If you have a spouse, children, or anyone who depends on your income, protecting that income and by extension their wellbeing becomes a top priority. Generally, there are two scenarios that you’ll want to protect against to ensure your loved ones are provided for: death and disability. We cover disability insurance in another article, and we’ll talk about the different types of life insurance below.
All life insurance is designed to pay out some amount at the end of the policyholder’s life, but the amounts, expenses, and terms can vary. We’ll cover the three main flavors of life insurance below, but here’s a quick cheat sheet:
Types of Life Insurance
|
Type: |
Term |
Whole |
Universal |
|
Duration |
1-30 years |
Permanent |
Permanent |
|
Guaranteed Death Benefit |
Yes |
Yes |
Yes |
|
Cash Value |
None |
Yes |
Yes, can be depleted |
|
Investments |
N/A |
Basic: low guaranteed minimum growth rate Variable: growth rate linked to investments |
Basic: low guaranteed minimum growth rate Variable: growth rate linked to investments |
|
Premiums |
Low, can vary |
High, level |
Medium, can vary |
|
Use Case |
Best policy in the vast majority of cases. Low cost, pure life insurance ensures you don’t pay extra fees for investment management. |
Families with taxable estates or other large end-of-life costs may benefit from a policy that covers anticipated estate taxes. The policy usually can be borrowed against and assets grow tax-deferred which can offset the higher cost of premiums and locked up assets when kept for very long periods of time. |
Families with highly uncertain financial situations that need a guaranteed death benefit. |
Term life insurance
Unreservedly, this is the best type of life insurance for the vast majority of people. It does exactly what life insurance is supposed to do - provide a guaranteed end of life payment - and no more. That’s why it’s also referred to as pure life insurance. Because the instrument is simple, fees are much lower than other types of life insurance.
Typically, we would recommend a policy (or a laddered set of policies) that replaces the income that you would not be around to earn and covers the debts that you would owe over the time frame that you need covered. This would generally be the period of time that you are working, have kids and a family to support, and have mortgage and education to pay for. As you grow older, earn income, support your family, and pay for life’s big purchases, you reduce the end of life amount that you would need to cover, and become better able to afford end of life costs with your accumulated assets. In other words, you reduce your need for a death benefit over time.
Determining the exact amount of coverage and how best to structure that cover can be complicated. Schedule time with an advisor who can help guide you on how best to do so.
Whole life insurance
Whole life insurance is a form of permanent life insurance. That means that instead of buying protection for a specific number of years, you are buying an insurance policy meant to last through the end of your life. You can think about permanent policies as having two primary components: a guaranteed death benefit and a savings component.
In some situations, it’s important to have a guaranteed death benefit for purposes beyond income replacement. For example, if your estate is worth $40m and most of your wealth is wrapped up in a private enterprise, your heirs might be forced to sell that stake at a significant discount because of its illiquidity to cover estate taxes. To protect them from that situation, a life insurance policy with a guaranteed payment no matter your age at death would be valuable. Or you might have a disabled dependent that you want to provide for in your absence that will have care needs far into the future. For cases like these, a whole life policy can be an important part of protecting your family in your absence. If you don’t fall into this type of situation, term life is probably a better choice.
On the savings component, you are almost always better saving outside of a life insurance policy because of the high fees and limited investment options available. As an investment vehicle, whole life policies provide very expensive access to securities. Usually the expenses you would pay on premiums and investment fees would not outweigh the benefits of tax-deferred investing, and cash values take very long periods of time to build. 45% of whole life policies are surrendered in the first 10 years with very little cash value built up to show for the expense. Only if you are very risk averse, have maxed out all other tax deferred options, and have a need for a death benefit would a whole life policy typically make sense as an investment vehicle.
To sum up, whole life insurance is most useful in estate planning for ultra-high net worth families or for families with permanently disabled dependents. Otherwise, it is a very expensive way to buy life insurance and requires very long periods of time to fully reap the benefits.
Universal life insurance
Universal life insurance comes with the guaranteed death benefit of a whole life insurance policy with flexibility to adjust the death benefit and premium payments as your financial situation changes. The flexibility universal life touts can usually be accomplished at much lower cost and full participation in any investment gains with term life policies and separate investment accounts.
Our recommendation
What’s the right type of life insurance for you? Unless you have complex estate planning needs, it’s probably term life insurance. Investing the amount you would have paid in premiums for a comparable whole life insurance policy is a lower cost option for achieving the same income replacement goal.