Buy Term and Invest the Difference

I've written a couple times about buying term life insurance and investing the difference (see Insurance and Investing: Buy Term and Invest the Difference and Former Insurance Agent: "No Way" is Permanent Insurance Better than "Buying Term and Investing the Difference"). For those of you unfamiliar with the phrase "buy term and invest the difference," it simply suggests that you do not buy permanent life insurance and instead by the cheaper term life insurance and invest the money you saved doing so. If you do this, you'll end up having more money in the long run as well as life insurance during the time you need it.

Turns out that Money magazine's "Mole" agrees that buying term and investing the difference is the best option for most people:

If you are a disciplined saver, I strongly recommend buying term and investing the rest. If you need a forced savings vehicle and you can't find that vehicle elsewhere, then you may want to consider a permanent policy. But either way, make sure you understand what it is you're buying and how much it's costing you.

He hit this one exactly on the head in my opinion. If you are disciplined enough to actually invest the difference (and not spend it), then buying term and investing the difference is probably for you. But if you're not able to save on your own, permanent insurance, though much more expensive, is likely a better option for you.

Comments

[traineeinvestor]

I definitely agree with this one. Insurance and investment are two very different things and the only reason for bundling them is to transfer wealth from the policy holder to the insurance agent. No thanks.

When it comes to investments and other financial products, I start with the assumption that any bundling of products for which comparative prices of each individual component cannot be easily obtained should be treated with the utmost suspision.

[got_surprized]

Be Careful!
I used this approach in '95 when I retired. Signed up for 10 year plan (premiums go up the longer the plan). At that time market was doing fine. Thought I wouldn't need the insurance after 10 years of growth.

Wrong on two counts:
1. Market pretty bad, as we all know.
2. Had a heart attack in 2004.

Result: When I went to buy the insurance I would like, no company would talk to me. I ended up using a clause in the 10 yr. term that allowed me to convert it to universal life. (It's a terrible policy requiring hefty investments with horribly high fees.)

[Mike W]

So for me, Insurance is just that... Insurance.

I am 29, have a wife a 2 year old and one more on the way in March. I have a generous term policy for me. My wife stays home and I am the primary breadwinner. My thinking is if I die I want my house paid off, living expenses taken care of for the first year or two, and enough money for a trust to be setup for my survivors (with a focus towards supporting my wife with the kids and helping - not outright paying... I don't plan on outright paying for my kid's college - with college.

So I signed up for a 25 year term. (We plan on having one or two more also). After that, I don't need any large term insurance. My 401 should be up there, an IRA I am starting for my wife for 2007 taxes (She doesn't work and I will then be able to setup a Traditional IRA and have Uncle Same "match" about 45% of my IRA money through the additional tax savings) should be up there. And my children should all be at least be in their 20s.

I will have a much smaller policy that will just take care of my funeral costs at that time (or just put it into a savings account).

From my point of view term makes sense and thinking logically about your insurance makes sense. I plan on instilling good principles in my children as far as money goes (once I understand them myself ;) ) and I plan on them helping out with their own college expenses (I want them to appreciate what they are learning and the value of it more). I want them to be able to survive if I were to die but not hit it rich.

I still need to setup a will and trust with my wife so we have our plans established should we both go but you get the point. I also have a small policy for my daughter that she can convert to term of her own when she is 18 (and she can raise the policy value 4 times in 4 years without any medical tests). I also have a small policy for my wife that would let me take some time off from work to figure things out and get my head on straight.

We also have a strong family and church support network which does help to give some peace of mind and help while waiting for insurance payouts and help with figuring out how to get back on our feet.

[SleepyOreo]

The only issue I see with this idea is that most people are not great savers(national savings rate at negative 1%), and that money will not go to investments.

With insurnace not only is it guarenteed to go to investments inside the policy, (Variable universal insurance, NOT WHOLE LIFE) but the investments grow tax free, and one can take policy loans out tax deferred. The tax free growth benefit alone is huge.

I think permanent is the way to go in many cases. The fees are higher, and in a situation like my own where I have nothing to insure at this point I would recognize term as the better product.

With people living longer and longer, the peace of mind one can gain from knowing that they are insured for the rest of their lives, and their estates are somewhat protected is worth a great deal, IMHO.

