Term vs Permanent Insurance
Posted by John Draper | Filed under Insurance
Based on my last post on life insurance and buying it young, I don’t think people have any idea of how inexpensive it can be. I’m going to use the example of $300,000 in insurance on a man (since they’re more expensive) who doesn’t smoke. If you were to buy a 20-year term policy, protecting your family from age 25 to 45, the premium would be only $287 a year, or less than $24 a month. Hey, we’re talking a case of beer here. But wait until you’re 39 to buy the same policy and your costs go up to almost $400 a year, which isn’t exactly a budget killer, unless you want a permanent insurance policy. Then the difference in the numbers is more significant. Buy a permanent policy at 25 and you’ll pay about $1645 a year or $137 a month. Wait until you’re 39 and the price goes up to $3025 a year or $252 a month.
I’ve received a few questions recently about whether term insurance is better than permanent (whole life or universal) insurance. Whether you buy “term,” “whole life” or “universal life” insurance will be dependent on two primary factors:
- the amount of insurance you need, and
- how long you need that insurance to be in place.
Term insurance provides protection for a predetermined period of time (perhaps 5, 10, or 20 years) or until a certain age. However, many term insurance plans end at a specific age, such as 65, 70 or 75 With men and women living considerably past that age, if you’re looking for longer-term protection, term insurance won’t cut it.
With term insurance, when the term of the contract expires your coverage ends unless you renew the term. Each time the term is renewed, the premium is adjusted upwards. So on the term policy above for the guy who bought a 20-year term at age 29, if he needed to renew for another ten years, the premium would jump from $304 to $552.
Think of term insurance as an expense, like rent. While it will give you comfort and peace of mind, it accumulates no residual value. If you want coverage to last your lifetime or want to use insurance to build assets, term insurance isn’t the right choice.
Term insurance is cheaper than permanent insurance, but that’s because the statistics are in favour of the insurance company with term insurance. With permanent insurance the company is going to have to pay out, it’s only a matter of when.
Whole life and universal life insurance are permanent, remaining in place until death. With whole life policies, the insurance company does the investing. (People debate that they don’t do a very good job of it, but they are purposely conservative, and with the recent swings in the market, you can see why.) With universal life, you have much more control over the types of investments the money is going into. The premium is generally the same for the life of the policy, so the annual cost can be low if taken early in life (when the risk of death is low), or very high if taken late in life. If term insurance is rent, then permanent insurance is a mortgage payment; in the early years there isn’t a lot of asset accumulation, but over the long term the pot will grow nicely.
Most whole life policies have a “reserve,” which can be refunded if you cancel the policy before your death. This reserve is referred to as the cash value of the plan. You can also borrow against this cash value at an interest rate set in the policy. However, if you haven’t paid it back, the money owed will be deducted from the death benefit.
So, back to the question, “What kind of insurance should I buy?” The best place to start is with the amount of coverage you need. Let’s say you’ll need $125,000 to pay off your mortgage, $5,000 to cover your funeral expenses, $15,000 to cover legal and accounting bills, and an additional $100,000 to cover the capital gains your estate will be hit with. All told, you’ll need about $245,000. Buying a policy with a lower payout clearly won’t serve your needs.
The next thing to look at is how long you’ll need the coverage. Some of your needs may be short-term. Declining term insurance is often the most cost-effective way to cover mortgage debt. On the other hand, the need to meet your funeral expenses and minimize the tax hit on your estate is permanent. So permanent insurance will be your best bet here.
Remember, since the premium on your permanent insurance will remain the same, while the premium on term insurance will rise each time the policy is renewed, the cost of term insurance will appear far less expensive in the early years of a policy. Compare the lifetime cost of both types of policies (remember to compare similar features and benefits — apples and apples), and then make your decision.
Another interesting fact: with some policies, you can buy the right to convert your term policy to a whole life policy at a later date. So if you decide to start off with term insurance to protect your young family, and then decide to convert to a whole life policy when your needs change and you have more money, your health won’t be a factor in setting the premiums. However, your age will be and the older you are the more your insurance will cost.
