Term Versus Permanent Life Insurance
A common question about life insurance is whether someone should buy term or permanent life insurance. While there are financial folks who are adamant about one or the other, the best choice depends on each individual’s situation.
Term insurance provides coverage for a certain amount of time and for a set annual cost. Two popular choices are 10-year term and 20-year term. The annual premium for a 10-year term policy is fixed and does not change during the 10-year period; after the 10 years, the premium will increase. Likewise, for a 20-year term policy, the annual premium is set and will not increase for the 20-year period. Then it jumps substantially.
Policy Types: There are only a handful of term policies. Guaranteed level term of varying lengths (10, 20 and 30 year periods) is the most common. Annual renewable term, which increases in cost each year based on the insured person’s age, is also available.
Here’s a real life example that I know a lot about: as part of my own personal planning, my wife owns a 10-year term policy on me that costs about $1,500 each year. If I were to die during this 10-year period, she would collect the resulting life insurance proceeds. While I have other life insurance, the purpose of this particular 10-year term policy is to provide an extra level of protection for my family during this 10-year period (while I am building assets, paying down debt and the children are young). At the end of the 10-year period, we will re-evaluate whether we need to continue this policy. My situation illustrates the purpose of term insurance: to provide a large amount of life insurance coverage at a relatively low cost for a specified number of years.
Advantages: The annual premium does not change for a guaranteed time period. Cash outlays can be minimized for a large amount of life insurance. The policy can be canceled anytime without any penalty or consequence, other than forfeiting the coverage.
Disadvantages: Premiums increase dramatically at the end of the initial guaranteed period. There is no cash build-up in the policy to offset future cost increases. If a health problem develops near the end of the initial term, few options may exist for alternative coverage. Dropping coverage or paying a much higher premium may be the only choices.
Permanent Insurance is used when the need for life insurance coverage is, well, permanent. Here’s an example: let’s say a 55-year-old couple, for whatever reason, needs to take out a new 30-year mortgage on their house. If the husband could not make the mortgage payment without the wife’s income, they would have a permanent need for life insurance on the wife. Most permanent life insurance requires annual premium payments until age 100 or until death, whichever comes first. If the insured person is still alive at 100, usually no more premiums are required, but the life insurance stays in effect.
Advantages: Coverage can be permanent. Premiums can be guaranteed for life. Cash value may build up in the policy to keep premiums the same each year. Some let you take a break from paying premiums or change the life insurance amount. Some policies let the owner direct how the policy’s money is invested. Policies can be simple, offering a guaranteed, “to death” life insurance as long as the annual premiums are paid. If a policy is no longer needed, it can be “cashed-in” to recover some of the premiums paid.
Disadvantages: Premiums are usually higher than term, at least initially. “To death” coverage can be uncertain and dependent on a variety of factors beyond the control of the policy owner. If not set up correctly, some policies can blow up or require a surprise jump in premium (more cash) to keep it going.
Policy Types: There’s quite a variety of permanent policies in the marketplace and some policies can be rather complicated. The two primary types of permanent life insurance are whole life and universal life. For an annual premium (that is usually for the rest of your life), whole life offers a guaranteed death benefit. Cash value accumulates in the policy. Surrender charges usually apply if the cash is taken out before a ten or fifteen year “surrender period.” For greater flexibility, insurance companies also offer universal life with a variety of options. Unless you buy a policy that specifically states it has a guaranteed death benefit, universal life may not provide permanent coverage. There are three types of universal life: traditional universal life, variable universal life and indexed universal life.
Traditional universal life (UL) usually requires annual premiums to keep it “in force.” The initial annual premium is determined when the policy is issued by the insurance company and it is based on two important assumptions: the interest that insurance company will pay into the policy and the charges deducted from the policy by the insurance company for the death benefit. Over the years, the actual interest earned may be higher or lower and the cost of the insurance can change as well. If the changes are unfavorable, the insurance company can require the policyowner to pay more premium in order to keep the policy.
Instead of earning a set rate of interest, variable universal life (VUL) allows the policyowner to select from a menu of investment choices. These “sub-accounts” are very similar to mutual funds. They can increase in value due to manager performance and/or the overall stock market. Favorable performance could swell cash value and, thereby, reduce the premium that is required each year to keep the policy in effect. Unfavorable performance (stock market losses) can reduce subaccount values and put the policy at risk; more premium may be required to keep the policy in place. Given its investment component and risks, VUL is both an insurance product as well as a security (that means a prospectus is required to be provided when it is sold).
Indexed universal life insurance (IUL) has been more recently introduced by insurance companies as a way for policyholders to get some upside potential while eliminating the downside risk. Instead of investing in sub-accounts, a policyholder earns interest that is tied to the performance of one or more stock market indices. These policies are not securities, yet if interest isn’t earned as expected, the policyholder may be asked to add premium to keep the policy in place.
Be aware that there are many variations of the above policies, such as: single premium (you only make one premium payment), limited-pay (there are a fixed number of annual premium payments), first-to-die (the death benefit is paid at the first death of an insured couple), second-to-die policies (the death benefit is paid at the death of the second person of an insured couple), and policies that provide long-term care coverage in addition to a death benefit.
Before you buy any type of life insurance, be sure you understand the moving parts. What might cause the policy to not perform as expected? Ask an experienced, independent insurance agent to help you find the right policy for your situation.
David D. Holland, a CERTIFIED FINANCIAL PLANNER™ practitioner, hosts a weekday radio show at 9AM on AM1380 Ormond Beach, AM1230 New Smyrna Beach and AM1490 Deland. He has also authored two books in his Confessions of a Financial Planner series. Holland offers investment advice through Holland Advisory Services, Inc., a registered investment adviser in Ormond Beach. He can be contacted at (386) 671-7526. Email your financial questions to info@DavidHolland.com.