Wednesday, December 10, 2014

Life Insurance: Permanent vs. Term

The internet is littered with debates over the merits of permanent life insurance and term life insurance. They both pay your beneficiary if you die. The main differences are that permanent life insurance costs more but has an investment component. Most debates are full of words, but the real answer to which is better is in the numbers. I looked at some numbers in an example from Gail Vaz-Oxlade and found her analysis to be seriously flawed.

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.

Vaz-Oxlade’s analysis

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.

Starting young

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.

Conclusion

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.

32 comments:

  1. Good points, appreciate that you are testing the assumptions and recommendations of the "celebrity" financial writers.

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    1. @Anonymous: Thanks. I'm happy to read many books and say what I really think whether they are written by celebrities or not. It's easy to be a cheerleader or a nit-picker. I prefer to stick to fair criticism and praise.

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  2. I agree with your analysis numerically.
    But, I think Gail's target audience (from her shows, apparently very few look at numbers) who needs life insurance might be better served with the forced savings of Permanent life insurance.
    Some return is better than no return, and they might not be at a financial literacy level for a better return.

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    1. @aB: I'd be more inclined to agree with you if it weren't for the fact that so many people who begin with permanent life insurance end up stopping making payments and essentially abandoning it. There are many other ways to try to force yourself to save where the numbers look better than permanent insurance.

      Trying to find ways to get people to save money and not tap into these savings or borrow against their savings is a difficult area. I'm not convinced that permanent life insurance is a good answer.

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    2. An abandoned permanent policy is profitable for the insurer (collected more premiums than with term life and didn't pay a claim) and advisor (higher compensation than term life). If the buyer gets more insurance, premiums will be higher because of their current age (if they are still insurable).

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  3. I sell life insurance. Nice post!

    The argument for buying young with no dependants is that you may not be insurable later in life. Or insurable at rated rates.

    Instead of thinking the decision is just between 10 - 20 year terms or permanent insurance with savings, there are other options. Term insurance can go as long as 40 years or some companies have a term to age 70 product. You can also purchase a permanent policy and not fund the savings, which basically makes it a term 100. Longer term, term insurance makes the most sense for most of my clients.

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    1. @James: I'm somewhat skeptical about buying life insurance when you don't need it just in case you don't qualify when you do need it, but I can see the logic for some people. Maybe there should be a product better targeted to these people. Offer a long term product that only pays out if you die after some future date. So, initially all you're paying for is future insurability.

      Longer terms can make sense, but you need to predict how long you'll need insurance. In my case, I stopped needing life insurance fairly young. It would have been a waste to get a longer term. The costs of longer terms rises quite quickly starting right from the first payment.

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    2. Agree in general, but the problem with a longer term can be changing life circumstances. My wife and I, when we had our first child (at 29) bought a 10yr policy. At that time, our net worth was small, we had a large mortgage, etc. Fast forward to near the end of that policy and our net worth is substantially higher, almost zero debt remaining, so when this policy expires, I will likely find my needs for the next policy to be dramatically different. A 10-yr renewal allows you flexibility to revisit - but as you correctly point out, also exposes you to higher costs due to illness, etc.

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    3. Both good replies. I view it as buying options or flexibility. You can reduce or cancel the insured amount of a life policy at any time, however you can not increase it without evidence of insurability.

      Of course I don't know your specific policy but recently it seems that consumers are more concerned with just debt elimination and not with income replacement regarding their insurance.

      I don't want this to sound like a sales pitch, but many people are not insurable and do not even realize it. So, you might not need all of it when you are young but at least you can get it. Your new product idea is good, but it would be hard to know what a safe future date would be.

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    4. @Anonymous: Yes, when choosing a term length you're trying to guess your future financial circumstances. Renewal clauses help somewhat, but the guaranteed renewal rates are often not great; people count on being able to re-qualify to get a better rate on the next 10-year term than the guaranteed rate.

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    5. @James: Taking a long term with the plan to cancel if you don't need it is safer but more costly. Every 5 years you add to the term hikes the premiums significantly because the risk of death is much higher when you're older. It's all a trade-off between cost and risk.

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  4. Gail fails to explain how one would access that cash value if needed (borrow or surrender the policy) and what happens to the cash value upon death (stays with insurance company). I agree Michael..... have yet to see an example where permanent insurance is a better deal than term life

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    1. @Anonymous: Excellent points. In effect, the insurance coverage decreases as the savings component increases. This is actually a reasonable feature, but it has to be factored in to any thorough analysis of the relative values of different policies.

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  5. I'm of the opinion that insurance is needed until you can self-insure. For some people, based on their business activities or for self-employment reasons, permanent is the way to go; especially if they create their policies young.

    On the other hand, I believe term is best for most folks that will not have long-term (20+ year) financial obligations.

    You're a perfect test case I think Michael, because you can self-insure now and have likely be able to do so for many years. Term wouldn't make sense for you now but it likely did in your 30s.

