By Jordan Arave
Life insurance can be a more complex financial planning topic than most people think. At a high level, there are two main policy choices, term or permanent. When you take a closer look, the picture becomes a bit more convoluted. Let’s take a look at these two options and compare their differences, starting with term insurance.
When it comes to term insurance you have a few options. First, you have a level term policy, which means that the premium you are being charged from day one is fixed for the specific timeframe you have chosen, usually 10, 20, or 30 years. This type of policy is guaranteed to not increase in premium cost or to cancel on you, no matter your age or how your health may change, until that term expires. The insurance company will pay a death benefit to your designated beneficiary so long as you continue pay the premiums. This type of policy is typically the least expensive since the insurance company expects you to outlive the term of the policy. For this reason, term insurance is usually the most appropriate option for clients looking to meet the needs of their family in the event of a premature death, and it’s what we recommend to our clients in the overwhelming majority of those circumstances. Once the term of the policy runs out, some policies have the option for the policyholder to continue their coverage, with the caveat that the insured will now pay an annual premium that is based on the cost of insurance for their current age. This is usually a substantial increase from what the policyholder has been paying all these years and understandably so; the chance of passing away – and thus the insurance company having to pay – are statistically much greater as you age. To avoid these dramatic increases, it’s important to select an initial term that matches the number of years you will need coverage until you are financially independent from an insurance perspective (i.e.: the kids are through college, the house is paid for, etc.)
Another type of term insurance policy that is prevalent is a yearly renewable term policy. This type of policy has a premium that starts out cheaper than that of a level term policy, but each year when the policy renews, the premium is subject to increases based upon your age. Depending on how long this type of policy is kept, it can end up being much more expensive than a level term policy in the long run. Some years, the change in premium can be dramatic, especially if you purchased the policy later in life.
Often, the best use for a yearly renewable policy is for someone that only plans to keep it for a few years because when compared to a level term policy, the premiums in the first few years can be much less. It may be that the policy is only needed for a short time until it is converted to a form of “permanent” life insurance, or it may be that life insurance is just not needed any longer; however, there will come a point in time in the life of a yearly renewable policy, that the total premium payments would have been less with the level term policy. For this reason, it’s important to determine how long you anticipate needing life insurance coverage, so you can purchase the policy that offers the lowest cost for the amount of coverage you need.
This is where the life insurance conversation starts to get a bit more complex. If your life insurance isn’t a term policy then it must be permanent, right? Well, it’s not that simple. There are various life insurance policies that fall within the category of permanent insurance, but for the purposes of this article, we will look at the three most common types.
First, let’s look at whole life policies. A whole life policy, in its purest form, is a guaranteed policy that will pay a death benefit to a beneficiary so long as you pay the premiums. Based on age, gender, and health history, a life insurance actuary prices out what it should cost to insure a particular person for their anticipated life expectancy. A whole life policy is the most expensive of the permanent policies. The main reason for this is a whole life policy is properly funded from inception. What that means is they allow for the policyholder to spread the cost of insurance across their whole life. Rather than have the policyholder pay a lower premium in the early years of the policy, and then increase the premiums to cover the higher costs of insurance in their later years, the insurance company keeps it level over the entire life of the policy. As the probability of paying a death claim increases, so does the cost of insurance to cover that event. Because a whole life is properly funded from inception, the policyholder doesn’t run the risk of the insurance company coming back and demanding more money to cover the higher cost to insure them in their later years.
Whole life policies also accumulate a cash value, which in some cases can be withdrawn or borrowed against for income. This is one of the “benefits” of permanent life insurance over term insurance often touted by insurance agents: if a term policy is not used, you are out all the premium dollars, whereas with a permanent policy, you can use the accumulated cash value at a later date. There are two problems with this line of thinking: one is that because of the higher cost of insurance compared to a term policy, a whole life policy is a more expensive way to cover the need. The other is that the growth of the cash value in the policy typically does not match the long-term growth that is achievable through investing those funds directly in the market through a diversified, low-cost investment vehicle, like an exchange-traded fund. Instead, you end up with the worst of both worlds: expensive insurance and underperforming investments. Plus, this argument misses the point of insurance; it’s like saying you should feel bad about paying for dental insurance if you’ve never had a cavity. The whole point of buying insurance is to spend a comparatively small amount of money to protect yourself from a catastrophe.
