Buy Term and Invest the Difference: Common sense or nonsense?
Back in the 1970’s an insurance man named Arthur Williams started his company with the simple philosophy: Buy Term and Invest the Difference. With this philosophy A.L. Williams was successful in flipping a great deal of whole life insurance policies over to term insurance. His company (now Primerica) was so successful that Mr. Williams was able to buy the NHL’s Tampa Bay Devil Rays franchise. Today this “Buy term and invest the difference” philosophy is mostly associated with popular financial-entertainment personalities Dave Ramsey and Susie Orman. If you haven’t heard it from Susie and Dave then you’ve probably heard it from your brother-in-law, your preacher, or your son’s soccer coach. Financial planners and firms specializing in managed assets, and fund managers on Wall Street love this strategy as it drives more than just institutional investors and the well-heeled into markets they may not otherwise enter. What people want to know is…does buying term and invest the rest work? Strap in folks. This is going to be a long one!
What does it actually mean?
‘Buying term and investing the difference’ (BTID) refers to using the amount that it would cost to buy a permanent life insurance policy and comparing it to the cost of a term policy for the same face amount (death benefit) just for the period of time (or term) it’s needed. There seems to be some confusion on this definition as proponents of BTID like to compare the return on permanent life insurance premiums with the same amount invested directly into the market, conveniently ignoring the cost of the term insurance. Typically, BTID is marketed as an alternative to whole life insurance.
Does it work?
That is a much more complicated question to answer. In fact, it probably isn’t even the right question. BTID looks like a marketing strategy rather than sound financial planning. The question is simply framed as an either-or comparison: buy whole life or buy term life and invest the difference. The reality is that there is a place in a diversified portfolio for term and whole life insurance as well as securities and other investments. The zero-sum dichotomy of these choices is a false narrative.
But which is a better strategy?
That depends. Do you believe that you are going to get a 12% rate of return from growth funds in perpetuity as Dave Ramsey’s strategy suggests? Can you invest your money better than an insurance company? Here are a few things you should probably consider:
· Term Life Insurance is only inexpensive during the level premium term. Once your level premiums expire your term policy will renew at your attained age and the premiums jump exponentially. Average premiums for term life policies rise above those of whole life premiums at 17–20 years.
· Your coverage need for life insurance will change throughout the course of your life. The BTID depends on you buying the maximum amount of term insurance for the longest term you can. Can you imagine your family’s insurance need will be the same in 10, 20, 30 years? Probably not. Life has too much variation. The fact is, industry wide the average term policy has a life expectancy of six years. Term insurance is far more expensive when it is written for longer periods because the risk from the later years of the term are spread over the life of the policy. Many reputable providers have even eliminated extended term policies from their product catalogues for just this reason.
· Only 2% of term life insurance policies ever pay a death claim. Part of the BTID marketing is to characterize insurance companies as disingenuous and greedy for selling “expensive” permanent insurance policies. That is simply untrue. The 2% claim rate is one of the reasons why premiums are less expensive. As long as premiums are paid, whole life insurance policies will pay a death benefit. The entire mortality table is considered.
· BTID assumes that your investment account will make you self insured by retirement. What does that even mean? I know its cliché but the only two things in life we can be certain of is death and taxes. Guess what, life insurance addresses both of those issues. Nobody lives forever and when we leave our assets are subject to taxation in numerous ways. Life insurance provides those we leave behind with a tax-free death benefit, income, and cash for expenses. Your need for life insurance doesn’t end at retirement. As legendary insurance man Ben Feldman said, “Term insurance is temporary…but your problem…is permanent.”
· Most participating whole life policies yield dividends capable of paying the annual premium in approximately 20 years. This means that after 20 years, 100% of your insurance premiums can be dedicated to your outside investment and you still get to keep your life insurance.
Is there any data on this debate?
As a matter of fact, yes! Wade Pfau, Professor of Retirement Income at the American College did an extensive study of BTID vs permanent insurance included in a comprehensive portfolio. The summary of his whitepaper can be found in Forbes (05/13/2015). Mr. Pfau found that there were substantial advantages to income and return when permanent life insurance was incorporated into a risk pooled retirement strategy in comparison to a BTID strategy.
The integrated strategy provides more income, and the next question is about the legacy value of their assets. One year later, their legacy would still be about 13% less in the median. But as retirement progresses, this gap will get smaller, and eventually, the integrated strategy will support a larger legacy. By age 100, the integrated strategy with investments, whole life, and an income annuity offers a legacy that is 228% larger than investments-only can offer. This is the value of risk pooling.
In addition to the extended legacy, having a combination of insurance products in the retirement portfolio was found to reduce sequence of return and longevity risks.
What else should I know?
Here’s the reality, BTID relies on you to actually invest the difference. What really happens, according to Professor David F. Babbel of the Wharton School is:
People don’t buy term and invest the difference. They most likely rent the term, lapse it and spend the difference…And even the minority of those who do invest the difference are prone to the real-world emotional investing when individuals investors tend to buy high and sell low, perennially under-performing market indices…Our study sheds light on Wall Street guidance that has been taken as an article of faith, but that clearly under-performs for many who follow it.
Conclusion
Buying term insurance and investing the difference in securities through mutual funds in qualified retirement accounts can provide a fine retirement for people who adhere to the program. That being said, BTID is taken as gospel by its most ardent supporters. There clearly is a place for permanent life insurance and other insurance company products in a diversified retirement portfolio. The most important thing you can do before making any financial decision is to consult with a professional financial advisor (not your brother-in-law) and make decisions which make the most sense for you and your family.
To find out more about the difference between permanent and term life insurance, investment options, and to learn more about other insurance and retirement matters be sure to join me at the Internet Insurance Guru.