Whole vs Term
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As it happens, I received a question from a YouTube viewer not long ago asking for my thoughts on whole life insurance versus term life insurance.
It’s not a very good strategy to give the ending away at the beginning of a post, but the answer is there are only two reasons I can think of to purchase a whole life policy and they are both estate planning strategies for wealthier individuals.
If you just want life insurance for its most common purpose, to cover those who depend on your income in the event of your untimely death, then I strongly recommend term life insurance and I’ll explain why in just a minute.
First, I want to talk at a high level about the two reasons someone might actually want to buy a permanent life insurance policy.
The Case for Permanent Insurance
Let’s start by making a semantic clarification.
Whole life insurance is a type of permanent life insurance. There are several others, universal, variable universal, and variable being a few of the most popular ones.
From this point forward, I’m just going to lump them into the permanent bucket because I don’t think any of them are very useful with the following exceptions.
First, there may be a case for using permanent life insurance to cover the cost of estate taxes after your death.
In 2024, each individual American has a lifetime gift tax exemption of $13.61 million dollars. This basically means if you die in 2024 you could have given away up to $13.61 million in your lifetime tax-free.
If you’re married, you both get the exemption but since couples rarely die together, form 706 should be filed to reserve the exemption of the spouse that passes first.
That means if you have an estate worth excess of $27.22 million you should probably look into how a permanent insurance policy could protect at least some of your estate from estate taxes.
Obviously, this will not apply to very many people.
The second case for permanent insurance will also likely only make sense for wealthier families who have assets that will not divide very easily after their death.
For example, suppose John & Jill Smith own a business that has turned into quite a valuable organization over time. So valuable, in fact, that it represents 80% of their total net worth.
The Smiths have two sons. John Jr. has worked in the business for years and is set to take over when his parents pass away.
The Smith’s other son, Tommy, is an engineer who works and lives over 1,000 miles away.
John Jr. and Tommy get along pretty well, but the Smiths know leaving 80% of their estate to the older brother could create a bit of animosity so they desperately want to equalize the inheritance.
There are a few ways they could do this, but one way is to buy a permanent insurance policy at such a value that Tommy will receive an inheritance that is somewhat equal to John Jr.’s.
This way John Jr. gets the business, but Tommy gets a large life insurance payout.
Real estate can also commonly be difficult to divvy up, creating another common use for insurance.
I have heard arguments that permanent insurance should be used to protect disabled heirs who cannot care for themselves.
I won’t shut the door on that method entirely, but in most cases, I think there is a better way.
Let’s look at those shall we?
Why Term is Better
I’m not going to belabor the point here.
The bottom line is insurance companies love selling permanent insurance because they make a ton of money on it.
Typically, the agents that sell whole-life policies receive a commission of 60% to 80% of the value of the premiums you pay in the first year.
That’s a little over $4,300 in commissions for a half-million-dollar policy sold to a 30-year-old in decent health.
And where does this “ton of money” come from? From years of exorbitantly high premiums protected by exorbitantly high surrender fees paid by exorbitantly mistreated insured parties.
Conversely, while permanent insurance is incredibly complex and expensive, term is simple and cheap.
You can buy term for only the amount of time you need it and the premiums are far, far less expensive than a permanent policy.
As it happens, my wife and I wanted a bit more term coverage a little while ago which required me to collect quotes from my insurance company.
For kicks and giggles, I also requested a quote for a whole-life policy.
Let’s walk through an analysis of the total cost differences and benefits of term versus permanent insurance.
The Math
In our situation, we were shopping for $1.5 million in coverage for each of us and wanted it to be in place for at least 10 years.
I knew the whole life premium would be high, but I did not expect this:
By the way, these premiums are for me only. It was a bit cheaper to insure my wife.
To be fair, in the case of the term policy, the insurance company just had to hope I make it to 52 years old.
I’m in good health and I plan to do my best to make it at least that far. The odds of them ever having to pay up on that policy are pretty low.
On the other hand, with whole-life, if I ever die they have to pay out $1.5 million.
I am a bit of an optimist but have to admit that I will likely die one day meaning the insurance company is basically promising that they’ll make this payout at some point.
And, as you might expect, it takes a lot of money and time to build up $1.5 million in assets.
Out of curiosity, I looked up my life expectancy when I was evaluating these policies and I had 37 years to go according to the mortality information I found.
I plan to do better, but we’ll go with this for our evaluation.
If I paid these premiums for 37 years, here is the total amount I would pay to the insurance company for each of these policies…
Again, the total costs are vastly different.
Truthfully, this makes me feel better about my odds of living past 52, but let’s keep analyzing, shall we?
You’ll note that the total expected premium for the $1.5 million whole-life policy is less than half of the total benefit.
Well, that’s because the insurance company is going to invest the premiums you pay them each month in order to make up the difference and produce a profit.
In a way, when you buy a whole life policy, you’re paying an insurance company to invest the additional premium value so you don’t have to.
They’re good at math, so they are happy to take the deal.
Now let’s look at what the $1212.46 difference in premiums between term life and whole life could earn for you instead of the insurance company.
Since the whole life benefit is $1,500,000, that’s the value of the policy for the remainder of your life. Even if the policy has a cash value feature, the death benefit will almost certainly be reduced if you access the cash value.
Most of the values in the term life column are the compounding effect of $1,212.46 invested each month in an S&P 500 index fund earning an average rate of 10.67% (the average annual return of the S&P 500 since 1957).
The value at 5 years is $1,596,420.33 because you have a $1.5 million insurance policy and $96,420.33 in portfolio value from the invested premium difference.
Once the term life policy expires at 10 years, everything from that point forward is the result of investing the premium difference.
In summary, if I died between 10 years and 23 years and 3 months, then the whole life policy would be better for my family.
I don’t know the odds of passing away in that timeframe, but I’ll be 64 when the 23-year window passes. According to the Social Security Administration, there’s a 1.88% chance I’ll die before then.
There are a few takeaways I want to highlight from this:
- The math is quite clear. Whole life is not a very efficient way to provide life insurance coverage.
- If you elect to buy term, and I think you should, you need to be investing to build enough assets so that life insurance is no longer needed once the term policy expires. $1,212.46/month is just under 20% of the median household income.
- The earlier you can buy life insurance, the cheaper it will be. This is true for permanent or term insurance.
- A common rule of thumb is to buy 10 times your income in insurance. A “rule of thumb” is an accurate characterization. To identify your exact need, you need to dig into the numbers and evaluate your income, cost of living (now and in the future), the ages of the people you’re insuring, and I think it is helpful to make some assumptions about inflation as well.
- When in doubt, buy a little more and buy a little longer.
When You Have a Hammer
Somewhere out there, there’s a life insurance salesman who thinks I’m calling him a bad guy. I’ll be a little shocked if I don’t hear from at least one or two in the comments below.
While I fully believe that there are people who sell these policies to anyone naïve enough to buy them, I think the majority of the time the people who sell insurance are only given tools to sell the most profitable products to clients.
If you needed to sell hammers to feed your family, you would get really good at finding nails. After a while, you might even decide that a lot of things that aren’t nails are close enough to justify the need for a hammer.
Gradually, everything becomes a nail.
And in insurance, there isn’t a fiduciary standard requiring insurance salesmen to act in the best interests of their customers.
Caveat emptor, indeed.