Shop around when looking for life insurance. Get several quotes, make sure you’re comparing apples with apples, and buy the policy that best meets your needs. Resist the urge to over-buy, but don’t sell yourself, and your family, short either. Evaluate your future earning potential and your family’s ongoing needs realistically, take inflation into account, and then buy enough insurance to meet your needs.
BTW, if you’re looking for information on how much insurance you should buy, go and read How Much Insurance.
Bookmark: del.icio.us Digg StumbleUpon
September 25, 2008 at 9:20 am
Gail – good explanation of a tricky subject. I have two small but important comments on your posting.
Life Insurance companies are a poor choice as an investment vehicle not only because they choose conservative investments, but because they charge a high fee to do so (approximately 4% MER). In general, the more conservative the investment, the lower the fee should be (ie .5% MER).
Second, it is my undeerstanding that there are no estate taxes or succession duties in Canada (if the estate is under $1.5M). However, taxes upon death have not disappeared. When a person dies, there is a ‘deemed disposition’ of all capital property. This means that the government treats all your property (unless jointly held) such as stocks, bonds, RRSPs, real estate, etc as sold at fair market value on the day of your death. Your estate will be required to pay capital gains tax on that property. This applies to your RRSP if you do not have a spouse to whom you can transfer it. So in other words, if you setup a will and transfer as much of your property to a living spouse, you’re set. And if you are the only living spouse, than of course your children can sell or liquidate these assets easily enough to cover the cost, so getting life insurance to cover a possible tax fee is not entirely logical in a cost/benefit assessment.
September 25, 2008 at 11:40 am
Any thoughts on disability insurance? In Canada the state will pay your medical bills, (but not drug costs), but it seems if anything more expensive than a quick death.
September 25, 2008 at 2:25 pm
It appears that the Devil is in the details… thanks for the insight Gail.
September 25, 2008 at 2:27 pm
ugh. My brain hurts.
I am glad you are describing all this here, if you ask an insurance broker (otherwise known as a SALESMAN) the pressures are different.
I am also glad that Geoff talked about the spousal transfers! That capital gains amount you mentioned scared me! I thought if I survived my husband (or visa versa) everything would transfer without penalty! !!!! So along as we are named as “joint” holding the accounts (and RRSPs) and we have survival transfers mentioned on the big stuff like the house, then we are exempt from capital gains taxes? Is that correct?
Do you have a link to see the rules on the government for that sort of thing? Is it different in each province?
September 25, 2008 at 3:18 pm
@ Tracy J – you are basically correct. I would recommend however you consult with your lawyer / estate planner and just ensure you’ve done all you can to avoid a tax hit (ie don’t miss your husbands pension plan, make sure you’re on that list, etc etc).
September 25, 2008 at 8:46 pm
LOL!!!! WHAT PENSION PLAN? You are so funny! Neither me nor my husband have ever had jobs that offer pension plans, nor basic medical. Small businesses on the west coast can’t afford to offer such luxuries as far as I have experienced…. not a bad thing really as we can’t get too cozy with expecting someone else to provide for our old age.
September 25, 2008 at 9:01 pm
I also caution you to first buy the right life insurance for you before getting tested for serious illnesses that may run in your family. Our family has a genetic disorder in our heart. My husband & I wished to renew our 10 yr term life insurance – so made a point of doing so BEFORE I got tested for the genetic disorder.
Re: Universal Life – we got it too – and guess what? Aftet switching agents (due to shoddy service) we found out that we were sold the wrong product. Namely, in the fine print, it says that of the amount that we contribute monthly, each year a larger percentage goes to the insurance company and less of the principal payments go to us. Now we’re locked into this ‘product’ until a full 10 yrs has lapsed. So read the fine print – and always assume that the insurance person doesn’t give a hoot about you – because for them, it’s all about profit.
September 25, 2008 at 10:20 pm
Doreen – why would you get term AND universal life?
