Which Life Insurance Is Best?

We review the pros and cons of term, whole-life and return-of-premium policies.

LIFE INSURANCE COMES IN three flavors. Term insurance offers plain-vanilla protection at a low cost. Then there's whole life, which has a savings component. A third type, the return of premium, is essentially a hybrid of the first two.

Here at SmartMoney.com, we generally recommend term life, as its low premiums allow consumers to get maximum coverage at little cost. (They can then invest on their own the savings they'll reap by forgoing pricier options.)

But don't just take our word for it. Before you head to an insurance broker's office, you should be familiar with the pros and cons of each policy type. Insurance agents are notorious for their heavy-handed sales tactics. Arming yourself with some knowledge ahead of time is the best way to make sure you wind up with the policy that's right for you.

Term Life Insurance

The Pros:
It's cheap. Term life is the most affordable variety of life insurance. Its reasonable rates allow people to buy policies with larger face values than they could otherwise afford. For example, a 45-year-old male nonsmoker could pick up a million-dollar, 30-year term policy for $2,600 a year, says Brian Place, principal owner of TermAssistant.com, a Web site that sells life insurance. A whole life policy, also known as permanent insurance, will cost 2.5 to 4 times as much, he says. (Click here for a glossary of life insurance terms.)

It's easy to buy. All you need to do is figure out how much you need — and how long you'll need it — and then shop around a bit to find a competitive rate. A broker could help you out, of course, but you also can do quick searches on the Web at sites like TermAssistant.com, AccuQuote or Insure.com. Just make sure the company you ultimately select is financially stable by checking out its rating with a service like Standard & Poor's or AM Best. Go with an insurer that's rated A or better.

It covers a temporary need. Remember, life insurance is meant to provide for your dependents. Later in life — after the kids are in college and you and your spouse have socked away a generous retirement stash — you might not have any dependents. So while you might buy a policy when your first child is born (and you might increase it as you have more children), you may only need life insurance for, say, 30 years.

The Cons:
It expires. There's a dark side to the expiration date of term insurance. If you find that at the end of that term you still need life insurance — maybe your company's pension plan just imploded, leaving your spouse potentially ill-equipped for life without you — you're starting from scratch. The older you are, the tougher the term market is going to be to you: If you're not in good health, you might not be eligible for coverage at all.

If you outlive your policy — or cancel it at any time — you get nothing back. Assuming things go the way you — and the insurance company — plan, you'll still be alive and well when your term insurance policy comes to an end. That means you will have paid thousands of dollars (most likely tens of thousands) for a policy you didn't use. You won't get any refunds for your accomplishment, which makes some folks feel like they've wasted their money.

But think of it this way: If you invested on your own the savings you enjoyed over the years by going with cheaper term insurance rather than whole life, you almost surely came out significantly ahead.

Whole Life Insurance

The Pros:
It's permanent. Provided you pay your premiums, year in and year out, whole life policies never expire. Since death is one of the inevitabilities of life, with a whole life policy, you know you'll have something to leave behind for your heirs.

It's forced savings. Whole life policies don't come cheap, but that's because whole life policies build up a savings account (called a "cash value") that grows tax-deferred, and which can be tapped in retirement. For folks with little or no savings discipline, this can be a lifesaver. (Just keep in mind that your death benefit is reduced by the amount you withdraw.)

It's a great estate-planning tool. For those who fear their estate will bear a hefty tax burden, financial planners often recommend purchasing a whole life policy. The death benefit is tax free, and if other aspects of your estate will be subject to estate tax (which in 2005 applies to estates worth more than $1.5 million), the payout can be used to cover that bill.

The Cons:
It's expensive. Not everyone will be able to afford the premiums required to obtain the amount of coverage they need. If paying the premiums would be a stretch, better to pick up a term policy for the right face value, says TermAssistant.com's Place. Another problem: People scrape together their pennies for the first couple of years of a whole life policy only to ultimately find they can no longer afford the bill. If this happens in the early years, they won't even break even in terms of what they receive as a return of premium. Surrender values (also known as the cash value of your policy) won't equal the premiums until the policy is anywhere from 12 to 15 years old.

Shopping around for the right policy will make your head spin. Whole life policies are very confusing and often sold based on rosy illustrations for how much the company intends to pay in dividends over the lifetime of the policy. These illustrations are only estimates and some companies are going to be more aggressive than others. A good agent can help you analyze the internal rate of return (i.e., the yield on the policy after all the fees and charges are subtracted). James Hunt, an actuary for the Consumer Federation of America offers independent evaluations of policies, for a fee. The cost is $60 for the first policy and $45 for each additional one.

You can most likely do better saving for retirement on your own. Whole life policies are notorious for having higher fees and administrative costs than other investment vehicles. While returns will vary, don't count on doing better than 4% to 5%, says AccuQuote's chief executive Byron Udell. Resist pitches from brokers who might tell you that a whole life policy can substitute for a 401(k) or IRA. It won't.

Return of Premium

The Pros:
It's a compromise. As with all insurance plans, with a return-of-premium policy, a death benefit is paid out should you pass away. But if you live past, say, the 30-year term, you get all of your money back dollar for dollar. So no matter what happens to you — whether you die while covered or outlive the policy — money is distributed.

It's pretty affordable. While a return-of-premium policy isn't as cheap as term life, it's significantly more affordable than whole life. A return-of-premium policy will cost approximately 50% more than a comparable term life plan.

No confusion here. Like term life, return-of-premium policies are easy to shop for. As long as you go with a good company, you can make your selection on price.

The Cons:
Don't expect a return on your investment. If you outlive the initial term, you only get back what you paid in. The insurer keeps whatever interest or investment returns your money made over the, say, 30 years you lent it. So you gave the insurer a free loan.

You most likely could do better on your own. A 0% return on your investment is no great shakes. So you need to think about alternatives, such as buying term life insurance and investing the money saved on premiums. The return on this strategy will depend on market performance as well as your personal investing choices. But it's safe to say that you don't need to be Warren Buffett to come out ahead with a term policy.

If you cancel this policy you get next to nothing in return. On a 30-year policy, if you walk away from your return of premium policy after, say, 10 years, you only get back 9% of the cumulative premiums you paid in, according to AccuQuote's Udell. After 20 years, you'll receive 35% and not until you hit 30 years will you get your full investment. "If you get out early, you get creamed," Udell says.