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- As a financial planner, I always tell my clients that the first step in choosing a life insurance policy is knowing how much coverage you need and how much you can afford to pay monthly or annually.
- For this example, I set an annual budget of between $2,500 and $6,000 and a minimum death benefit of $400,000.
- Ultimately, choosing the right policy requires some calculations and asking yourself tough questions about your ability to save and invest money.
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The only thing harder than committing to a life insurance policy is deciding which type to buy. Is it better to buy term or whole life insurance? Should you pay less and invest more, or choose insurance that pays your premiums 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 fuzzy differences between term, whole life, and other life insurance options can become clearer.
start by looking at your budget and how much coverage you need
Your life insurance research should start with knowing how much coverage you need and how much you can afford to spend based on your budget.
Let’s assume for this exercise that our budget is between $2,500 and $6,000 available to spend annually, for a death benefit of at least $400,000. For pricing purposes, we’ll use a healthy 40-year-old male, because that’s what I am and it’s easy to get quotes for me.
Granted, this situation is a bit unique given the range of spending, but we’ll assume all other financial needs are covered and there’s still a significant amount of discretionary income available for insurance. We’ll look at term life insurance, whole life insurance, and a relatively new option called return-of-premium term insurance.
the difference between term life insurance and whole life
The two most basic types of life insurance are term life insurance and whole life insurance, also known as permanent insurance. while term life insurance is cheaper, it disappears once the term is up. A more expensive whole life policy is permanent until you die and your death benefit is disbursed to beneficiaries, or takes the cash value while you’re still alive.
Within term insurance, we’ll 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 investment from insurance.
After running different quotes from different vendors using an annual budget range of between $2,500 and $6,000, I came up with the following options:
running the numbers
term life insurance
term insurance is the easiest situation to calculate. You spend $2,500 per year for 30 years, which means that in the end you have spent $75,000 and have nothing to prove except your peace of mind during the insured period. you just rented your insurance and luckily you didn’t need it because hey, you’re alive!
For me, term insurance is the best option for most people. it’s affordable, it can be aligned to the exact time period it’s needed for, and most importantly, it allows any additional money not spent on premiums to be invested in other financial goals. however, there are times when it may not be the best option for some.
refund of premium insurance
The option to purchase return of premium coverage makes things a little more interesting. in this case, you pay $4,000 per year for 30 years, which equals $120,000 in premiums. however, the big difference is that at the end of 30 years, you get back all of your premium, if you are still alive. that’s a lot of money. the downside is that when you get the money back, it hasn’t grown at all. due to inflation, it has lost purchasing power.
Let’s stop for a minute and compare these two approaches to term life insurance 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 case we should have purchased the return of premium policy.
but what if you’re a savvy investor and 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 most important factors here are the rate of return and the discipline of the individual, ie whether they will actually save/invest the difference or just spend it. Missing one of these $1,500 annual payments ruins the bottom line.
whole life insurance
now we have to compare the term with all of life. Let’s assume that we first buy the regular term policy at $2,500 per year and take the difference between this amount and the total cost of living, $6,000 per year, and invest it.
Remember that the main defining factor of “whole life insurance” is that it doesn’t just pay a death benefit, it builds cash value. in addition, it does not disappear at the age of 30; will always be there for you as long as the life insurance company doesn’t go out of business.
In this comparison, if we invested $3,500 over 30 years and earned 6%, we would end up with an account worth $276,703.65. this account would be worth more than guaranteed cash values for lifetime examples and close to unsecured.
The downside to this, of course, is that it’s less than the death benefit on both whole life policies. however, this difference will decrease each year as a diversified portfolio outperforms the whole life policy’s cash value growth rate.
Also remember that term life insurance disappears once the term is up. if you live more than 30 years, you are left with zero cash value. A whole life policy, while more expensive, is permanent as long as you continue to pay premiums. it has value until you die (even after 30 years) and is disbursed to beneficiaries, or you take the cash value while you’re still alive.
It is important to note that the cost term in this example is based on a death benefit of $2,000,000; hence this comparison is close. If we really want to compare apples to apples, we should use the true cost of term life insurance with a $400,000 death benefit, which would only cost about $600 a year.
comparing the term with all of life
If we invest the difference between $6,000 and $600, $5,400 annually, at 6% for 30 years, the money would grow to an account worth $426,914.20, which is similar to death benefits for secured securities and less that the unsecured securities; again, this difference will decrease over time as a diversified portfolio outperforms insurance returns.
So, what is the best insurance for you? Like many other financial planning decisions, the type of insurance you choose depends on many factors, including your budget, risk tolerance, and investor discipline.
which policy is the best?
As you can see from our analysis, if you use a 6% return assumption and, more importantly, are disciplined enough to save the difference in policy premiums, you should choose the return term of the premium instead of the usual. term, $120,000 after 30 years compared to $118,587.27, if you invest the $1,500 difference in premiums.
Electing term and lifetime is a bit more difficult because the death benefit is very similar for life and what your account balance might be worth if you simply choose term and invest the $5,400 difference per your account for 30 years. By investing, you retain value even after your insurance is gone in 30 years.
what will really help you decide between these two policies is estimating how long you are likely to live. Obviously, this can only be a guess, but the longer you live beyond the 30-year time frame we used for analysis, the greater the difference between simply having an account that you’re investing in on your own, and having an insurance policy. Entire life.
for example, after 50 years, the guaranteed death benefit in the policy does not change compared to 30 years; it’s still $426,665. the unguaranteed death benefit could be $853,590. but if you continue to pay, your investment account could be worth $1,567,813.88!
Even knowing these numbers, there may still be an argument for a lifetime. With this type of policy you are obliged to save; you must make the premium payments to maintain the insurance. you are also putting the investment risk on the insurance company.
For people who have difficulty maintaining a disciplined savings plan or who lack the ability and risk tolerance to invest on their own or find a good investment manager to do so, whole life insurance is a good option. alternative.
charles weeks is the founding partner of barrister, a registered investment advisor, providing financial planning, investment management and risk management for individuals, along with retirement planning and insurance solutions for business entities.