|
|---|---|---|---|---|
|
Term Life |
$255 |
$7,650 |
$0 |
$291,978 |
|
Whole Life |
$3,346 |
$100,380 |
$197,679 |
$0 |
Source: https://www.insuranceblogbychris.com/term-vs-whole-life-insurance-comparison-calculator/
The difference in the value of the two accounts is $94,299 after 30 years – that’s over 50% more money by choosing term life and investing the premium difference.
It’s common for insurance consumers to get caught up in the sales tricks of insurance agents. Whole life insurance is often sold as a “you can’t lose” type of product. The reality is that the commissions for whole life insurance are significantly higher than those of term life. There’s a big conflict of interest and insurance agents are incentivized to recommend whole life over term life. Keep that in mind when speaking with an insurance agent.
However, every person’s financial situation is different. This article is not meant to be generic advice for everyone. There could be situations where a whole life policy is an acceptable solution. But I have found that in most cases, term life is the best solution. Ultimately, life insurance is just a piece of your overall financial and risk management plan. As such, I suggest that you work with a qualified financial adviser you trust who can help you with your insurance needs and with all areas of your financial life.