[Kirk]

I don't buy the forced savings argument for permanent insurance. It is a sales tactic, not a sound principle. Here are my reasons against permanent policies as savings vehicles:

1. Over 75% of permanent policies lapse within 5 years. That number jumps to 90% for 20 year periods. Why? They are too expensive. If you take a young couple or a family who don't do the "buy term, invest the difference" because they are poor savers, then the probability that they will afford the high costs of permanent insurance is also slim. Cash flow is the reason, in most cases, they can't save. So they end up not affording the permanent policy premiums either.

2. For whole life, the return almost never lives up to the projected return. Some companies do provide solid returns in whole life like Northwestern Mutual and some of the other non-profit groups, but most fail to meet the salesmen projections. For universal variable, the fees of the funds are egregious. The choices tend to be limited as well. And most of these policies use annual renewable term as the insurance component, which usually requires folks cough up large portions of their investments in later life to afford the insurance. I have known folks in their 80s get large insurance bills because the investments could no longer fund the insurance.

3. Commissions. It takes several years to have a cash surrender value equal to your basis or payments. This is due to the commissions paid to the salesman. Even without a salesman, many insurance companies still factor a full load commission into the policy. I have trouble believing you are getting a good investment when it takes several years to just break even.

I have seen many more people with high net worths from traditional portfolios than from large insurance gains. Even those who brag about their gains in their insurance policy are amazed when you really analyze the numbers and show them they earned a rate barely above inflation.

[Skott]

1. Because permanent is so much more expensive than term life insurance, many people with permanent life insurance policies end up under-insured.

2. Don't forget the importance of long-term disability insurance. Many people without dependents don't need life insurance, but everyone should have long-term disability insurance to cover themselves if something bad but less-than-fatal happens to them.

[Matt]

I take a much harder line on this. Permanent life insurance is only good for the insurance agents and insurance companies. Virtually nobody should buy it.

Even for the undisciplined savers out there, term is the better option. Chances are, if you try to use permanent life insurance as your savings vehicle, you'll end up woefully under-insured.

If you have a family and many earning years ahead, you need a lot of coverage. Figure about 10 times salary at the time you buy the policy. Keep in mind, your salary is likely to grow in the next several years and you might even have more kids. I bet if you look at the premiums for that much permanent life insurance, you'll find them utterly ludicrous.

Another thing to consider is that you don't have to invest even close to the full difference between term and permanent premiums to come up with an equivalent nest egg because of the tremendous cost drag of permanent life insurance.

For those who have trouble saving, just find some other, lower-cost way of automating it. 401k or 403b plans are a good option if they are available to you, but you can also set up an IRA or Roth IRA with Vanguard or Fidelity that will automatically deduct money from your checking account every month.

[ChampDog]

Sometimes you don't really need to “go all the way to whole life” or “go all the way to term life”. There is another option is you can go for both. For instance, if you have trouble saving and yet you want to have full coverage (not under insured), you can consider to buy both of them. Whether what is the best ratio, you should know the best based on your financial status. This is just my 2 cents.

[FMF]

Got Surprized --

Do you really need life insurance in retirement? Who's relying on your income when you're retired?

[coachok]

Let's put aside the forced savings argument for a moment. Which is a better deal term insurance or whole life? I ran the numbers on this scenario: standard rate male age 36, non-smoker, Universal Life, for $100,000 coverage was $96.36 per month. The payments for 20 years of the plan would be $23,126 for a A+ rated company. A term policy from an A+ company for 20 year level term at $100,000 would be $16.36 per month or $3926 over 20 years. That is a difference of just under $20,000. Term life is a way better deal even if you can't be forced to save. :)

[Hadley]

I chose to go with a large amount of term life insurance and a smaller amount of whole life coverage to provide maximum protection while needed for my young family, while still maintaining some permanent life isnurance for final expenses.

Although, many of us may have enough saved by age 55+ to pay for final expenses, unless we pass away earlier.

But, in general, I definitely believe term life offers the best value based on need for maximum protection for a specific number of years.

