New insurance option takes some of the sting out of term policies

Many people scoff at us buyers of term life insurance. They claim we're suckers for paying hundreds of dollars a year for a policy we can't collect on while we're alive.

That sums up several comments I fielded during a recent online discussion with Kimberly Lankford, author of "The Insurance Maze: How You Can Save Money on Insurance and Still Get the Coverage You Need."

"I've never understood why people would choose term insurance over whole life," one reader wrote. "Term insurance ends. If you don't die during the policy term, then the money has pretty much gone to waste. Why not take out a whole life policy where you can always get the money back?"

With the help of Lankford, I wanted to answer this reader's question.

First, here's a quick primer on the difference between term and whole life insurance, the latter of which falls into the broad category of "permanent life insurance."

Term life insurance is not unlike buying insurance to protect your home or car. You purchase term life insurance for a specified period of time. Under term insurance, when the policy runs out, you typically get nothing back.

I say typically because there's a new version of term life insurance that's a lower-cost alternative to permanent insurance. A "return of premium" policy will give you back all the money you paid to cover yourself under a term life insurance policy -- provided you are still alive when the term is up.

As Lankford points out in "The Insurance Maze," your annual premiums under a return of premium policy will be higher, but you get a lump sum of money after 20 or 30 years. For example, a 41-year-old man could pay about $405 for a regular term policy with a $500,000 death benefit. If that same man bought a return of premium policy, he could expect to pay about $1,330 a year, all of which he would get back at the end of the term. That's $26,600 over 20 years tax-free because you're getting back your premiums.

A typical return of premium policy might cost about 25 percent to 50 percent more a year than regular term. The insurance company takes the extra amount you pay and invests it -- that's how you get your returned premiums.

To be sure it's right for you, do the math, Lankford says. For instance, if you took the difference in what you pay annually for the term life insurance policy and the return-of-premium policy ($925 in Lankford's example) and invested it, you would only need to earn an annual interest rate of more than 2.8 percent (before inflation) to beat what you get with the return-of-premium policy, she says.

Assuming a rate of 3 percent, that's $27,271.40 after 20 years, excluding taxes. If you add $75 to that annual investment of $925, you would have enough money to buy an EE Treasury bond, which as of Oct. 31 was earning 3.7 percent. Put the money in a diversified mutual fund and you could earn even more -- with added risk, of course.

You do fare better if you get a 30-year return-of-premium policy. Let's take the same 41-year-old man. A 30-year traditional term policy for $500,000 would cost about $930 a year. The annual cost for a return-of-premium policy would be about $1,425 (although keep in mind the price you pay will vary greatly depending on the insurer, your age, and your health).

If you take the $495 difference between the two policies, the insured man would have to earn at least 6.2 percent per year to accumulate the $42,750 he would get back in premiums.

But keep in mind that if you have to cancel a return-of-premium policy before the term is up, you may only get a percentage of your money back.

Even with its cons, Lankford prefers return-of-premium policies over permanent life insurance.

"The problem with many cash-value policies is that the premiums -- and fees -- are so much higher than they are for term insurance," Lankford said.

I know the debate over term versus permanent won't end here, but I hope at least we've made the case that you don't have to feel like a chump if you opt for term life insurance.

Michelle Singletary is a columnist for The Washington Post.