Insurance. Even saying this word makes some people cringe. For the most part, you are familiar, and perhaps used to, the insurance you have on your car, house, and hopefully to pay your medical bills. It’s a part of your normal budgeting that you take for granted, and in the case of car and house, hope you never need to use.
Life insurance is part of most responsible people’s financial planning. Whether it is to make up for lost income, send a child to college, or provide for other loved ones, you should understand your options and choose accordingly.
Term Life Insurance
There are two main categories of life insurance, Term and Whole Life. Term is the simplest to describe and that where we’ll start. Term is just that, a policy that has a fixed cost for a certain period of time, most often 10,20, or 30 years. For a 40-year-old male non-smoker, a $500,000 policy would cost about $250 per year for 10 years, $425 for 20 years, and $700 for 30 years. One might choose a certain term to match up with an expense that may go away. The birth of a child is often the time that one first considers the need for insurance, and a 20 year term policy fits nicely with the timing of raising the son or daughter and sending them off to college. The 30-year term, if bought at this age, will bridge the gap till retirement so a spouse (working or not) is not left with the sudden drop of income. The amount you choose to purchase is another discussion, too little and your family may have serious consequences upon your passing, too much and your throwing money away that you should be investing or otherwise using to enjoy life. For complete replacement of income, a good rule of thumb is to insure yourself for twenty times your income. As time passes and this number is impacted by inflation, your retirement savings should be growing so the total real value continues to increase. For others, a term that coincides with other life events, such as planned mortgage payoff, makes sense. Note: Many term policies come with a guaranteed renewal feature; you can buy a new term policy with no exam, but at the rate in effect for your age at the time of renewal.
Whole Life Insurance
Quite a bit more complicated are Whole Life and its variants, namely, Traditional whole life, Universal life, and Variable life.
Compared to the above, a Traditional whole life policy with a $500,000 death benefit may cost closer to $4000 per year. Quite a jump, but in return you get dividends which can be used to increase cash value or eventually grow large enough to reduce or fully pay the premiums or be borrowed from the account. The investment vehicle is hidden from the customer, and the insurance company announces the return each year, with a minimum usually set.
Universal life differs slightly in how the premiums payments are capped and how returns are calculated. Typically, the policy earns interest each year, again with a guaranteed minimum. One variation of universal is a Single Premium policy, in theory, the accumulation within the account will always provide enough funds to cover the mortality premium. It’s possible, however, that the account value is depleted and years later, premium payment become due.
Variable Life Insurance
Last, and likely least understood, is Variable life. This insurance offers the most choices of end products to use as investments within the account, typically the same variety of funds as most mutual fund families will offer. There are no guaranteed cash values and as the account is subject to both death benefit premiums each year along with internal expenses and fund expenses, this is a very expensive way to invest for the long term.
The Whole life policies do offer features that term cannot provide such as the ability to borrow money back at a low interest rate. But, of course, this is your own money you are borrowing. Given the ‘forced saving’ nature of this flavor of insurance, they appear best suited to someone who may not be disciplined enough to do this on their own and would otherwise find themselves with no real savings to speak of. For someone comfortable making their own investment decisions, the advice to buy term and invest the difference continues to remain the superior choice.
Do you have life insurance? If so, which type did you buy? Which do you think is the best for most people? Tell us your thoughts in the comments.
26th February 2010