[Atoosa]

If I am paying for life insurance, It means I want my beneficiary to get the proceeds. I am not going to lose the bet with the insurance company by buying term insurance and I am not going to pay for an overpriced whole life even the ones that pay dividends. Instead look at a Universal life that is guarantted to pay up to age 120. I don't care about cash value, I care about death benefit.....

[Stephen Weik]

GET IT RIGHT
Buy Term and invest the difference? First of all, term and whole life has its place—they both provide different solutions....and neither are considered investments. I use Roth IRA’s, brokerage accounts and retirement plans also, but a properly structured dividend paying whole life policy is a great foundation and it also creates a second estate (the death benefit)-which allows you to spend down your other assets (401k,IRA’s, real estate, etc) while you are in your prime retirement years without fear of living too long and running out of money because—-when you die the death benefit will replace your spent assets…and/or if you live longer—you now have a build up in your cash values to use!!!!! .I love the possible gains you can get in securities, but Whole life insurance is an important product also due to the features and versatility it offers-NOT the return you get on the "cash value" portion-although that is useful too. The life insurance policy buys you something more important than money……….time!

It is awesome to be able to have access to your nest egg PRINCIPAL and INTEREST instead of just living off interest/income of 5% or whatever your financial advisor tells you is safe because you don’t know how the market will perform and how long you will live! I know its a radical concept, but it works. But don’t just take my opinion or anyone else’s. Know the details, get the WHOLE STORY and THE WHOLE PICTURE…and decide for yourself.

Bottom line: No, life insurance is NOT considered an investment, but if used correctly, it will definitely enhance the assets and options you would have concerning the other areas of your financial life!

Term insurance is good temporary protection but it will expire when you are most likely to need it at older ages and it will be MUCH more expensive to renew it at that point. And if you think term insurance is cheap…add in the lost opportunity cost (you could have invested those premiums) on the premiums you will have paid over the years and add that to the premium cost!

Anyone ever notice how the term vs whole life arguments are usually concentrated on the products themselves? They both are useful when used correctly---one is meant to be temporary and the other one is permanent! No big mystery about how to use them and no need for all the debate!!!! The back and forth arguments about life insurance are endless and redundant, because most are only looking at it in a financial “vacuum”. Of course you will draw different conclusions about whole life or term insurance if you only look at the product themselves and not what else is going on in that individuals financial world! Obviously if you need protection for your family and you can’t afford permanent insurance or your income is unstable..etc …you would want term insurance until you get permanent, but if you are trying to build wealth (cash value itself and leverage techniques based on the death benefit) and want the insurance to be there when you will actually need it…….you want the permanent type!
If your advisor is not taking your whole financial picture into consideration when talking to you about life insurance, you are not getting the most efficient service!
When you are able to efficiently put together a synchronized financial plan, you can then get passed all the hype and misinformation and see how everything works out with the FACTS! So, until you are able to see this on paper with your own eyes and fully understand it, don’t be so quick to believe the “armchair” financial gurus—the financial noise! (Disclaimer: I am only speaking for myself and not any financial institution)
Stephen Weik

[Jeff Bigg]

I always find it interesting that I've never read a consumer advocate promote cash value insurance. The only people who seem to promote it are those with a financial interest in selling it for a commission. Every policy has a term insurance element in it called a mortality charge. Just look at your policy and you will find a page listing the cost of insurance. It generally goes up as you get older and list those per thousand charges untill the age of 100. Why would anyone want to pay higher administrative charges and sales charges associated with a cash value policy when they can avoid those charges buy simply purchasing term? The ability to control your own assets invested or saved is worth the choice on it's own. If the product wasn't so profitable for the industry, why is it they pay 5 to 10 times more in commisions to agents who sell cash value? Go figure.

[Seth Baker]

Term insurance is the most expensive form of insurance. Imagine a person engages in two financial transactions. The first transaction involves buying $100 worth of lottery tickets. The second transaction involves spending $10,000 on a CD at a current market interest rate. Which transaction was more expensive assuming the lottery tickets did not win?

You would be hard pressed to find anyone who would argue that the CD was more expensive because it cost $10,000 whereas the lottery tickets were "cheap" because they only cost $100. A lost dollar is the most expensive investment that you can make. If you buy term insurance and you do not die while the policy is in force it is like buying a losing lottery ticket. Not only do you lose the premium dollars, but you also lose the time value of money (lost opportunity cost) on those premium dollars.

