Life insurance is one of the most commonly owned financial products in the United States, and there is no shortage of internet articles comparing the pros and cons, features, and other characteristics of different types of life insurance products (e.g., term and permanent insurance).
However, these articles tend to focus on qualitative factors and typically avoid any in-depth quantitative analysis. But ultimately, investors care about real dollars and want to know how choosing one type of policy over another will affect their actual financial situations. That is why I have created the following analysis, which compares term and whole life insurance in a quantitative way that I believe should help investors arrive at a clearer conclusion regarding which product is right for them.
As most investors are aware, the primary difference between term and permanent life insurance is the cash value component that permanent policies carry. This is an attractive feature to some investors. However, there are drawbacks to the permanent insurance structure, including lack of liquidity and higher costs.
A permanent life insurance policyholder’s premium payment is split into three parts: cost of insurance, cash value, and administrative/operating costs. Term policies also include an administrative/operating cost element, but at much lower levels than permanent life insurance policies. This disparity exists because of the relative simplicity of term insurance.
The administrative costs of permanent policies can eat up a material portion of a policyholder’s premium, leaving less available for cash value accumulation. These higher administrative costs explain why it may take decades for the cash value of a policy to surpass the total amount of premiums paid into the policy.
The following chart helps to illustrate this issue. In both the whole life and term insurance examples below, the death benefit is the same ($500,000 in this case). My example assumes that the investor takes the difference between the greater whole life insurance premium and the lesser term life insurance premium and invests the capital in a taxable investment account.
By a large margin, the investor who wants both 1) $500,000 of life insurance coverage, and 2) to maximize the value of his/her asset base would be better off purchasing term insurance and deploying the excess capital in a taxable investment account. For the purpose of this analysis, I assume that the taxable account grows at an after-tax rate of 4.65%.
In addition to illustrating the disparity between whole life cash value growth and the growth of a taxable investment account, the above example also highlights the fact that the cash value of many whole life policies does not exceed the total premiums paid into the policies for a number of years. In this example, the cash value of the whole life insurance policy does not exceed total premiums paid until the 19th year of the policy. This is because so much of each premium payment is going towards the administrative costs of the insurance company.
In our example, the maximum value that a policyholder can receive from the whole life policy is very unlikely to ever exceed the face value of the policy, which in this case is $500,000. The term policy would provide the same $500,000 death benefit for 30 years, plus the additional capital that has accumulated in the taxable investment account.
The term policy death benefit would of course drop to $0 after the 30 year term, but in this illustration, the taxable account would have a value of $302,000 at that time and would surpass $500,000 nine years later, when the policyholder is age 75. This is illustrated in the chart below, in which I show the maximum possible value that a policyholder’s beneficiaries would receive from each type of policy in the event of the policyholder’s death.
As the chart clearly indicates, the term life policy would provide a policyholder’s beneficiaries with a materially greater benefit upon the policyholder’s death in every year except during a span of nine years which, importantly, is likely to occur at a stage in life when most investors have minimal liabilities and no longer have minor children.
In addition to providing the greater maximum benefit throughout the majority of a policyholder’s life, the term policy also provides the greatest benefit per dollar of premium, as the chart below illustrates.
I view life insurance as a highly effective risk management tool, and I believe it should play an important part in the financial plans of most investors. However, for most Americans with typical insurance needs, such as replacing the income of a deceased wage-earner, I believe term insurance is the most suitable life insurance product.
Given the simplicity of term insurance and its substantially lower premium structure, term insurance offers the most protection for the lowest cost (over the relevant term, of course). By purchasing a policy with a lower premium, a policyholder’s incremental capital is free to be invested in whatever way he or she sees fit. This means that the policyholder can put this capital to work in ways that could potentially earn higher returns than might be offered on the cash value of a permanent insurance policy while also enjoying far greater liquidity without sacrificing important insurance coverage during the years in which it is most needed.
Policy Illustration and Comparison Analysis
Taxable Account Return Calculation
* The Annual Investment Return assumption is based on a 60% / 40% allocation to equities and fixed income securities. Over a long period of time, the S&P 500 has generated an average annual rate of return of roughly 10% per year, while the bond market has generated an average annual rate of return of roughly 5% per year. However, for the sake of conservatism, we have assumed an equity return of 6.5% per year and a bond return of 4% per year. With a 60/40 allocation, this would generate a 5.5% annual pre-tax return.
 Policy details for both policy types and growth illustrations for the permanent policy are taken directly from policy quotes generated by Northwestern Mutual Insurance Company.
 Return calculations are provided at the bottom of the article.
This information is prepared for informational purposes only and should not be considered investment advice. The views expressed are those of the author as of the date of this report, and are subject to change at any time due to changes in market or economic conditions. Investing involves risk, including loss of principal. There is no guarantee that the investment strategy discussed will outperform any other strategy in the future.