Brief description of term and permanent life insurance
Term life insurance is fairly simple. You pay a monthly or yearly premium for 10 or 20 years, and if you die, your beneficiary gets the coverage amount. The size of the premium is based on the amount of coverage and how likely you are to die during the 10- or 20-year term. The younger and healthier you are, the less you pay. If you don’t die during the term, you have nothing to show for your premium payments. But, the premiums are lower than they are for permanent insurance.
Permanent life insurance has a number of variants, but the main idea is that you get a savings component in addition to the life insurance component. Your beneficiary gets paid the coverage amount if you die, but you get to access the savings if you live. You can think of the premiums you pay as being split between the life insurance part and the savings part. For this reason, premiums for permanent insurance are higher than those for term life insurance.
So, which type of life insurance is better? It all boils down to the numbers in the savings component. Some people might like the forced savings part of permanent insurance, and some people may benefit from tax considerations, but this just slightly shifts how good the savings component has to be to tip the scale to favour permanent insurance.
When I was buying my own life insurance years ago, I looked at numbers from a life insurance salesperson and every permanent insurance scenario he described looked worse than term insurance after crunching the numbers. In fact, it wasn’t close. The first time I heard Gail Vaz-Oxlade speak positively about permanent insurance, I was surprised. But I’ve always respected both Gail’s genuine desire to help people and her skills at steering people to handle money better. So, I assumed she knew something I didn’t.
In her book Money Rules, Vaz-Oxlade showed her usual skill at helping people manage their money better and stop growing debt. In one section she made it clear that she favours permanent life insurance for young people. She also provided a justification for this preference with some numbers:
“I bought life insurance when I was 30. It’s a whole life plan, and many people scoffed at me. At the time I had a mortgage but no husband or kids, so I just wanted to make sure I’d have insurance if I ever needed it. I’ve been paying just under $90 a month for $200,000 in coverage. By the time I turn 65, I will have paid $37,800 in premiums, but my policy will have a guaranteed cash value of $32,000. That means 35 years of life insurance coverage cost me $5,800, or $13.81 a month.”I was shocked to see her ignore 35 years of inflation. Quite apart from the questionable choice of buying life insurance when you have no dependents who need it, how can we ignore the difference between the value of $90 in 1989 (when she was 30) versus the value of $90 in 2024 (when she will be 65)? Assuming inflation over the next decade of 2% per year, dollars in 2024 will buy less than half as much as they did in 1989.
Adjusting for the time value of money
It isn’t fair to judge a permanent life insurance policy solely based on cashing it out at age 65, but that’s the measure we have here. I decided to repeat Vaz-Oxlade’s calculation taking proper account of inflation. In 2024 dollars, the total of the premiums works out to $53,154 rather than $37,800. This makes the total insurance cost $21,154. Coming back to 2014 dollars, this is $41.32 per month. This is a far cry from $13.81 a month.
What if we assume that Vaz-Oxlade could have invested her money with a return of 2% above inflation over those 35 years? In this case, the future value (in 2024) of all her premiums is $78,927. The total insurance cost in 2014 dollars works out to $91.66 per month. You may wonder how this could be more than the $90 she pays each month. The answer is that her initial payments back in 1989 were considerably more valuable than $90 today.
What if we consider a person who doesn’t handle money well and is mired in debt? In this case, the higher premiums for permanent insurance could have been invested at an even higher rate of return by paying off some debt. So, the calculated monthly life insurance cost would be even higher.
In a later section of the same book, Vaz-Oxlade claims that permanent insurance is cheapest over your lifetime if you start young. As evidence, she adds up the monthly premiums for a $200,000 permanent life insurance policy starting at ages 25, 30, 35, and 40. The total premiums paid to age 65 turn out to be lowest if you start at age 25, but only because she ignores inflation.
Factoring in inflation, total costs are highest when you start young. This doesn’t mean you should necessarily wait until you’re older to get life insurance, though. If your family depends on your income, you need life insurance.
I don’t claim to have a definitive answer to which type of insurance you should buy. But I can say that I still haven’t seen an example where permanent insurance looked like a better deal than term insurance. When comparing term and permanent life insurance, be sure to account for inflation, returns you expect on your savings, and your need for forced savings.