When it comes to insurance the most important factor is to insure your "human life value". For most people term will be a necessary part of their insurance portfolio because they don't have the cash flow to purchase whole life. If a person is in their 20's they should have about 30x income, 30's 20x income, 40's 15x income, 50's 10x income and above 60 at least 1x net worth. These are the general ratios and insurance company would allow as the maximum amount of insurance you can have.

If you had a $500,000 house how much would you insure it for? The only logical answer is full replacement cost. What about a car or boat? Again full replacement cost. Is there anyone out there that would argue you should insure you house for less that full replacement value? Of course not, so why would you insure your "biggest" asset--your ability to earn a living, for less than full replacement?

Buy term and invest the difference is really only valid for people who have assets and the cash flow to invest the difference. If you do not have the cash to invest the difference term is your only choice.

Question: If you write yourself a check from Bank of America and deposit into you Wells Fargo bank account--do you have any more money? Do you have any less money--no. You simply shifted money from one account to another. When you have a whole life policy after around 5 years every dollar you pay in premium is immediately credited to your cash value account as a "living benefit", meaning you have access to that money while you are alive.

So why not buy Whole Life and invest the difference??? This is what I mean buy that. Let's say your whole life premium was $10,000 per year, after about 12 years you should have around $120,000 in cash value. Unlike stocks and bonds,
your cash value can never decrease in value, it only increases. So could you not wait for an opportunity like now when the market is down 40% and do an asset allocation and rebalance some of the cash value money and buy equities while they are dirt cheap, or use the money to buy real estate. A properly structured whole life policy is one of the most efficient places to store and grow cash. Money goes in after tax, grows tax deferred and you can access it income tax free--sounds like a Roth doesn't it?

If fact for all you invest the difference people--how many of you would argue that EVERY investor should be 100% equities and 0% bonds throughout their entire life regardless of their risk tolerance? Would any argue that? So question: If A --> B and B-->C, is it always true that A-->C? Yes. It is always true (--> means "implies" for those who do not remember their high school logic class).

So, If you put your money with an insurance company, and the insurance company invest 90-95% of their money in high quality AAA bonds, Are you not putting your money into bonds? A-->B, B-->C, then A-->C. Whole life represents the bond portion of your investment strategy. If fact Whole Life is more comparable to a Municiple Bond or a Roth. It just offers significantly more benefits then other investment vehicles.

How about you google what a MEC is (modified endowment contract). Imagine a glass filled about 75% full. The bottom of the glass would represent Term premiums, the top of the water would represent Whole life premiums, and the top of the glass would represent MEC level premiums. Who sets the term premium level? The insurance company. Who sets the Whole Life premium level? The insurance company. Who sets the MEC level? The IRS. Now why would the IRS care how much you pay for your life insurance? Was it a lot of poor, stupid people who were funding life insurance policies at such high levels, or was it smart, rich people who were doing that. Could it be they feared a lot of really smart, rich people would dump hugh amounts of cash into whole life policies to take advantage of the tax benefits? Of course and that's exactly what happened and who MEC rules were instituted.

If you use whole life properly--as an efficient bond substitute, you will achieve the "holy grail" of investing, you will increase your returns, while lowering your overall investment risk.

The buy term invest the difference crowd loves to point to their mountain charts which show $10,000 per year getting 10% for 30 years and pow--$1.8 mil. They don't however tell you how 65%--or $1.1 mil occurs in the last 10 years. So what if in the last 10 years of your BTID stratgy the market does what it did this past year and drop 40%, or what if the S&P is down 28% from 10 years ago---invest the difference is based entirely on assumptions that may or may not prove true. So would it make sense to have a portion of your portfolio in something the will grow at about 6-8% tax free, and can never go down. A good Whole life policy after about 25 years will have about a 13% after tax rate of return on the Death Benefit and about an 8% after tax rate of return on the cash value.

One of the worst unintended consequences of term insurance is the permanent loss of the death benefit. Whole life will allow the average person to have about 30-40% more spendable retirement cash flow than not have it. For people who actually understand and know how to use a whole life policy-it will blow BTID out of the water every time...