How to Spend Money Wisely » Insurance

Buy Term and Invest the Difference

Buy Term and Invest the Difference

Here’s a concept that most readers of financial blogs will be familiar with – buy term and invest the difference. It’s a concept that came in to fashion in the 1980’s and is still going strong in some corners of the financial world. The end decision in all cases behind this concept though, is that term insurance is the best life insurance product.

Now think about that for a second. Do you believe that term insurance and investing the difference is the best product for everyone, 100% of the time? I think most folks will agree that this can’t be the case. And yet buy term invest the difference proponents ALWAYS arrive at the conclusion that term life insurance is your best buy. Doesn’t that smell a little bit funny? Like it’s a foregone conclusion?

Sure enough, there’s some holes in the story. And like many ideologies, finding these holes happens when we start looking at assumptions and guarantees. The math doesn’t show the whole story in this case.

Basic Concept

Buy term and invest the difference works like this; you compare the costs of term life insurance with permanent life insurance, where the permanent insurance typically has a cash surrender value. The concept shows how if you bought the cheaper term life insurance now and invested the savings you’ve kept over buying permanent, about age 65 when you don’t need life insurance anymore, you’ll actually have more money. Cool! Let’s run the numbers.

Example:
I ran a whole life insurance quote using Compulife (R) (Compulife is the standard life insurance company rate database used by agents in the US and Canada). Let’s say you’re a male age 40 nonsmoker. For an amount of $100,000 I grabbed the least expensive 20 year term (turned out to be Equitable Life’s 20 year term) and compared it with the least expensive whole life product in the comparison (turns out to be Empire Life’s Solution 100 with values).

The next step is to cancel both products at age 65 and see which product gives us the most money. We’re doing this because the concept says we don’t need life insurance past age 65 – by that point our savings will have left us self insured.

I’ve assumed a nice conservative interest rate of 3%. Based on that, if you had bought the cheaper term life insurance you’d have saved $7,941.86. If you bought the whole life insurance policy and cancelled it at age 65, you’d have $13,200. Wait, what?

I’m reminded of the 5 P’s. Prior Planning Prevents Poor Performance. Because if I was in front of a client convincing them how important it was to buy term insurance, I would be very embarrassed right now. I’ve just shown that you would be better off buying the whole life insurance policy and cancelling. Whoops.

So comparing the least expensive 20 year term with the least expensive whole life doesn’t work. So what are they comparing to make this work so well? What am I doing ‘wrong’?

Do You Know What Assume Spells?

It spells assumptions. Like all good theologies, the flaws lie in the unquestioned assumptions. Let’s have a look at some of them, see if you agree with them.

Problems With My Comparison

First, while that comparison I just quoted shows that the whole life policy is better, what I didn’t mention is that the $13,200 of cash surrender value would actually be subject to taxation. Only a small portion of it would be taxable, but you would be unlikely to receive the full $13,200. However, even after taxes I’m pretty sure you’d still have more money with the whole life, using those assumptions.

Speaking of taxes, we assumed a 3% rate of return. Depending on what that’s invested in, the 3% could be subject to taxes as well. Easy enough to avoid those taxes, but if you don’t, that makes the whole life policy even more favourable.

Secondly, we’ve assumed that we’ve kept the 20 year term policy for 25 years – 5 years past the 20 year renewal. I can’t imagine someone would keep a term policy these days past the renewal. Renewal premiums are simply too high. Most consumers would either buy a new term policy at renewal or convert to permanent (despite the fact we’re trying to disparage permanent insurance with this concept). So fair enough, if you bought a new term policy in year 21, you’d have lower term premiums in years 21-25 than what I used, helping the term cause a bit. Is this something a consumer would catch?

Interest Rate

I believe interest rates are the biggest single concern with this concept. If I have assumed 3%, the whole life policy looks better. If I assume 6% and no taxes on earning, then the term insurance policy is about break even. If I assume 10%, now the term life insurance policy is about $29,000 better.

So what interest rate do you think you should be using? 3% or 10%?

Now if an insurance agent wants to sell you a life insurance policy plus their miracle-gro investment strategy, what rate do you think they’re going to use? 3% or 10%?

But lets say we’re OK with the 6%. Nice fair comparison over 25 years and the term insurance wins by about $4500. I’m going to assume that $4500 over 25 years is close enough that we’ll call it a tie.

Cancelling at Age 65

But is it a tie at 65 if we used 6% rate of return? We bought a whole life policy, or bought a term and earned 6%, and in both cases we just cancelled and ended up pretty close to the same financially.

