By Peter Colis
Learn more about Peter at NerdWallet’s Ask an Advisor
Life insurance is a massive part of the American economy. With more than $20 trillion of life insurance coverage in force in the U.S., it’s even larger than the mortgage market.
Yet in most cases, one of the main forms of life insurance — permanent life insurance — is a bad financial idea for consumers. Most people overpay for it without seeing any benefit at all, it produces poor investment returns, and sales incentives may cause insurance agents to recommend policies that may not be the best fit for the consumer.
Here’s a closer look at some of the reasons permanent life insurance isn’t a good idea for most people.
Term life is often more appropriate
The concept of permanent life insurance is pretty simple: Pay an annual premium, and when you die, your beneficiaries collect a payout. It protects your family from a loss of income, immediately builds an estate and covers debts in the event of your passing. Permanent life insurance lasts until the death of the policyholder and includes a “cash-value” investment component.
Another form of life insurance called term life insurance lasts for a specific term, such as 10 or 20 years, instead of a whole lifetime, and is often used by people with growing families to guard against an economic catastrophe in case of an early death.
Term life is a better option for most people, because it’s much more affordable and offers insurance when it’s most needed. Term life doesn’t have any cash value, but the cash-value component of permanent life insurance offers poor investment returns.
It’s hard to keep up with the premiums year after year
But here’s a very damaging aspect of permanent life insurance: Many people are not covered by the policy when they die. In fact, nearly 88% of universal life policies (a type of permanent life insurance) never pay a claim.
This is largely because many people allow their permanent policies to lapse, and the No. 1 reason is they can’t afford the premiums due to a period of unemployment or other financial setback. Or they may decide it’s no longer something they want or need.
Term life insurance has just as low a payout rate, but term life is only meant to cover you for a specified number of years, typically when you’re young or middle-aged, and people who outlive their term life policies are generally happy to do so. But since permanent insurance is meant to cover you till death at any age, its low payout rate is cause for greater concern.
All of those paid premiums from a lapsed policy just go to the insurance company as pure profit, so the insurance industry isn’t bothered by lapse rates — in fact, it counts on them. A policy that never pays a claim is much more profitable to an insurer than a policy that pays a claim.
It’s not consumer-friendly
Insurance agents are incentivized to sell consumers overly complex and expensive permanent life insurance policies because of larger commissions. Because consumers often don’t understand the complexities of life insurance, they buy what the agent recommends — things like variable universal life insurance with an annuitized benefit option. If that confused you, don’t worry, it confused me, too, and I’m a licensed insurance agent.
So is permanent life insurance ever a good option? Not often, no. Term life insurance is the right option for the vast majority of people. It’s cheap, and it protects your family.
It only makes sense to buy permanent life insurance when you’ve maxed out your 401(k) and Roth IRA, which are far better investment options and are much more effective in safeguarding your financial future; when you know for certain that you’ll never lapse the policy; and when you are seeking certain estate-tax advantages, making it an option for some high-income individuals.
Owners of permanent life should re-evaluate their life insurance needs and look into alternative options before lapsing their policies. Premiums can sometimes be recovered by surrendering the policy for a cash value.
Another option is to sell the policy to a third-party investor; this is called a life settlement. (Full disclosure: My company is a life settlement brokerage.) If you qualify, an institutional buyer pays you an immediate cash settlement (averaging around 20% of your policy benefit), and you transfer ownership of the policy to the buyer. The investor will continue to pay the premiums until you die and will then collect the policy benefit. Life settlements can be complex, so make sure you do your research before pursuing one.
Your hard-earned dollars are at stake with any life insurance policy, so make sure you take the time to review your options thoroughly before deciding.