The Buy Term and Invest The Difference Puzzle
For decades, the rallying cry of the so-called financial gurus in the advice industry has been for clients to buy term insurance and invest the difference.
Do they buy or rent.. life insurance?
The problem is that most people never execute the second part of the invest the difference equation.
As a result, many find themselves either uninsured or worse yet uninsurable later in life. This leaves them and their loved ones unprotected during their retirement years.
In order to solve the Buy or Rent Puzzle, a person should begin by choosing the insurance protection that closely aligns with their financial goals and desires.
Let’s address the pros and cons of the Buy Term and Invest The Difference strategy.
THE BUY TERM AND INVEST THE DIFFERENCE CONCEPT
Buy Term And Invest The Difference is a simple concept to grasp. For starters, it’s not a religion, though some insurance and industry professionals treat it as such. It’s not something that you either believe in or not. It involves an insurance product, Term Life insurance. It’s important that the public is thoroughly explained how the concept will work for them and the options it will provide them.
Essentially, the concept is to buy term life insurance and invest the difference of what Cash Value Life insurance would have cost for the same face amount (the death benefit) in something that would provide a potentially higher return.
The basic difference between the Buy or Rent and the Buy Term and Invest The Difference concepts lie compares buying term life insurance to renting a house. Eventually, most renters’ goals are to become home buyers. The term life insurance is compared to renting and the Permanent or Cash Value Life insurance is compared to buying a home.
The costs of renting could be lower, but one may experience an increase in price at their next lease renewal. This is unlike owning the property where any equity (cash value) leftover from selling or moving would be carried forward into the new home’s purchase cost – giving residents more opportunity for economic gain than those who just rent.
When explaining to a younger insurance applicant the concept of Buy and Hold, a simple analogy may be to compare Netflix vs owning a movie. If they cancel their Netflix subscription, they don’t get to keep the shows they’ve watched.
Similarly, if Netflix removes a show (the term is up), that person no longer has access to the content. However, if the person buys the movie, they could always sell it later if they choose to, and there’s no risk that someone will take their DVD after the “term” is up.
They can then watch that movie for their whole life. (No puns intended!😊)
A question then presents itself. Aren’t all forms of life insurance essentially term insurance? They are. They’re either for a temporary period of time or for a longer one.
Term Life insurance is temporary insurance. It’s typically sold for 5, 10, 15, 20, 25, 30, or 40 year-terms. The premiums are level for the purchased period of time. Once the purchased period of time expires, the rate increases year after year.
Like any other form of insurance, buying life insurance, term or permanent, transfers the risk of economic loss to an insurer. The insured may pass within the term period,.. or not.
Kind of like a gamble perhaps. Any gamble may pay off or it may not. If one is betting, who or what are they betting against?
In this example, the insurance company IS the casino.
BETTING AGAINST THE HOUSE
When a person buys temporary insurance (term life) for a permanent need, the life insurance carrier acts in the role of a casino. As the applicant sits down at the blackjack table, he/she bets on the next 10, 20, 30, and even 40 years’ worth of premium payments.
By accepting the bet (the risk), the insurer is counting on the client being alive when the policy expires. At the same time, the person is betting that he or she will be dead for their family to “cash in”. This is a bet most people shouldn’t make and one they are almost sure to lose. Life insurance companies are much better and more skillful at this type of bet than the average person. Some insurers have been gathering data about mortality for well over a century.
Lesson to be learned: When looking to purchase life insurance, one shouldn’t bet until they know the odds!
THE OTHER SIDE OF THE PUZZLE
Cash Value Life insurance, unlike term life insurance, is permanent in nature. The premiums remain the same (level) for the person’s whole life. The policy will remain in force as long as the premium continues to be paid. This provides the assurance (no pun intended again! 😊) that the person’s family or business partners will receive the death benefit.
Companies called “mutual insurers”, also offer Cash Value Life insurance policies in the form of a limited period of time: 10, 12, 15, 20 years, or to age 65. These are called Limited Pay Life policies. Once the policy reaches its term, it’s considered “Paid-up” and the death benefit will continue until the insured passes away. These policies have been known to pay death claims to individuals as old as 120 years of age.
Mutual life insurers that offer Cash Value Whole Life insurance policies are historically known to provide annual dividends (a portion of the insurer’s profits) that can increase the cash value and provide other benefits. While not guaranteed, many mutual life insurance companies have paid dividends to participating individual life policyholders every year since 1851.
If dividends are paid and reinvested into the policy as “paid-up additions”, they become part of the guaranteed cash value and part of a new, higher basis or floor that increases future gains—both guaranteed gains and dividend payouts.
The cash value can’t decrease and is guaranteed to grow by at least a minimum guarantee. Any dividends paid and reinvested ensure that any future cash value gains and dividend payouts are actually increased.
Also, a Cash Value Life insurance policy grows on a tax-deferred basis, so one doesn’t pay taxes on the gains. For Cash Value Life insurance policyholders (Whole Life insurance), the IRS defines dividends as a return of excess premium and therefore not taxable.
However, if a person takes dividends in cash, they can owe taxes on them over and above the cost of the premiums paid. Dividends re-invested as Paid-Up Additions are not taxed.
HOW DO THEY COMPARE?
When evaluating the Buy or Rent puzzle decision for a family or business needs, one must consider the current specific situations in their lives. A knowledgeable insurance professional should ask the following questions:
- How old is the person?
- How good is his/her health?
- What are their family’s financial needs?
- What are their children’s ages?
- Are long-term health expenses and serious illness a concern to them?
- What is the amount of their mortgage and other debts?
- What are their plans for retirement?
- What college plans are in place for their children?