But what if we don’t want to cancel the life insurance? Yeah, I know, the concept doesn’t allow for this possibility. But let’s say at 63 you had a cancer scare. The now-65 year old that had cancer two years ago that bought the term policy – how do they feel about their term life insurance policy? Not too good. The policy has ever increasing premiums and eventually it actually expires.

So what if I said to this 65 year old, hey, I can not only get you healthy rates for life insurance, but I’m going to lock it in for the rest of your life level. And I’m not going to give you the rates of a 65 year old. I’m going to give you the healthy rates of a 45 year old. Would you be interested?

If you made it through all of that sales speak, the point is that at 6% you’re the same financially if you cancel, but if you decide not to cancel, the whole life insurance policy is going to be a real deal breaker.

I appreciate that the rabid buy term and invest the difference advocates will refuse to entertain the idea that one could want insurance past 65. And perhaps my cancer scare example is a bit overboard. But two things are true – even if you don’t want permanent insurance now, there’s some possibility you may change your mind in the next 25 years and secondly, if you do change your mind, having bought the whole life policy in this example is going to be a much better solution. More choice in 25 years, for about the same cost.

The other aspect about cancelling at 65 is that in my experience, many people around retirement age want some permanent insurance. They want to cover final expenses. Some want to leave money behind for kids or grandkids that doesn’t come from the estate. Whatever the reason is, it’s been my experience that some people’s idea of the financial value of life insurance changes as they get older. That may not be you, but you should leave yourself open to the possibility that it could be.

Still not convinced? Would you believe that many people are interested in a smaller life insurance policy after retirement? That’s probably obvious. And with a 25 year old whole life policy already in force, all you need to do is drop your face amount down when you hit 65 – instant small life insurance policy, guaranteed.

Self Insured

This is an easy one to debunk, just take it to the extreme. It’s clear that people with high net worth can run into tax complications at death. If they don’t want their beneficiaries or family to have to sell assets at fire sale prices or dip into liquid cash to pay these taxes, then life insurance is an easy answer.

So if you do become self insured to the point of being really well off, there’s a reasonable chance that you are going to want permanent life insurance. Again, it’s not 100%, but it’s a possibility you shouldn’t exclude.

Guaranteed vs. Not guaranteed.

At our 6% rate of return, the term life insurance and whole life insurance products were basically even. But they’re not. We just compared a guaranteed result with a non-guaranteed result.

That 6% rate of return you earned on your ‘savings’ from buying the term policy – was that guaranteed? Not even close.

The $13,200 of cash surrender value on the whole life policy? That is guaranteed. And frankly, an agent should be ashamed of themselves if they’re comparing guaranteed vs non-guaranteed in front of a consumer and neglect to mention it to them.

So how does the term look now? The person that bought the whole life insurance policy is guaranteed $13,200 less some taxes at age 65 if they cancel. To get the the same results from a term policy, you’d have to earn more than 6%. That’s almost like saying you can get a guaranteed 6% interest rate. I’m not saying that! But at what point do you need to be before a guarantee matters? For many Canadians, having to invest in something that will earn more than 6% to beat a guaranteed option is going to be a no brainer. They’ll let someone else take the risk.

And that’s only if you cancel. We’ve already covered how the whole life insurance compared better by giving you better coverage cheaper if you decide to keep your insurance after 65.

Other Considerations

So how do we make these comparisons ‘work’ to favour the term insurance.

First, use a higher non-guaranteed interest rate and compare it to a guaranteed cash surrender value. (and then lead into a discussion of sale of investment products rather than mentioning the non-guaranteed aspect 🙂 ).

Secondly, don’t compare least expensive with least expensive. If you have a non-competitive whole life product and compare it with a current term premium, of course the term policy is going to look better. Try comparing the term product with a competitive permanent product. Or comparing your existing permanent with a new, competitive permanent product. (I compared a 20 year term with a competitive Universal Life policy and the total cost difference at 3% over 25 years was only $5100).

Thirdly, use optimistic health class on the ‘new’ term policy when comparing against your existing insurance where you didn’t receive those optimistic rates. In other words, compare ‘preferred’ term rates with ‘regular’ permanent insurance rates. Of course, if the insurance company gave you a regular health class when you bought your permanent insurance and now you’re a couple years older, what’s the chances that you’re going to spring into those preferred rates with your new term policy?

Summary

Despite how it may have read, I’m not proposing that buying term insurance is bad, or that whole life is good. I’m suggesting that at a minimum, sales techniques that start with a predetermined conclusion are not suitable for all circumstances. The right way to start a conversation on the merits of term insurance vs. permanent is to ask the question “How long do you want the insurance for?”.

Secondly, when comparing insurance products, be very mindful of guarantees and non-guarantees.
And thirdly, be mindful of salespeople who are biased on only one product type.

