Buy term and invest the difference
|This article does not cite any references or sources. (August 2012)|
Buying term and investing the difference is a concept involving term life insurance and investment strategies that allows individuals to eventually "self Insure" and provides an alternative to permanent life insurance. Generally speaking term insurance premiums are considerably less expensive in the short term than permanent life insurance for an individual for the same benefit amount. Permanent programs are more expensive because they force the policy owner to "Self Insure" by combining some form of cash accumulation with the insurance program as a single package. Consumers making use of the "buy term and invest the difference" concept separate their investments from their insurance by setting aside money every month equal to the premium that a permanent plan would require, then use a portion of this money for the term premium and place the rest in a tax-deferred investment vehicle.
Cases for and against implementing the strategy
The advantages of this strategy, if implemented correctly by the Theory of Decreasing Responsibility, are the ability to Self insure and get rid of the need for insurance, immediate accumulation of investment moneys, more investment options that allow for similar tax advantages, and return of cash accumulation. Other advantages include elimination of loans and stability in the death benefit.
Obviate the need for permanent insurance
This viewpoint assumes consumers will self insure on their own and will eventually be able to eliminate the need for permanent insurance which forces them to self insure. Most responsibilities for which life insurance is purchased are temporary in nature (paying off mortgage and/or debts, provide education for dependents and create cash reserves to replace the income of the breadwinner). In the event of the insured's death, many or all of these responsibilities can be resolved using the proceeds from the policy or policies. When the consumer has cash reserves large enough, they consider themselves to be "self insured". Insurance terms may be a number of years in length (1, 5, 10, 20, 25, 30, 35 years or more) which, in theory, should provide enough time for the insured to invest and eliminate these responsibilities. See Theory of Decreasing Responsibility
In the event these responsibilities are not eliminated at the end of the term, many insurers will allow the insured to renew their current policy (guaranteed renewal) or purchase a new policy (conversion) without being subject to the same medical and financial qualifications as a new applicant.
Those who believe in buying term insurance and investing the difference in premium between a term and permanent policy must intend to self insure, since the term policy will eventually expire or become too expensive. If they are not disciplined enough to invest, pay off their debts, or assist their dependents in becoming independent, they still have a need for insurance.
Immediate accumulation of investment money
With the concept of buying term instead of permanent insurance, more investment vehicles are available, all of which are independent of the insurance program and remain in control of the insured if the insurance portion is canceled. All cash accumulated is available based on the investment vehicle selected by the investor not the insurance company (granted the investment vehicle could be a sock drawer in which the cash is readily accessible but not growing).
Permanent or whole life insurance (life insurance that typically provides a death benefit for the lifetime of an insured person up to age 100) policies usually direct a portion of the premium payment to a sub-account within the policy, called cash value and the other portion to insurance. There are many different permanent life insurance products available with a range of options involving the cash value of the policy, including the ability to withdraw the cash value, borrow against it, and to allow it to be drawn on to pay the insurance portion without additional premium payments. Ultimately, all permanent life insurance policies are combination of term insurance with a savings vehicle. Insurers may break down a policy into 2 components, the term insurance portion (the net amount at risk) and the cash value (the guaranteed amount).
The cash value in the sub-account can accumulate over the life of the policy depending on the policy, however it is not always available for the first several years of the program.
Universal and Variable or Variable Universal policies typically have immediate accumulation in the sub-account, but these funds are not available for loans and are often subject to a surrender charges for the first several years of the program (in the case of plans paying a premium close to the minimum, this is frequently in excess of the accumulation).
Again, this approach requires discipline. As with budgeting, many consumers who reduce expenditures fail to invest the money saved, and simply allow it to be reabsorbed to become part of their monthly spending. An example is someone who quits smoking thinking of all the money they'll save. Looking at things a few years later, it is a rare occurrence for anyone to actually have a large amount of money in their special "non-smoking" investment account.
This practice leaves the insured open to utilize whatever investment options they see fit. Permanent programs require the policy holder to use only the investment options available through the policy. Neither Term nor Permanent life insurance death benefits are generally subject to Federal income tax. Death benefits are, however, potentially subject to Estate (Death) taxation, depending on how the ownership of the policy is structured. Cash value growth in permanent plans is tax-deferred as long as the policy is in force. If the policy is canceled (because the need for insurance is obviated) any accumulation in excess of the adjusted cost base (ACB) will be taxable. In most cases the only way to avoid these taxes is for the insured to die while the policy is in force (essentially making these monies unavailable to them). Premiums are most often paid with after tax money, though there are exceptions where the policy holder can use pretax money (as a business obligation in a corporation for example). Variable plans provide the insured the opportunity to choose the investments, though the investment vehicle is still within the life insurance plan.
To attain similar tax advantages, the insured may make investments through a tax deferred vehicle, such as an annuity, variable annuity, IRA, Roth IRA or even 529. Monies applied to a traditional IRA is pretax money while that applied to a Roth IRA are after tax. Both investment vehicles grow tax-deferred, similar to cash accumulation; however money withdrawn from a Roth are not taxed. 529s are educational accounts, and annuities are another form of life insurance account. (see http://www.irs.gov/pub/irs-pdf/p590.pdf http://www.irs.gov/retirement/article/0,,id=136868,00.html)
Each program has provisions for accessing monies invested early as does permanent insurance; however as a separate investment the term insurance death benefit is not impacted by accessing it.
