Kyson helps people make better personal finance decisions by challenging cliché advice and common misinformation.
The Insurance Debates
Life Insurance is one of the most contentious topics in the personal finance world. Popular personal finance gurus like Dave Ramsey and Suze Orman sternly warn people away from whole life insurance, and tout the superiority of term insurance (check out Dave Ramsey yelling about life insurance in the clip below). On the other hand, many personal finance and life insurance experts defend the merits of whole life insurance.
Making matters worse, both parties have financial incentives that might bias their advice. Ramsey, for example, receives advertising money from term life insurance companies. On the other hand, many financial advisors and life insurance agents make huge commissions from selling permanent life insurance.
Who do you trust?
When it came time for me to decide what sort of life insurance was best for me, I took a deep dive into trying to understand the pro's and con's of each type of life insurance. It was difficult! I had no expertise or experience in finance or life insurance, and most of what is written on the subject is dense and technical. I decided it was important to share what I learned with others in an easier, more approachable way.
This article compares the way both policies work, what they cost, and how they can be used in an investment strategy.
Is Dave Right?
Life Insurance: The Basics
There are two, basic, types of life insurance available today.
Term Life Insurance: Life insurance that pays a death benefit to your beneficiaries if you die within the terms of the policy. If you purchase a 30-year policy in 2020 and die before 2050, your beneficiaries will receive the death benefit. If you die in 2051, your beneficiaries receive nothing. During those 30 years, you pay a monthly premium to keep the policy in force. Stop paying the premium, and the policy will lapse.
Whole Life Insurance: Life insurance that pays a death benefit to your beneficiaries whenever you die. There is no term limit. This type of policy is also an investment. Your death benefit can increase over time (depending on how the policy is structured), and you can access a portion of the death benefit while you are alive through a few different mechanisms, and can use that to supplement your retirement income or for a large purchase.
Comparing the cost of different types of life insurance policies can be misleading, because they are very different products and can't easily be compared $ to $. It's like comparing a car to a bus pass. One is clearly cheaper, but may not do you any good if you live in the country.
It's more useful to compare the cost is in light of the different benefits and risks inherent to each type of insurance.
Costs of Term Life Insurance
Term life insurance is almost always "cheaper," in the sense that the premiums that you pay every month are typically pretty small compared to Whole Life Insurance. However, there are some drawbacks that come with this cheap cost.
For one, you/your beneficiaries are likely to never to get any money from the policy. The life insurance company's business model depends on the assumption that most people who buy policies will never get a payout--either because they outlive the term, or stop paying the premium. If you survive past the term, which you are statistically likely to do--all you've done is help pay for the payout of someone who died during policy. The peace of mind, however, might be worthwhile to you. It is very comforting to very cheaply pay for a stop-gap to support your loved ones in the worst-case, even if unlikely, scenario.
Costs of Whole Life Insurance
Whole life insurance, undoubtedly, requires higher premiums. A general rule of thumb is that whole life is 10 times more expensive than term, all other factors being equal. And the premiums must be paid most of the rest of your life (usually until age 90 or so) if you want to keep the death benefit intact. The amount of money you will pay in premiums over your lifetime is considerable. However, there is at least one significant benefit that you receive in trade for these high costs: The benefit is permanent. As long as you keep paying the premium during the time period you are supposed to, you or your beneficiary will receive some money back for what you paid into it.
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One other consideration: if you decide you want to add more term insurance later in life, it will be very expensive. In that case, a permanent insurance policy might have cost you less in premiums in the long-run.
Comparing the Numbers
Let's say you are a young, fairly healthy young male adult (30 years old). You could probably get a 30-year term policy worth $150,000 in death benefit for around $15/month. A whole life policy with the same amount of death benefit will probably cost around $150/month. In 30 years you will have spent $5,400 on term insurance, or $54,000 on whole life. However, let's say you get to 60 years old. You might decide you wish you had more life insurance--maybe you have kids who aren't financially independent yet, or your spouse has medical needs and you don't have much money saved up for them to use if you were to pass away. If you extend your $150,000 policy for, let's say, another 25 years in hopes it will last until you die, it will probably cost around $170/month. Over 55 years, you will have spent $56,700 for (hopefully, unless you live past 85) $150,000 death benefit for your beneficiary. If you had had whole life the whole time, you would have paid $99,000 over the same 55 years. Yes, that is still quite a bit more expensive! But wait, keep in mind that the death benefit of a good whole life policy has the potential to grow over time, if you are working with a good, reputable life insurance company. Let's estimate a conservative growth rate of 3%--it will have grown to $762,000 by the time you are 85. Would you rather pay $56,700 for the likelihood of passing on $150,000 to your beneficiaries, or $99,000 for the guarantee of passing on $762,000 to your beneficiaries? That's a question to consider as you decide what is best for you.
But there are some other pro's and con's to consider in addition to this cost analysis.
Which is the Best Investment?
"Buy Term and Invest the Difference"
Strictly speaking, term life insurance is not an investment. You will likely not get any money back from it, but it provides assurance that your family will get some money in the worst case scenario. That sense of security may be worth the cost to you.
Permanent life insurance is, technically, more of an investment, albeit a somewhat complicated one. Because it is complicated, and does not grow as fast as other investments, like the stock market, advocates of term insurance say you should buy a term policy rather than a permanent policy, and put the difference into the stock market. But is that really the best way to invest your money?