Comments

  1. QuickQuote Financial

    You can also compare an ROP (Return Of Premium) term policy vs. a regular term policy. This calculator provides the rate of return on an ROP term life policy and the rate of return that would be required from outside investments to match or exceed the return provided by the ROP term life policy.

  2. Just curious, it seems the comparison is absent “additional” savings. What I mean is- wouldn’t the money saved from the term life policy be invested with other monies already invested? Not independently invested on its own? That $7900+ when added with other potential investments (401k, Roth IRA or simple mutual funds) and then compounded with interest could far and away out gross the whole life plan- isn’t that possible?

  3. One very important part that you failed to address is death. If you purchased the whole life policy and died at age 64 you would only get the face value from the life insurance. The $13000+ the insurance company gets to keep. Now this doesn’t sound like much but if you are buying a $500k policy and die before you use any of the cash value you are losing a large some of money ($60k-$80K). If you had bought term you would have the face value and the invested amount for your heirs.

    • Glenn Cooke

      You are correct. There’s a variety of things that aren’t addressed – not enough room.

      Nevertheless, your point about the invested difference is a bit simplistic, it depends entirely on ‘when’ you die. My opinion is that the amount is mostly irrelevant anyway, since there’s a fairly narrow window where the amount would even be noticeable – 10-15% in your example.

      By contrast, that amount you mention is not guaranteed, the CSV on the whole life I mentioned is gtd. I could’ve compared the term against a non-guaranteed whole life with dividends, which would’ve actually been a more ‘fair’ comparison, but to the detriment of term (non-guaranteed whole life with dividends would’ve compared much much better against the term than the gtd. product I used).

      In the end, it matters what assumptions you use. Assuming 12% isn’t the right answer for everyone.

  4. DB

    You’ve got 20 years (which leaves them at 60, not 65) to endure the fluctuations of the market…which have yielded an average of 12% since the 50’s for index funds – investing in strong business, like the banks who post billion dollar profits. Oh, and interesting that you didn’t post the actual costs of life insurance. And did you also fail to mention that if you had Whole Life and died before 65, your family doesn’t even see your savings? Yup – they get the face value, eventually, but the savings are gonzo. One more thing…did you know that in Canada, the company selling the Whole Life policy actually has to go to a re-insurer and buy TERM on your life??? Yup – and at a bulk price, you should know that they are paying very little for the insurance portion. So, what happens to the rest of your moola, you say? They invest it for themselves and give you a portion of that (very low rate as stated in your policy that I hope you read before you signed). Also, keep in mind that in Life Insurance, “dividends” are overpaid premiums, so if you get a “dividend” cheque once a year, you’re simply getting your money back – the money that you shouldn’t have been paying in the first place! Is there interest on that? Not likely.
    Anyways, do yourselves a favour – don’t listen to this bonzo or what I have said here — read reputable financial books out there like the Wealthy Barber, Canadian Finance for Dummies, the Canadian Consumer Reports, Suzy Orman’s books, David Ramsey’s books…they all say that any kind of life insurance product with a savings feature bundled into it will rip you off. This is a math game…2+2 always = 4. So, read up, do your own math, and you will see.

    • Glenn Cooke

      The market does not yield 12% in Canada, it yields 6% IIRC. The 12% figure is thrown out normally by people looking to sell only term insurance and/or mutual funds. I’m suspicious that you’re in that crowd, particularly since you name the usual litany of American talking heads.

      You are correct though, at 12% assumption, term looks good. You just have to believe you’re going to get 12%.

  5. Brian Poncelet,CFP

    The big thing to consider with life insurance is what it can do.

    Protect the family (early death)

    Provide a higher amount of money in retirement.

    I wrote a blog on annuities awhile ago http://www.milliondollarjourney.com/how-annuities-work.htm
    (in a nutshell if one is in their mid 60’s to 70’s) they can get 6-8% guaranteed for life and pay a log less taxes.

    There is other ways one can have at least 20% more money to spend and pay half the taxes, and have control of their money, but it starts with the right kind of insurance.

  6. Oscar German

    I know it has already been mentioned, but one big advantage of life insurance is the ability to take tax free loans. There is always a risk that tax rates will be higher when you retire and if you have some tax free funds that you can receive from a permanent life insurance policy, you will be very happy.

    • Glenn Cooke

      Tax free loans from life insurance policies are a thing of the past. They used to makes sense in the 80’s when you could borrow from your policy at 3% and invest at 18%. Today, I believe you’ll get charged prevailing interest rates on any loan.

  7. Investment Plans

    I have seen your blog here, It is nice to meet you! I will keep watching it in future.

Leave a reply

Your email address will not be published. Required fields are marked*