    Mark

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    1. @Mark: I don't follow your logic for why some should get permanent policies. Long-term need isn't a good reason; you can get a 40-year term policy and investing the difference would build substantial savings over 40 years. So, a permanent policy would have to have a competitive savings component to make sense.

      I don't need life insurance at all, so it's not a question of term or permanent.

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    2. I guess I was thinking some folks are likely to renew terms, and if so, they could have had a permanent policy in the first place, potentially with the same premiums AND cash value because some whole life plans have the investment component.

      I'm not saying people should do that, I didn't and don't intend to.




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    3. @Mark: I guess if someone intends to keep renewing term insurance until they die no matter how long they live, permanent might make more sense. But if you intend to stop at some age when you expect to have built adequate savings, term has looked better in the examples I've looked at.

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  6. At whitecoatinvestor.com there is several very good articles looking at this issue. He concludes that one should not mix insurance with investing, as although there are tax advantages with permanent insurance, the very high commissions received by insurance agents, the fees charged by the insurance companies, and the poor investment returns due to the fact that the funds are actively managed, results in these tax advantages being hugely overwhelmed. I think that articles promoting permanent life insurance are generally written by those benefiting from selling these products.

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    1. @Grant: Whenever I crunch numbers on a permanent life insurance policy, the returns look very poor -- consistent with what you're saying.

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  7. A tangent: I wonder what the mortality rate is for people with life insurance vs the uninsured. Seems like life insurance gives people a subtle incentive to die. Probably not enough to tip the scales too drastically, since the desire to remain alive counteracts the incentive to die and hit the jackpot.

    Of course, it would be hard to adjust the death rate data for all externalities (education level, job safety, wealth, health, etc)

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    1. @Gene: I assume insurance companies do this sort of analysis. Maybe not the subtle incentives, but rather the broad statistics. No doubt they have data related to additional factors such as education, etc. as well.

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    2. @Gene: Mortality rates are lower for insured lives than for the general population. That's because the underwriting process eliminates the higher risks (higher premiums or declines).

      Dying is an odd way to to "hit the jackpot". To deter "gamblers", there's usually a suicide clause for the first 24 months (refunds premiums).

      @MJ: Mortality studies are done by gender, age and smoking status. Insurance companies make adjustments based on their target markets, including projections for future mortality.

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  8. Another problem with permanent life insurance is that because it's so expensive, people end up buying too little coverage (especially when inflation is taken into account). My insurance agent recommended $500-750K of coverage given the size of our mortgage and income replacement needs, and that is huge for a whole life policy. For term (20 years) it was a reasonable amount.

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    1. @Anonymous: I've seen that with some older members of my extended family. It's kind of sad to collect on life insurance policies of $10,000 or $15,000.

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  9. Has anyone here bought life insurance for their kids? i set up a whole life 20 pay policy for each of my daughters just after they were born. The premium is only about $300/year, so the total outlay is $6k for an initial policy value of $25k. the policies are set up to use the dividends to purchase paid-up additions, so the policy values will continue to grow over time and they will have them forever once the main policy is fully paid-up (after 20 years). Did I go a little overboard here?.

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    1. @Chris: I never did. Some try to justify life insurance on children based on burial costs and needing to take time off work to deal with the pain. But that seems like weak reasoning to me. I could take time off work without receiving $25k. I don't have enough detail to judge whether the savings component of your policy is any good, but I'm not optimistic.

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    2. Insurance is used to protect against unexpected financial loss (car, home, life). As heartbreaking as the loss of a child would be, it is not a long-term financial hit. No need to insure someone who is not making a financial contribution to the family unit. (paid or unpaid)

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    3. This video by Jim Ruta may be useful: the unthinkable argument for child life insurance

      @Chris: What you did made sense to you at the time. Life insurance on children isn't common --- tends to be sold, not bought. Coverage amounts tend to be small, especially after inflation.

      Critical illness insurance may make sense for children since there are special illnesses they face (e.g., cerebral palsy, cystic fibrosis).

      @MJ: When I was a kid, an agent wanted my parents to buy insurance on me because I might not be insurable later or may need to be cremated. Like you, they found the reasons was weak. They decided to self-insure.

      @Anonymous: Parents grieve in different ways. Some children suffer extended illnesses before dying. Taking time off costs money and focus. A self-employed person may be unable to work for months or longer. For some, insurance helps.

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  10. Thanks for your thoughtful post, Michael. You inspired me to write about the ingredients underlying life insurance, both term and perm. I hope that adds to the discussion.

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    1. @Promod: I read your article. Even someone who appears to have a permanent need for life insurance may choose term insurance anyway if the savings component of the permanent insurance offered is poor. It makes sense to compare the numbers on a permanent plan to the following strategy. Get term and invest the difference. As the savings grow, reduce the term coverage amount. Eventually, eliminate the life insurance entirely when the savings have grown to the original coverage amount.

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    2. @MJ: You're tough to convince! I'll email you comparisons soon. Right now an applet is refusing to run ...

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    3. @Promod: Only numbers will convince me here because it all comes down to the implied returns of the savings component of the permanent insurance.

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