Last week’s Cavalcade of Risk included an interesting article written by Canadian insurance broker Glenn Cooke. His article examines the popular wisdom of “buying term and investing the difference” when shopping for life insurance. I particularly liked his summary points at the end of the article, advising people to be wary of salespeople who are biased towards one particular type of product for 100% of clients, and to be aware of the difference between guaranteed returns and non-guaranteed returns.
Glenn rightfully points out that brokers should be asking clients how long they want to have life insurance in place before making the determination of whether term of permanent coverage is suitable (a person who just wants insurance in place until her children graduate from college would be a good candidate for term coverage, whereas a person who wants life insurance proceeds available for heirs to use to pay taxes on a non-liquid inheritance would be better served with a permanent policy). But there’s more to it than that. In a perfect world, the determination would be made based on how long the client wants to be insured. But in the real world, money is a big part of the equation, and there are two other questions that are equally important: How much insurance do you need? (eliminating the cash value/investment value portion of the equation, and focusing instead on the life insurance face value) And what is your budget for premiums?
In that same perfect world, everyone who buys term insurance would indeed go ahead and invest the difference that they save by not buying permanent coverage. But in the same way that many people purchase HSA qualified health insurance but don’t have money to fund the HSA, a lot of people are able to afford only the premiums on the term policy, and don’t have money left over to invest. For those people, the primary concern is having life insurance in place, and having an adequate face value. The premiums are probably the part of the equation that they will be focused on the most – and whether or not they can afford them. A person with a set amount of money that can be devoted to life insurance premiums will be able to purchase significantly more face value if she goes with term coverage. But the insurance will be in place for the rest of her life if she goes with permanent coverage (assuming she doesn’t cancel it). There’s no one-size-fits-all answer to whether term or permanent life insurance is a better option, and it depends largely on the person’s budget, face value needs, and long term planning.
Glenn’s article does a good job of pointing out some of the flaws with the argument in favor of recommending term life insurance 100% of the time. I believe that term coverage is more appropriate for most people, but definitely not for everyone. There’s one change I would have liked to see in Glenn’s comparison of term and permanent policies: I think it would have been more fair to start with a 45 year old applicant getting a 20 year term policy or a permanent policy that he cancels after 20 years – both at age 65. Instead, he started with a 40 year old applicant getting a 20 year term policy and then keeping it for an extra five years, and compared that with the same 40 year old applicant getting a permanent policy and cancelling it after 25 years. (Glenn does acknowledge that very few people keep a term policy after the term is up, because the premiums increase dramatically at that point). My own 20 year term policy currently costs me $385/year in premiums. But if I choose to keep it after the term is up, the premium in year 21 will be $7,345. Keeping the policy for five years after the term expires would cost me an extra $43,105 in premiums (compared with $1925 for five years of coverage during the regular term of the policy). That’s a huge difference, and makes the comparison significantly biased in favor of permanent coverage if we have to assume that the insured will extend a term policy beyond the original term. If we want to compare apples to apples and have the end point be when the insured reaches 65, we should start with either a 40 year old applicant getting a 25 year term policy or a 45 year old applicant getting a 20 year term policy – and compare those numbers with a permanent policy that is cancelled at age 65 (at the same time that the term policy would be ending).
