If you have done any research at all, you’ll find that insurance policies are split mainly into term and whole of life. Term policies, as the name suggests, provide coverage for a fixed term and expires thereafter without a payout if no claim is made. Whole life policies cover a person until he/she makes a claim.
Many people buy whole life policies because they think that their need for insurance is greatest when they are old. Sounds sensible, but let’s examine this in greater detail.
The Theory of Decreasing Responsibility
When we start our careers as young working adults, our need for insurance is the greatest. This is not to be confused with the chance of claiming insurance. The chance is indeed low, which is why our premiums are relatively affordable.
However, our cash savings are low, our mortgage is mostly unpaid, our kids are young, and our aged parents are still around. If anything were to happen to us, the financial impact is tremendous.
Compare this to someone in her sixties. She’s out of the work force after accumulating enough to retire, and her mortgage is paid. Her kids are financially self-reliant and her parents are long gone. If she gets sick, her Medishield Life (and private upgrades) covers her hospitalisation, and if she passed on, it’d be a sad affair but hardly a financial impact to her loved ones.
This is the Theory of Decreasing Responsibility: your need for insurance is the greatest as a young working adult.
Given that whole life plans tend to be a few times more expensive than a term policy, working adults who buy whole life coverage tend to overinsure themselves for an age that is few decades away, only to overlook that they have underinsured themselves when their need for coverage is greatest.
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Buy term, invest the rest
Furthermore, there are practical upsides to buying term compared to buying a whole life plan. If a whole life plan costs $3,000 a year while a term costs $1,000 for the sum assured, you can then invest the $2,000 difference.
Now, this has a few advantages over a whole life policy:
|Term + Invest||Whole Life|
|Invest in virtually anything with ability to get better returns over the time horizon||No choice; only insurer’s Participating Fund which is too risk averse for a long time horizon|
|Freedom to stop investing if cashflow is tight||Policy will lapse or start going into policy loan which generates high interest rate|
|Tweak coverage-investment ratio to your affordability||Often leads to underinsurance|
More appropriate risk-return investments for the time horizon, with greater flexibility and freedom
When you purchase a whole life policy, your money will be invested in the insurer’s Participating Fund. Typical Par Funds are quite risk averse: a small 20 to 30% in equities and the rest in fixed income and other safer asset classes.
This is arguably too conservative for working adults with a time horizon of decades ahead of them. An investing guideline called “the Rule of 100” states that your portfolio should be X% of equities, where X = 100 – your current age. For most twenty and thirty somethings, that’s around 70% – way higher than 30%. Some even propose raising the number to 120.
The historic returns for the US stock market, looking at the S&P 500, is an average of roughly 10% pa¹ since while Singapore’s Straits Times Index did an annualised 9.2% from 2009 to 2018². This is merely just buying the index which is easily done with little hassle or investing acumen involved.
Investing this way also does not require a regular commitment unlike a whole life policy which would lapse if premiums are not paid. During times where cashflow gets tight, you could easily scale back the investing and service only the premium for the term policy. A whole life plan would require your premium to be paid regardless, or you would have to take out a pricey policy loan on your own cash value of the policy.
Lastly, some younger working adults won’t have the budget for a $3,000 whole life policy anyway. They end up buying a $1,000 policy with a third of their coverage needs, ending up underinsured when they need the coverage the most. A term policy lets them get covered first, and they can defer their investment until they’re more financially stable.
Flexibility is a double-edged sword
Of course, flexibility can sometimes be a curse as much as it is a blessing. Instead of buying term and investing the rest, people buy term and squander the difference, either through spendthrift pursuits, or losing money in their investments.
But the effort required in maintaining a term policy with regular investments is next to nothing as long as you are just a little bit involved in your finances. And given that you are reading this right till the end, are you not?
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