So for the last few weeks my girlfriend and I have been evaluating insurance policies for her. Basically it came down to a debate of 1) “Whole Life” – (WL) or 2) “Term + Invest the difference” – (TID). Before this evaultion, I always believed in “Term + Invest the difference” because the cost was lower and the returns from stock investment would be more than that I can get from whole life.
However there is always a nagging doubt that term might not be the right choice because it doesn’t cover you in old age which is the time when you might need insurance the most. In the end after much discussion we came up with a strategy that both of us thinks make financial sense. Thanks to my girlfriend whom helped put the nagging doubt to rest by crystallising my thoughts.
First let’s make sure you understand both term and whole life insurance
“With term insurance, you’re covered only during the life of the policy, while you’re paying the premiums. If you carry a term life insurance policy for 50 years, regularly pay the premiums, and then quit paying and die a year later, you’re out of luck. (Well, you’d be out of luck regardless — but, in this case, your beneficiaries are out of luck, too.)”
“Whole life insurance, meanwhile, is designed to cover you for your whole life. These policies charge you a fixed premium each year, one that’s typically higher than term insurance. The advantage touted by insurance companies for whole life insurance is that, while part of the premium covers what term insurance would cost, the surplus resides in an account that pays interest and accumulates a cash value. As this “accumulation account” grows, your premiums can decrease over time. Eventually, in some cases, the interest earned can pay the premiums for you. So, you won’t be paying any more premiums, but you’ll still be covered for the rest of your life.” http://www.fool.com/foolu/askfoolu/2002/askfoolu020725.htm
So if you distill the 2 polcies these are the differences between the 2
1. Forced Savings in WL
2. Cost of premiums (WL is more expensive)
3. Coverage after 60-65 years old (That WL has whereas TID doesnt)
Of the 3 differences, only the coverage after 60-65 years old cannot be replicated by a TID strategy so that is what we based our decision upon.
Since the main diffierence of WL and TID is that WL covers you after 65 years old, we should then only buy WL for that function and only intend to use its insurance after 65 years old.
The strategy goes as follows
“Before 65, buy enough whole life that you will need in old age and then whatever amount of term you need to get enough coverage for current times. After 65 discontinue your term policies and hold on to your WL policies.”
The reasoning goes like this:
Before age 65 is when you have the most liabilities (loans, dependants etc) which means that the need for insurance will be highest at this point. However to get whole life is way too expensive for the average person to consider so the cheapest option is term insurance with a critical illness rider. Plus getting whole life also means that you are probably wasting money in old age since you do not need that much coverage.
After 65, most of your liabilities will have been repaid and your dependants would have grown up and thus you no longer need the insurance to ensure their livelihood or pay off debts if something happens to you. Also after 65 years old, term insurance cost also skyrockets so it is not something that is worth keeping for its cost.
Yup, so that’s the strategy. As for timing and how much to get, it based on each individual but do remember that $100,000 might not be worth much when you are 65 years old so that you need to increases your coverage as inflation catches up.
I think the most important lesson is that one should always think about what they are buying and why they are buying it. If you are reading this, most probably you have already done much research on financial planning. But most people will not have research on what to buy so go out and spread the message to them.
In the next blog post, I will discuss which WL policy we chose and why we make that selection.