- How will they pay for funeral expenses?
- What are their concerns about estate planning and tax ramifications?
- Have they set up a trust as part of their will?
- Do they want to leave part of their estate to charity?
- Is there existing life insurance, perhaps through their employer?
BUY TERM AND INVEST THE DIFFERENCE AT WORK: A HYPOTHETICAL EXAMPLE.
In a hypothetical example, a 25-year-old non-smoker married male in superior health condition earning $100,000 a year, will pay $385 a year for a $2 Million 10-year-term policy. Should he die prematurely, he wishes to provide his wife the $100,000 annual salary to live the next 20 years without the need to trade dollars for hours.
Most would consider this $2 million dollar nest egg the deceased’s “Human Life Value”. This, however, falls short, because there are other factors involved in this calculation. Besides, no one can predict the future. That’s God’s department.
Consequently, this 20 times-income factor is within the upper limits that an insurance carrier is willing to provide. This ignores the likelihood of earning 5% ** every year consistently and the family’s periodic needs to purchase items like cars, vacations, college education, and weddings.
(**Note: This hypothetical example is for illustrative purposes only, and its results are not representative of any specific investment or a mix of investments. Actual results will vary.)
On the 11th. year, the annual policy premium exponentially jumps to $4,085 because, throughout the past 10 years, he took up smoking. The insurer lowers his health class to smoker status.
Now age 35, he shops the rates around and finds a new 10-year-annual policy premium for $585. This is still considered inexpensive.
However, a problem presents itself. The new $585 annual premium no longer covers his human life value because his income increased to $150,000 between the ages of 25 to 35. To keep the 20 times income multiple, his human life value increases to $3 million. The new premium jumps from $585 to $835.
One may think: “-His family really doesn’t need that much”. Just stop and consider how much tone would be willing to cut out of their family’s lifestyle at age 35. Their family now includes the spouse and children ages 8, 5, and 2.
Ten years later, they face the same decision. He’s now 45 with a child entering college and two in high school.
His income is now $200,000 and the annual term premium in the 11th year is $14,065. He shops around again for a better quote. By now, the insurer lowers the multiple to 15 times his new income from 20 times.
What’s the insurer’s reasoning for this decision? Throughout the past 10 years, his height has lagged behind his weight so they reduce his health rating. He is now too “short” to be considered for a better rate.
The lowest annual premium he can find now is $2,875. His premium cost has just gone up from $835 to $2,875 a year, the same year that his oldest son enters college. At this time, their “invest-the-rest” nest egg continues to deplete.
At age 55, he arrives at the conclusion that he must work to age 65 because the tuition they spent from their “invest the rest” nest egg must be replaced. This event reveals the reality of what they weren’t informed about when they first bought their policy.
The government (The IRS 🤬) has now determined that due to his success in this approach, their asset level is enough to pay for college. They’re now informed that their child doesn’t meet the qualifications for higher education financial aid due to the “family’s contribution”. No financial aid will be available.
The individual now has one more 10-year time frame to protect his family. He reduces the multiplier to 10 times his income, assuming he has topped off at $200,000 per year. His new health class (health rate) is downgraded to standard smoker rates due to a negative finding on his medical history.
The lowest new 10-year term insurance premium he can find is now $6,255 a year.
Ten years later, after making many personal life sacrifices, he’s now 65 years old and officially retired. At their retirement dinner, he shares with his wife that their plan has worked. All the years of paying for the “cheap term insurance” has finally come to an end. The policy will be canceled the next day.
If he had died the day before, his wife would have collected $2 million dollars. But tomorrow, because their plan was so successful, his family will get 0. Prayerfully, he’ll make it through the night.🙄😥
Let’s add up the cheap insurance.
- $385 for the first ten-year period = $3,850.
- $835 for the second ten-year period = $8,350.
- $2,875 for the third ten-year period = $28,750.
- $6,255 for the last ten year-period (from age 55 to 65) = $62,550.
The 40-year total is $103,500.
Most people don’t understand or count on the return they could have earned on that money had they not spent it. The miracle of “compound interest”
is dwarfed when money is spent. This is known as the Lost Opportunity Cost.
Applying the numbers to a calculator, the term insurance cost of money over those 40 years saved in an account hypothetically earning 6%,** the true cost of that insurance was $227,638.
(** Note: This hypothetical example is for illustrative purposes only, and its results are not representative of any specific investment or a mix of investments. Actual results will vary.)
At this moment, the individual realizes that:
- The insurance company will not return the funds to them, even though they didn’t pay a death claim.
- The funds will not be available for their enjoyment or future needs.
- The insurance company keeps all of the premiums and the compounded money they earned.
The original purpose of “Buying Term and Invest The Difference” is to invest the rest. Human nature being what it is plays a role in this age-old approach. For this life insurance strategy or plan to work, a consumer needs to “invest the rest”. Otherwise, it will fail miserably. People will most likely rent the term, lapse it and spend the difference.
BUY OR RENT: CONCLUSION
There’s no question that term life insurance serves a valuable purpose in providing temporary answers to the risk of dying too soon. The most important thing a family can do, however, is to consult with a seasoned insurance professional (not anyone’s brother-in-law) to assist them in making decisions that make the most sense for them as a family.
A lesson to learn: Term life rates rise and ultimately become unaffordable with age. A temporary policy should not be bought for a permanent need.
*Note: Though the character in this article is real, the examples are hypothetical and for illustrative purposes only. They assume a steady 6% annual rate of return, which does not represent the return on any actual investment and cannot be guaranteed. Moreover, the examples do not take into consideration account fees and taxes, which would have lowered the final results. Speak with a financial professional about how these examples might relate to your own investment circumstances.