Another type of policy that is often categorized as a permanent policy is universal life. Due to the various options that can be adjusted after the policy is in force, this type of insurance is sometimes called a flexible premium or adjustable life policy. Like whole life, these policies are often sold as a type of policy that won’t expire and leave the policy holder with nothing to show for all the premiums paid, as term insurance will. What is often not mentioned is the very likely outcome that this policy won’t last until a person’s death, if they live close to their actuarial life expectancy.
Unlike a whole life policy, which is properly funded from inception, it’s not that simple with a universal policy. The insurance company will offer you a recommended premium option and a lower minimum premium option. As the premium payments are made, a portion of the payment accumulates in the policy as a cash value. This cash value earns an interest crediting rate which can fluctuate, and some years will pay more than others, but there is usually a minimum interest that is credited. Since you have flexibility on how much premium to pay, you have some variation on how the life of the policy can turn out. The biggest issue with this is, far too often, the policy holder isn’t told what the ramifications are to their decisions, in terms of how to pay their premium. If the policyholder only pays the policy minimum premium, their policy is not likely to last their lifetime. In fact, far too often, policyholders pay premiums for decades, only to be notified in their 70’s that if they don’t dramatically increase the premium they pay each year, their policy will lapse. You may be asking yourself, how could this happen? Let’s dig into the details.
Universal life policies are attractive due to the lower premium compared to a whole life policy. The reason the premium is cheaper is due to the flexibility of only paying the policy minimum premium. But that lower premium comes with a hidden cost: in the early years of the policy holder’s life, if only the minimum premium is paid, there are no signs of any issues. The premium more than covers the cost of insurance, with the excess dollars being deposited into the cash value. As the policyholder ages, the monthly cost of insurance starts to rise. Eventually, the cost of insurance surpasses the minimum premium payments. If the premium payments are not increased, the policy will automatically start to cover the additional cost of insurance from the cash value that has been accumulating in the policy. At some point, the policy’s interest crediting rate won’t keep pace with the increasing cost of insurance, the cash value will start to decrease, and it is only a matter of time before it’s entirely depleted. Once the cash value is gone, and assuming the policyholder declines to pay the now dramatically higher cost of insurance, the policy lapses and the policyholder no longer has life insurance. The policy that was once believed to be “permanent” is now no longer in existence, usually leaving the policyholder in shock and disbelief. They paid into something for so many years, only to have it disappear with nothing to show for it. This sounds very similar to the criticism often associated with buying term versus permanent life insurance, doesn’t it?
Finally, we come to the last variation of permanent life insurance that we will touch on, variable universal life. Variable universal life works like any other universal life policy, with one major change: the basic interest crediting on the policy’s cash value is replaced with an investment-like component. Much like the retirement plan you have at work, the policyholder has the choice to invest your cash value in a variety of pre-selected investments. Instead of calling these investment choices mutual funds, which is essentially what they are, they are called “subaccounts.” The concept behind this type of insurance is since the minimum interest rate that you are credited in a universal life policy is not likely to keep pace with the rising cost of insurance, investing the cash value portion of your policy in the market would give you a better shot at earning enough return to pay for the extra costs later in life. This would theoretically allow you to keep the policy in force longer; however, one issue that comes up with these types of policies is the projected investment returns shown in the illustrations often aren’t realized in real life. Whether this is due to the high expenses built into investments in the subaccounts, the lackluster performance of the investments themselves, or policyholders withdrawing the funds that are required to sustain the policy, things frequently don’t work out quite like it was explained in the sales pitch.
There are more variations on what are categorized as “permanent life insurance policies”, but these are the foundational principles other policies are built on. For the vast majority of people that are looking for life insurance, term policies likely fit what they need. For situations where a permanent policy might be needed – such as funding a buy/sell agreement for a business owner or as part of an irrevocable trust for estate planning purposes – it’s important to understand what you are buying, and how to properly fund that policy, so as to make sure it lasts as long as it needs to.
Jordan Arave, MS, CFP®
This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.