Term vs. Whole Life: The Insurance Debate Continues

An email from reader Steve Spearman asks, "Based on the articles I've read, I've always purchased term rather than whole life because I would rather do my own investing. What do you think?"

Steve's question goes to the heart of the life-insurance debate. The popular answer these days is "buy term and invest the difference."

But that does not mean you should not buy variable life insurance or variable universal life. There are many components to the three most popular forms of permanent insurance: whole life, variable life and variable universal life.

All three have things in common.

• They pay a death benefit when you die, just like term insurance does. In most cases, this benefit is free from income tax.

• They build some form of cash value.

• They are permanent -- they stay in force until the day you die (assuming the premium is paid).

• They charge interest for money you borrow.

• They offer a tax-free cash buildup.

• They have pure term-insurance and death-benefit components that rise in cost every year. Though the premium may be level, the amount of cash inside the policy to pay for the death benefit increases each year as you get older.

Whole life is now considered an old-fashioned kind of policy. There are two kinds of whole life, participating and nonparticipating. A participating policy is issued by nonpublic companies that pay dividends every year. A policyholder can use the dividends to reduce the cost of insurance or to buy more insurance. These dividends are not taxable because they are considered a refund for an overpayment of the premium. A nonparticipating policy is issued by a public company owned by shareholders. While policyholders do not receive any dividends (they go to shareholders), the premiums are usually lower than for policies from participating companies. The policies still build up a cash value.

Variable life has a fixed premium for the life of the policy. The amount of life insurance is fixed at a minimum guaranteed level on the date of purchase. The actual amount varies thereafter only as a result of positive and negative investment results above the initial guaranteed amount.

Variable life also offers an insurance contract with a choice of underlying mutual fund-like investments called sub-accounts. The unique advantage of variable life is that, even if investment results are poor, you will never be called upon to pay a larger premium than originally contracted for nor can the face amount of your policy decrease below that at which you originally purchased it. No other kind of policy has these features. The disadvantage can include a lower value in the sub-accounts if the investments don't fare well.

Variable universal life (or universal variable life) is like variable life except that the face amount and premiums can fluctuate. These policies are more flexible and customizable than variable life policies and can be more easily adapted to your situation. (For more analysis of variable universal life policies, see a previous Game Plan column.)

Term insurance is pure death benefit -- it pays a fixed, predetermined amount when you die. There is no cash value. In younger years, it is inexpensive. The older you get, the more expensive it becomes. Term insurance is designed to cover needs that are temporary. Any need that runs out by the time you reach 60, or even 65, could be considered temporary. So if your kids are through college, your mortgage is paid off and you have enough investments or survivor's pension for a spouse, you probably do not need term insurance anymore.

Part of your planning now -- whatever your age -- should include reasonable assumptions about your future financial condition. One of the most compelling reasons for permanent insurance is to pay estate costs and other costs associated with dying. If you determine a need for permanent insurance, you should consider obtaining it now. It will cost less, and you will have a greater chance of building enough cash to reduce or eliminate your premium in later years.

Here's my take on buying life insurance: I separate the death benefit (pure insurance) from the investment component. For any temporary need, I suggest pure term insurance. For permanent needs, I suggest variable universal life. It is a good idea to start the variable universal life as soon as you can. As soon as there is enough money in the policy to pay the insurance cost, you can discontinue paying the premiums.

By keeping your investment program separate from your insurance program, you are providing more simplicity and freedom for both programs. You want the freedom to choose your own investments and make changes anytime you want.

Have another happy, healthy and profitable week!