September 26, 2008 at 5:54 am
Geoff – I got term to pay off our debts (mortgage + secured line of credit) should me or my husband die while we are raising a family & have debts (10 yrs max). The universal life is the permant type of insurance. Like Gail writes if I try to get regular life insurance when I’m older it will cost me an arm and a leg. So the regular ‘reasonable’ amount means I have this insurance for life (pays for funeral, taxes and leaves a bit of funds for our children).
September 26, 2008 at 9:23 am
Wouldn’t it have been better to get a 20 or 30 year term insurance instead? Insurance needs decline over time, once you get to a certain age your debts/mortgage/child raising years should be behind you.?
September 26, 2008 at 11:40 am
We have permanent insurance that allows us to pay extra amounts as an investment called a shuttle account. This amount is added to the death benefit and accrues interest. When we retire, we will be able to borrow money from the death benefit and the loan is repaid upon our death and the amounts left over are paid out to our beneficiaries. Since money that is invested and borrowed from life insurance is not taxable we will not have to pay taxes on the money when we take it out at retirement age. Is this a sound investment? It sounds too good to be true. Should only pay the premium, or is the investment portion a rip-off? Help! This is all confusing.
September 26, 2008 at 2:15 pm
Also worth considering when trying to determine the amount of insurance needed, is figuring out how much your spouse will need to maintain the lifestyle she is accustomed to… we have 3 young kids, and my is fortunate enough to stay at home.. therefore, the life insurance on my life is much greater than it is on my wife’s. My wife’s insurance is enough to pay off the house, and allow me to ease back into work, however my insurance is enough to make sure my wife can stay home, pay off the house, and raise the kids without ever worrying about money.(including school tuition, retirement etc..) – it’s the best $110 i spend every month !!!
September 27, 2008 at 7:15 pm
if you plan it right, i don’t understand why you need insurance once you’re kids are supporting themselves and your mortgage is paid. as nice as a chunk of change is, why would i give that chunk of change to someone else to only give it back to me. i’ll keep it and do my own thing with it for the future. and the benefit? no one has to die to use it!
we have term to cover our children and the running of our home.
we are fortunate to have disability thru work (well i don’t but hubby does), and i would sink my money there before covering my 85 y/o funeral costs. we have used it several times now after an unfortunate accident, lasting in over a year off and multiple surgeries, we were glad we had it.
October 3, 2008 at 10:18 pm
I agree with Kristin. At a certain point, many people are essentially able to self-insure…i.e., mortgage is paid off, there are no dependents and adequate assets to provide for any survivors.
As a result, I don’t see why a fiscally responsible family requires permanent life insurance…
December 23, 2008 at 7:55 am
Hi Gail,
Here is a question for your readers.
“If what you believed was true, turned out to be wrong…when would you like to know”?
You made some excellent points a term vs. permanent insurance. Let me add a few points. Whole life is where the insurance company pays a dividend which is based on a number of factors. Investments, mortility rates, and expenses. The companies who offer these products have paid dividends in some cases over 100 years each and every year. Ususally 2-3% higher than any 5 year GIC that can be bought over the last 30 years! This money can be tax sheltered and can be accessed in a tax free manner.
The reason this has not been popular, is when you are told you can get or your co-worker has made 12 or 20% on their stocks who cares! Buy term and invest the difference! Now that the TSX is down about 40% wiping out five years of returns, getting a positive dividend for 2008 does not look so bad.
With Universal Life (UL) you decide where the money goes. If the market goes south so does your money. GIC’s in a UL plan? Read above. If you only put a small amount of money into a UL plan then you just bought a term to 100 policy.
The insurance company does not make any money until about year five. Underwrting, commissions, nurse to get medical information etc. So when you look at cash values expect the numbers to be very low. Only by year ten is the money (given back) grow much faster. Like an RRSP you need to add to it and give it time to grow.
If you like the new TFSA (tax free savings account) need insurance, can leave the money untouched for at least ten years then look at a whole life insurance policy.
Like cars or houses this is not for everyone. But finding something that is conservative and has been around for over 100 years is difficult today.
regards,
Brian