Whole Life as an Investment
Permanent life insurance offers some unique benefits, however, that might make it worthwhile as an investment for some people. It works as in investment in these three ways:
1. You or your beneficiaries will, at the very least, have the 'return' of the death benefit on the 'investment' of your monthly premium. In the example given above, the internal rate of return on the death benefit alone (for someone who dies at 85, for example) is ~3.7% annualized.
2. The policy has a cash value that grows. This is the part of the policy that is most intriguing, but also the most controversial. In addition to your death benefit, you have an 'account' of cash value that grows at a guaranteed rate (often 3-5%) over time. This is cash you can access in a few different ways while you have the policy.
Critics of whole life insurance point out that, when you die, you only get the death benefit. The cash value disappears. This is technically correct. However, it is misleading. The cash value is not separate from or additional to your death benefit, but is best thought of as a portion of your death benefit that the company allows you to access while alive. If you withdraw the cash value, your death benefit is reduced by the same amount. There are a few different ways to access the cash value. At the most basic level, however: You can use this cash value like an investment account, and withdraw from it any time for a large purchase or to supplement your retirement income from other sources. Notably, withdrawals are typically tax free, which is an advantage it has over other investment accounts.
3. The best life insurance companies pay a dividend. This comes from their extra profits as a result of investing your premium payments. The dividend is not guaranteed. But the best companies have a long track record of paying a dividend consistently, every year. Your dividend is based upon how much is in the cash value portion of your account. As your cash value increases, so will your dividend payments. The company typically offers you a few different ways you can use the dividend: You can use it to buy more life insurance--in this way, your death benefit can grow, and your cash value will increase as well, as a result. This is the way that the life insurance works like a more traditional investment. It grows and compounds. You can also receive the dividend as a cash payment to you, many people do this later in life once their death benefit has reached the point they want it to be.
It is true that the stock market will probably earn higher returns than investing in life insurance. A reasonable assumption is that the stock market will earn the typical investor 6-8% annual returns, averaged out over a long period of time. Life insurance typically gets you something like 3-5% after factoring in all its various nuances. However, it should be noted, life insurance has unique tax benefits, and is easier to access (no penalties if you withdraw before retirement age), so it has some advantages that might even out those differences.
Furthermore, it's important to consider that taking advantage of a good stock market return depends on timing. If you withdraw during bad market years, your portfolio will decrease much more rapidly. Even if the market recovers, you may never recover from the losses of the bad years (see this explanation here). Comparing average returns are one thing, but the timing of market highs and lows can have a huge impact on your ultimate prognosis. An investment like a life insurance policy has a lower average return, but is much more stable--your cash value and death benefit do not decrease after they have increased (unless you withdraw from them), and there is a guaranteed increase in liquidity (cash value), which often leads to increased dividend payments. In this way, it can be a helpful tool to cushion the blow of losses in the stock market.
Life Insurance as Alternative Form of Banking
A Note About Whole Life Insurance Cash Withdrawals
Withdrawals from a whole life policy can be complicated and there is lots of misinformation out there. You can usually withdraw in two primary ways:
1. A straight-up cash withdrawal. Call the life insurance company, verify your identity, and tell them how much you want to withdraw. You get the cash pretty quickly. Your death benefit will decrease by that amount after you die (because, remember, the cash value is technically a portion of your death benefit), unless you recoup the loss by paying extra payments or using divided payments to replenish your account (remember that your dividend payments are based upon the cash value. If your cash value goes down, your dividend payments will go down).
2. OR, you can take a loan from the life insurance company, and they use your cash value account as collateral. So, again, this money is ultimately coming out of your death benefit--if you die without repaying the loan, they will deduct your loan amount (plus interest) from your death benefit. It may sound counter-intuitive, but this can be the most financially advantageous way to use the cash value. When you take a loan, your cash value does not decrease (which means your dividend payments also do not decrease and those payments can help you pay back the loan). Also, the loan is usually at a pretty good rate, 5% simple interest (as opposed to compounding interest as is the case with most traditional loans), and there is no payback schedule. You can pay as much as you want back, whenever you want. And here's the kicker: When you pay the insurance company back, you are actually, ultimately paying your future self back, not the company: You are, technically, replenishing your death benefit. In the end, taking a loan from a life insurance company, if done in the right way, can be a great way to access 'cheap' money.
NOTE: Withdrawals are something you want to do in conversation with a financial advisor or life insurance agent. They can help you understand the overall impact on your policy if you take a withdrawal or loan, and help you strategize the best time/amount/and schedule for repayment that works to your advantage.
Which Do I choose?
The best choice is the policy that works best for you and your particular situation and concerns.
In short, both types of policies have different pros and cons which depend on what kind of financial and personal risk you are comfortable with, and what kind of retirement plan you want or need. Term insurance is cheap, provides simple security against a worst-case scenario, and leaves you lots of room in your budget to make other investments. Permanent/whole life insurance provides some unique benefits that can help cushion you against stock market losses, and provides a permanent death benefit you can pass on to your beneficiaries. You might decide a combination of both is best for you—buying a whole life insurance policy to primarily use for retirement, or to have a tax-free legacy to pass to your beneficiaries when you die, and term insurance to insure against a worst-case scenario while you are in the prime of your life and have people who depend on you.
Hopefully, this brief introduction to both policies will help you make a more informed decision!
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.