One of the most frequent questions clients ask us about life insurance is what type of insurance they should purchase, whole life or term life insurance. Whole life policies are still popular among some agents, but we think there are usually more suitable alternatives. Whole life, as its name implies, is insurance that is meant to cover you for your entire life and it is a type of permanent insurance. As long as you pay your premiums, the insurance can’t lapse and that’s a point that agents often tout with selling the policy. The problem is most people don’t need insurance to cover their entire lives.
We think most people need life insurance for two possible reasons – to insure those that depend upon their income, and to pay down debt. Nearly all clients we work with plan to retire at some point, and once a client is retired, typically the only income they earn is social security, and expenses tend to drop when one spouse predeceases another. Thus, replacing social security income is often unnecessary. As for debt pay down, most of our clients are on track to pay off much of their debt once they have retired so there is little need for life insurance in retirement for that reason either.
Given that life insurance is often unneeded in retirement, we think the best solution for most client needs is term life insurance. Term life insurance is insurance that has a level premium for a specific number of years. Term insurance is “pure” insurance in that it lacks the investment component, while whole life insurance has both an insurance – or face – value and a cash value. The cost of the insurance component itself is lower with term insurance for a few reasons, but the primary reason is that the likelihood of a claim is lower with term insurance than whole life insurance.
There is an investment component to a whole life policy, which is referred to as the cash value of a policy. The cash value will grow if you continue to make premium payments. However, if you were to invest the difference in premiums between a whole life policy and a comparable term policy in a low cost diversified portfolio, over the long term the value of the portfolio would likely exceed the cash value of the insurance policy.
There are some instances in which the permanent insurance offered by whole life is needed. Parents who care for a disabled child or dependent often need whole life, as do business owners who might need liquidity for their business at some point. Irrevocable life insurance trusts are still in use to cover estate taxes, although they have become less common since the estate tax exemption was increased several years ago. Finally, high income earners who want to minimize investment related income and who also need insurance might find such policies useful. However, for most people, term life insurance offers the coverage they need at the lowest cost.