By Russ Banham
Life insurance is one of life’s essentials, with different types of products aimed at different life stages. When young and in the formative years of a career, term life insurance can provide ample financial protection to dependents at a relatively low cost. In later life stages, permanent life insurance may offer, depending on the type of policy, the opportunity to accumulate cash value on a tax-deferred accrual basis, money that can be used for diverse needs.
The question many people deliberate is which type of life insurance is best for them, at which life stage. It’s an important question belying easy answers. Both types of life insurance and their varying options and permutations present unique benefits, designed to address wide-ranging buyer needs and financial considerations.
While term life insurance and permanent life insurance policies provide a death benefit, they differ in many other respects. Permanent life insurance, for instance, offers lifetime protection, a death benefit paid to beneficiaries no matter how long the policyowner lives, assuming the premiums are paid. Term life insurance, on the other hand, provides coverage for a specific period of time, such as 10 years or 20 years. When the policy term concludes, the death benefit ends.
These are just the basic differences. While owners of many term life insurance policies have the right to renew the policy once the period draws to a close, the cost will increase upon renewal, and can be considerable. Permanent life insurance policies (which include whole life insurance and universal life insurance, have the potential to accumulate guaranteed cash value that increases every year. In certain cases, universal life insurance may or may not offer this feature.
From the standpoint of life stages, another key difference between the life insurance types is their cost. The premiums for term life insurance for the same death benefit of a permanent life insurance policy are generally much less, hence its applicability to someone just starting a career and a family.
“Given the death benefit provided, the cost is extremely low,” said Kevin Lynch, an assistant professor of insurance at The American College in Bryn Mawr, Pennsylvania.
Lynch equates the difference between buying term life insurance and permanent life insurance to the difference in renting and buying a home.
“You’re young, starting your career, and living on your own for the first time,” Lynch said. “Do you buy a three-bedroom, two and one-half bath house or do you rent? Typically, you rent. The same (analogy) applies to the decision to buy term life versus permanent life insurance.”
Once people reach a point in life where their income is more substantial and their financial needs have grown, they have the means and the incentive to purchase a house that will build financial value.
“You rent as long as that makes financial sense,” Lynch said. “Once you get to the point where your income (is) rising, and you have new responsibilities like a spouse and dependents, you generally opt for something more permanent like a house with a fixed mortgage. This is exactly how whole life insurance should be looked at. Like a house, it’s yours for life and can generate greater value over time.”
Why Not Stick with Term Insurance?
While there is absolutely nothing wrong with maintaining term life insurance well into one’s middle years and beyond, the cost of the insurance typically rises along with the person’s age on renewal. An annually renewable policy will be priced higher at the time of each renewal; the same applies to renewing a 10-year or 20-year level premium term policy. Term insurance also does not build cash value. Had the individual purchased permanent life insurance, he or she could have access to a potentially significant source of supplemental retirement income in the future (depending on the policy type), while preserving the death benefit in perpetuity (note, however, that the death benefit and cash value of a policy is reduced in the event of a loan or partial surrender, and the chance of lapsing the policy increases).
Similarly, there is nothing wrong with buying permanent life insurance at the beginning of one’s career. The problem is that this may not be feasible for many people, giving the comparatively higher cost of the product. In such cases, term life insurance may be the better choice.
The decision boils down to the person’s needs and financial wherewithal. When young and with dependents, the needs are high but often the financial wherewithal is low.
“If you’re young and making $35,000 a year, you want to ensure that if you died tomorrow your spouse and kids would receive the financial equivalent of 20 to 30 years’ worth of your lifetime income,” Lynch said. “After all, this is the essential purpose of life insurance — to replace the ability to `bring home the check.’”
In the case of a married couple or domestic partners each earning a salary, both can replace the ability of the other to provide a source of ongoing income. If one spouse or partner is working and the other is staying home to care for children or other family members, life insurance helps absorb the financial impact in the event of one person’s death. In both examples, term life insurance would provide an ample death benefit to the beneficiaries at a much lower cost than permanent life insurance, which may not be within the financial reach of these buyers. However, five to 10 years in the future, the person’s financial means may rise appreciably. If this is indeed the case, permanent life insurance could be more affordable for the individual. (Calculator: How Much Life Insurance Do I Need?)
