One of the most common questions that comes up in insurance planning is weather a client should get Whole or Term life insurance. If you just want to cut to the chase, Term life insurance is the best option for the vast majority of people. End scene.
You don’t have to keep reading unless you have a significant amount of wealth that would subject you to an estate tax or plan to have a significant amount of wealth by the time you die. If you do not have a significant amount of wealth and someone is trying to sell you Whole Life insurance, you should probably walk out the door, hang up the phone, or send the e-mail straight to spam – that person is probably not looking out for your best interests.
So, what’s the primary difference between Whole and Term life insurance? Term life insurance policies are policies that are in effect for a set number of years (often 10, 20, or 30) and then expire after the term is over. Term life is considered “pure” insurance in that there are two potential outcomes: the insured dies during the term of the policy and the policy pays out or the insured doesn’t die over that time and the policy does not pay. There is no value to Term policies beyond insuring against that specific outcome.
On the other hand, Whole life policies are designed to be kept in force until the end of the client’s lifetime and pay out whenever that may be. So, with Whole life, insurers expect to pay the death benefit at some point and the risk involved on their side is when that death will be. Whole life policies also contain a cash value that can be sold, borrowed against, or surrendered for cash. So, while Term life is “pure” insurance, Whole life is actually an insurance product mixed with an investment product (a very expensive one, at that).
There are several types of Whole life products (Straight Life, Universal Life, Variable Universal Life). We’re not going to get into the options now, but all of these are a mix of insurance and investment products.
As we talked about in “How to Think About Insurance,” insurers need to not only insure they are able to pay out any benefits but they also must cover the costs of running a business and provide a profit to their shareholders. So, as you can imagine, they’ve got loads of actuaries making sure that your expected return on any insurance product is less than your investment so they can cover those expenses. For Whole life policies, in order to ensure the policy can pay upon death, the annual premiums are often far higher than Term life (where the insurer doesn’t pay anything as long as the insured doesn’t die during the policy’s term).
What this adds up to is that Whole Life Policies are a bad investment (for most of us). A better option for the majority of us is to purchase Term life insurance and invest the difference in premiums between Whole and Term life policies in the market.
As an example, we had a young client who had recently purchased a $450,000 Whole life policy. That Whole life policy came with premiums of $461/month. A $1 Million, 20 Year Term life policy on the other hand would only cost about $25/month. Below is a chart comparing the amount the client would pass on to their heirs based on three separate options: The Whole Life Policy, Investing the Premium in the Market (7% annual return), and the Term Life Policy + investing in the market.
As you can see, the Term Life policy insures a benefit from an early death, while the investment of the excess premiums in the market ensures that the client’s net worth/estate is significantly higher should they live a long life.
There is a small gap between 2044 and 2050 after the Term life policy has expired where the Whole Life policy appears preferable. That can be easily remedied with either a larger or longer Term policy or a second Term policy if necessary.
The moral of the story though is that for most of us Term life is the far superior option. Many financial advisors who are not fee-only advisors receive commissions from insurance sales. As you may guess, their commissions can be significant for Whole Life policies – which is why a lot of folks out there have been sold unnecessary Whole Life policies.
So, your next question might be, “In what situations do Whole Life Policies make sense?” I’ll get to that in my next post.