Making Sense of Life Insurance - Term, Whole or Both?
Let's dive into a crucial topic that affects many of us as we plan for our futures: life insurance.
In our previous episode, we discussed the four major risks to your retirement, one of which is the risk of dying too soon. We touched on how life insurance can serve as a protective measure for your family against this risk. Today, I want to expand on that conversation by exploring two primary types of life insurance: term insurance and whole life insurance.
Lets start by defining these two types of insurance. Term insurance is temporary coverage that lasts for a specified number of years, while whole life insurance is permanent and designed to last your entire life.
Next, it's important to understand the proper amount of life insurance needed, which I refer to as "economic life value." This concept highlights that your ability to earn income is your most significant asset, and if that income stream is interrupted, it can have devastating financial consequences for your family.
Let's look at a hypothetical scenario to illustrate how to calculate your economic life value. In a simplistic example, if you plan to work until age 60 and you are 30 with a starting salary of $100,000, you might need around $3 million in life insurance coverage (30 years x $100,000). BUT, that's only if you never get raises and you experience no inflation! Financial reality would dictate that you would need more. In practice, we perform a more detailed calculation of economic life value to calculate the death benefit needed that would replicate your future earnings stream if it were a pot of money growing at a reasonable rate. In other words, we want life to go on financially for your family as if you were still here. However, many people shy away from this amount due to cost and a lack of understanding of its importance.
Next, let's delve into the pros and cons of term and whole life insurance. Term insurance is generally more affordable and straightforward, akin to renting an apartment. However, it has no cash value and can become increasingly expensive as you age. On the other hand, whole life insurance offers lifetime coverage, a guaranteed death benefit, and a cash value component that can be borrowed against or withdrawn, as long as you pay the premium. While the outlay is more, it provides stability, a lifelong death benefit and a forced savings mechanism.
I also discuss the common advice of "buy term and invest the difference," which suggests that young families should opt for cheaper term insurance and invest the savings elsewhere. While this can be a valid strategy, I caution that many people fail to actually invest the difference, which can lead to missed opportunities for long-term growth. This concept also fails to take into consideration the lost premiums and lost death benefit if you don't die within the term (only about 2% of term insurance ever pays a death benefit because people outlive the term insurance).
I want to stress the importance of having adequate life insurance coverage, especially for young families. I recommend that if you anticipate needing permanent insurance in the future, consider purchasing convertible term insurance that can transition into whole life insurance without requiring additional health assessments.
As we wrap up, the choice between term and whole life insurance ultimately depends on individual circumstances, including financial goals and family needs. I encourage you to think critically about your insurance needs and to consider both types of coverage as part of a comprehensive financial plan.
Thank you for joining me in this episode! If you found this discussion valuable, please subscribe, share it with friends, and leave a review. For more resources on insurance and retirement planning, visit our website at www.happinessinretirement.com. Remember, good financial planning is about purpose, not just products. Until next time, take care!