“The choice between term life or permanent life insurance is not a case of which policy is better; it’s a case of which policy is appropriate for the current period in a person’s life,” Lynch said.
Many people also find that the combination of permanent life and term life insurance can provide the lifetime protection and cash value accumulation they need, at a price they can afford.
Financial professionals agree that both forms of life insurance serve distinctly important purposes, based on an individual’s life stages.
“Term life insurance is very beneficial when you have a limited budget,” said Dean Aita, president of Aita Financial Group Inc., a Washington Depot, Connecticut-based financial advisory firm. “You would never want someone of very modest income to buy a permanent life insurance policy that they couldn’t afford on an ongoing basis. If they fail to pay next year’s premium, the policy can lapse.”
As a person’s income rises, Aita said it makes less sense to continue to buy term life insurance, as the premiums will rise appreciably and don’t accumulate cash value.
“A better alternative may be to purchase a permanent life insurance policy that accrues a cash value,” he explained. “You’ll pay more in premiums, but you gain additional benefits beyond just the death proceeds.”
Some permanent policies are eligible to receive dividends, and although they aren’t guaranteed, they help to increase the cash value and death benefit of the policy. As the policyowner accumulates cash value inside the policy, the person can access the cash value, through loans or partial surrenders, which can be used for a variety of personal needs, such as quick cash for an emergency or to help supplement retirement income.
“Many permanent policies allow you to apply the dividends to help pay future premiums,” Aita said. “The uses are many and depend on each person’s financial needs.”
While the cash value feature is an attractive option it’s important to remember, though, that tapping into the cash value of a life insurance policy reduces its value and death benefit and increases the chance the policy will lapse. And if a policy lapses with an outstanding loan in excess of the cost basis, it’s taxable.
Twists and Turns
Since life is unpredictable, term insurance often has an added feature: the ability to convert the term policy to permanent coverage within a certain conversion period – for example within the first 10 years of a 20 year policy.
“To buy another term policy requires proof of insurability, basically a medical exam. The individual may not be able to buy a new policy when the person is older. Fortunately, the industry has addressed this possibility.”
He is referring to an important component of some, but not all, term life insurance policies — the ability to convert all or part of the term policy, during the conversion period, into permanent life insurance, irrespective of the policyowner’s health or proof of insurability.
Now or Later
The key question for many term life insurance policyowners is when best to progress (or convert) from term life insurance to permanent life insurance. Each person’s decision in this regard is different, due to unique circumstances.
“The decision depends on the individual’s current and anticipated income stream, number of dependents, a spouse’s income, and the family’s assets and savings, among other factors,” Lynch said. “From a financial standpoint, often the younger you convert to permanent life insurance the better, as the premiums will be less for the policy, whereas the premiums for the term insurance can go up at each renewal.”
He added, “It’s always best to sit down with a financial professional or insurance agent to determine the opportune time to move from one policy to the other or to keep both (types of) policies in place.”
Aita agreed with this perspective. “Affordability is the key,” he said. “Because the premium on permanent life insurance goes up as you age, the earlier you buy the product or convert a term life policy, the lower the initial costs. Also, the cash value will accumulate sooner in certain policies.”
Potential buyers need to perceive the value of permanent life insurance as providing more than just a death benefit, he added. “If premiums are paid properly and the policy is monitored through the years, permanent life can be a very beneficial financial asset that can help supplement a person’s overall retirement and estate planning,” Aita said. “This is more than a standalone product, given its integral role in overall wealth management.”
Aita said he owns several life insurance policies, which he converted as a younger man. “I’ve had clients for 20 years thank me for advising them to convert from term life to permanent life insurance when they did … The value of the policy can grow significantly,” he said “It’s a very useful planning tool.”
Russ Banham is a Pulitzer-nominated business journalist and author who writes often on insurance consumer issues.