Buy Term or Whole Life insurance?

FOR MOST PEOPLE, the right type of life insurance can be summed up in a single word: term. But before we explain why, it's important to understand the differences between the most common types of insurance available.

The basic difference between term and whole life insurance is this: A term policy is life coverage only. On the death of the insured it pays the face amount of the policy to the named beneficiary. You can buy term for periods of one year to 30 years. Whole life insurance, on the other hand, combines a term policy with an investment component. The investment could be in bonds and money-market instruments or stocks. The policy builds cash value that you can borrow against. The three most common types of whole life insurance are traditional whole life policies, universal and variable. With both whole life and term, you can lock in the same monthly payment over the life of the policy.

Forced Savings

Whole life insurance is expensive: You're paying not only for insurance but also for the investment portion. That extra cost might almost be worth it if these policies were a good investment vehicle. But usually they aren't. Insurance agents like to call these policies retirement plans, emphasizing the "forced savings" inherent in forking over the premiums each month "for retirement."

Leaving aside the fact that there are many better ways to save for retirement, these policies come with high fees and commissions, which sometimes lop off as much as three percentage points from the annual return. On top of that, there are up-front (but hidden) commissions that are typically 100% of your first year's premium. Worse, it's often impossible to tell what the return on the investment will be, and how much of what you pay in goes toward the insurance and how much toward the investment.

Premiums for term insurance are downright cheap for people in good health up to about age 50. After that age, premiums start to get progressively more expensive. The same holds true for whole life policies, though people who need coverage starting in their 60s and beyond may have no alternative but to buy whole life. Most companies simply won't sell term policies to people over about age 65.

Term: Where the Value Is

To get a real sense of the value of term, let's compare a term policy and a universal life policy. Say a 40-year-old nonsmoking male has a choice between a $250,000 Met Life universal policy with a $3,000 annual premium and a same amount of renewable term coverage with a 20-year fixed premium of $350. At the end of one year, the universal policy, assuming it paid 5.7% per year, tax-deferred, would have a cash value of exactly zero (cash value is the amount you would get back if you canceled the policy). But say he had instead invested $2,650 (the difference between $3,000 and $350) in a no-load mutual fund that averaged a total return of 10% annually. At the end of the first year, he'd have $2,841, accounting for taxes on the earnings at a 28% rate. At the end of 10 years, he would have accumulated more than $46,000 in after-tax savings in the mutual fund. Over the same period, the cash value of the policy would have climbed only to $31,819.

That's not to say that whole life insurance is always a bad idea. Wealthy people can use whole life in their estate planning by setting up an insurance trust that will pay their estate taxes from the proceeds of the policy. And for the growing number of people in their late 40s or early 50s who are just starting families, whole life is at least worth a look.

Sizing Up a Whole Life Policy

One of the great problems with whole life is only an expert can tell if a policy you own or are considering will ever become a decent investment. James Hunt, actuary for the Consumer Federation of America, who has analyzed thousands of policies, notes that whole life policies hardly ever yield a reasonable return unless held for 20 years or more. So if you buy one be prepared to pay into it for the very long haul.

The key to a whole life policy is its internal rate of return -- the yield on the policy after all fees and charges are subtracted. A competent analysis can determine at a minimum whether the weight of the fees and charges built into one of these policies will ever allow a worthwhile return. Such an analysis will also pinpoint the minimum amount of cash value that you can derive from a policy at any given time interval.

Some financial planners, actuaries and accountants can perform internal rate of return analysis on your policy. The Consumer Federation has a service that will do this, calculating the real return year by year and comparing it with other investments. The fee is $70 for the first policy, $50 for each additional. (Click here for details).

Keep Your Old Policy?

You've been faithfully paying into that whole life policy a good pal of your brother-in-law sold you 10 years ago. And now you're thinking, "Hey wait a minute, I should be bailing out and getting a cheap term policy." Not so fast. First and foremost, keep in mind the substantial sum you've probably paid in over the years. How much will you get if you "surrender" or cash it in now? The answer to that question can be found in the illustrations you got when you signed on the dotted line. If you can't determine the surrender value you may have to -- heaven forbid -- call your agent and ask. But it's worth taking the trouble before you make a decision.

Most policies don't start to build decent a cash value until their 12th or 15th year. So if you cash in after 10 years, you could be out of a lot of money. And you can be sure that if you surrender in the first five years or so, practically every dime you put in will be down the toilet. The next thing you have to consider is whether you are still insurable at a reasonable rate if you switch to term. That's because you'll have to requalify medically. If you are over 50, smoke or have health problems, you may find it's cheaper to hold onto your old policy. Another option worth considering is a tax-free transfer of the value in your old policy into a better one, perhaps from a low-commission company like Ameritas.

How to Check an Insurer's Ratings

If you're looking for whole life coverage or a term policy that you'll want to keep 20 or 30 years, the financial soundness of the insurer is a critical concern. You want some assurance the company will be around in case you aren't. For insurance companies, the major credit agencies like Standard & Poor's rate claims-paying ability.

Fortunately, information on the credit worthiness of insurance companies is easy to obtain. Reports are cheap or free over the Internet. You can always contact the insurance company and ask about its ratings, but it's best to get this information independently. In general, go with an insurer rated A or better; the most financially sound insurers are rated AAA, though some rating agencies use slightly different letter grades.

The premier Web site in terms of detail and ease of use, (best of all, it's free) is insure.com where you can get ratings online from Standard & Poor's as well comprehensive reports on individual insurers. AM Best has a huge database, but you have to pay for it. While you can access ratings free of charge, a detailed company report will set you back $75.

Make sure any report you get is current, say within the last six months. Be extra careful to confirm ratings you'll find on many of the online quote services, which may be stale.