In last week’s column, we discussed how to determine the amount of life insurance you need. Now that you know that amount, you are faced with a choice between whole-life insurance and term life insurance.
Term insurance is pure insurance. If you die, the insurance company will pay your beneficiaries the face amount of the policy. Each year most term insurance policies become more expensive because the chances you will die increase. As you will see in the chart below, the cost of term insurance becomes prohibitive after retirement.
Whole-life insurance, as well as universal life, is insurance that includes a savings account. All permanent insurance is a combination of two types of insurance policies, both of which are sold separately as well.
The first is a decreasing term policy that decreases in face amount each year as you get older. The second is an increasing annuity (like a saving account) that increases in value each year as you contribute extra money to it. In permanent insurance, the decreasing term policy is structured to decrease in value exactly the same as the increasing value of the annuity, always producing the same face amount. The excess savings in these types of policies are called “cash value.”
Therefore, your premiums are used to pay for the insurance and to build the cash value. The money in the policy’s savings account grows tax deferred. Many people consider this a forced savings plan.
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However, your access to your cash value is restricted. You can either borrow it, in which case you are paying interest to borrow your own money, or you can cancel the policy and take whatever cash is in the account.
As you will see in the chart below, the premiums for whole-life insurance remain constant, but are significantly higher than term policies until just past the age of retirement.
It is my recommendation that you use term insurance if your insurance need is temporary and use whole-life insurance if your insurance need is permanent.
A temporary problem is one that will no longer exist by the time you retire. For example, if you are putting aside money for retirement and will have enough for you and your spouse to live on by the time you retire, at that point you no longer need survivorship life insurance for that purpose. However, if you have trouble saving and feel you will not have enough for your spouse should you die after you retire, then you have a permanent need for life insurance and would be better off with whole-life insurance.
Selecting the right whole-life insurance policy
Should you determine that you have a permanent need for life insurance, you will find a wide variety of whole and universal life insurance policies on the market, all with surprisingly different costs. The chart below compares three different whole-life policies, each with a face value of $500,000.
If you bought one of these policies and died the next day, obviously the cheapest policy, policy A, would be the best deal. However, what if you should live well into retirement? Which policy would be the best deal under that scenario? Again, it is policy A.
Remember, the only way to get your cash value is to either borrow it or cancel the policy. If you borrow the money, the loan will stand against the policy and you will be paying interest for the money. If you cancel the policy, then you will not have any life insurance. Your best bet is to buy the least expensive policy.
The final factor is to check out the financial strength of the insurance company with whom you are thinking of doing business. Only choose companies with a rating of A or A+ from A. M. Best, an insurance company rating firm.
The bottom line
If you establish a investment plan, as recommended earlier, your need for life insurance should mostly be temporary. If you determine the cost of all of your financial goals and then start paying that cost, by the time you retire you should no longer need life insurance. Additionally, if that is the case, you will be able to save a significant amount of money by using term insurance.
One word of caution, however; do not cancel any existing policy until you have a new policy in hand. Your medical condition may have changed since you last purchased insurance. Therefore, you may have a difficult time qualifying for new coverage. If you are thinking of replacing a whole-life policy with a term policy, make sure your new policy is in force before you cancel your existing policy.
Disability insurance protects your most valuable asset: your ability to earn income. To choose a disability insurance policy that is right for you, consider the following:
- If you work in a specialized field, buy a policy that covers you if you are not able to do your job. The policy’s definition of disability is very important.
- Select a waiting period based on your savings. The longer the waiting period, the less expensive your policy will be. However, if you choose a long waiting period, make sure you have enough money in savings to provide for your needs while you are waiting for the policy to take effect.
- Select a policy that is annually renewable and guaranteed non-cancelable.
Make a list of all your policies. Make sure you have every area of vulnerability in your Personal Security Formula covered. Also, be sure you are not paying for duplicate coverage. For example, if your health insurance covers any hospital stays, make sure you are not paying for the same coverage in your automobile insurance.
The back-down compromise
After you have re-evaluated any advance debt repayment schedules you have set up and thoroughly examined your insurance portfolio to find all of the cost savings opportunities, the last step in reducing a negative cash flow involves compromising a bit on your goals. You could retire later, or with a lower level of income; you could provide less assistance for your college-bound children; you could cut back on lifestyle expenditures; or you could compromise on any other goals you have established.
Let us look at an example. In an earlier column, we determined that to save enough for a 20 percent down payment on a $250,000 condominium in five years would require monthly investments today of $858.09 at 10 percent. However, what would happen if we decided a $150,000 condo would do instead? Now the 20 percent of the purchase price is $30,000 (20 percent of the $150,000). In five years, with inflation running at 8 percent, the cost would be $44,100; and that would require monthly investments today of $564.80. Backing down to a slightly less expensive condominium would free up almost $300 a month for other important goals not being met.
Using the Back-down Compromise option, you can reduce various goals (including current lifestyle), until you find a budget that fits within your income. This will allow you to focus on obtaining goals that are realistic within your income, instead of pretending you will have goals that are not. The only other option is to find a way to increase your income.