Again this requires the implementer to research investments and how to best take advantage of them.
Return of Cash Accumulation
The greatest advantage of buy term invest the difference strategy is the return of cash accumulation. Each permanent program handles treatment of the cash value differently, but in the end the cash accumulation is always surrendered, even in return of premium policies or universal life plans that elect to pay the cash value option as well as the death benefit.
To illustrate this, consumers may review the loan provisions on their permanent policy. The cash accumulation could be drawn out of a permanent program as a loan, to be paid back with interest to the program. However, in the event of the insured's death, the death benefit is reduced by the amount of the loan. If the policy is cancelled, the loan is deducted from the cash value and the net paid to the insured.
Variable programs handle the accumulation in a separate investment owned by the insurance company. The investment is subject to surrender charges and is not available for loans early on. In the event the insured dies while the insurance policy is in force, the Insurance Company is the beneficiary of the investment. The Policy beneficiary receives a death benefit but they do not receive the investment. Some policies include a provision that states the beneficiary receives the investment, when in actuality they receive an additional death benefit distribution equal to the investment. There may or may not be tax due on the investment account depending on whether the investments are in a gain or loss position. If the insured dies when the policy is no longer in force, the beneficiary of the investment receives the value of the investment account, again after any applicable taxes, but no benefit from the insurance policy.
Some permanent insurance contracts offer "Plus Fund" or "Return of Premiums" as options for receiving the death benefit. In these plans, the initial amount is paid out, plus the cash accumulation or all premiums paid. In these programs that appear to pay out the cash accumulation, the insurance company, in essence, creates an additional policy. Premiums are generally higher for these types of policies than the pure death benefit provided by a pure term life insurance product.
Because of the increased premium at attained (then current) age, additional consideration should be given renewal or conversion of term insurance at the end of the original term. (In plain English review the renewal options to confirm renewal if required is not cost prohibitive). Also, purchasing annual renewable term insurance can add complexity to long-term investment strategies because premiums increase as the insured ages (so don't do this). To correctly implement this strategy term insurance with a Level premium should be used over an annual renewable source.
The Buy Term and Invest the Difference strategy will in most cases have the advantage for short planning horizons. While it may be advantageous for the knowing investor, the longer term benefit may be illusory, especially for smaller amounts or unsophisticated investors. Also, the theory relies heavily on the premise that a person's needs for insurance disappear before retirement age because the individual has become self-insured.
Factors weighing against the strategy may include:
- Investment returns are often exaggerated. The strategy is usually sold with a view to equity or growth fund investments, and often ignores the tax advantages of insurance. Comparing Life Insurance values with more risky investments sets up an "apples and bananas" comparison. A more accurate comparison would be to bonds, C.D.'s, or other "fixed dollar" instruments which correspond to the safety inherent in permanent life insurance. A prudent investment plan involves diversification and usually suggests some part of the portfolio be placed in conservative investments with a high degree of safety. The cash values of Permanent life insurance fits this function. Interest crediting rates on cash values have generally been much more favorable than banking in recent years, but obviously bank savings are more liquid.
- Failure to save or invest the difference between perm and term premiums. A substantial portion of insurance buyers will not be knowledgeable about, or have the discipline to save or invest the small amounts under consideration. An exception would be those with access to employer thrift or 401(k) options. Even so, many 401(k) participants find themselves taking loans against their account.
- Term Life is less secure, because failure to pay a premium will result in the lapse of the coverage. Changes in health may prevent reinstatement. Cash value insurance, on the other hand, is more durable and is often able to sustain itself over a period of temporary financial hardship without premium payments. Of course, this assumes the policy is seasoned and has overcome the front load. Most policies of this type will have "lapse-proof" features, such as automatic premium loan. Universal life policies will remain active until the cash account will no longer support the monthly term withdrawals.
- Changes in plans. Many investors assume their insurance needs will have become non-existent after 20 or 30 years, only to find themselves moving up to a larger home or some other unforeseen life event which will call for more insurance for an extended time. The most common 10 or 20 year term plans have very expensive renewal rates after the expiration of the original term period. Poor health may prevent taking out new life insurance.
- Loss of Employer Group benefits. Many individuals who have generous group life benefits are unaware that these almost always evaporate with the loss of employment or premature disability. Even those who reach retirement with adequate assets are often "uncomfortable" when they find themselves with no post-retirement life insurance.
- Early disability often spells financial disaster and the ruin of investment plans. Term plans are more vulnerable to loss, and Employer Group is usually lost in this scenario. Permanent life insurance with Disability Waiver of premium rider usually has the best chance to weather this storm, and may be the last line of defense.
The debate about term vs permanent insurance is endless. If it is true that "there is no best investment for everyone," the same is true with life insurance. Why should it be an "either/or" situation? Since financial risks are so varied and unforeseen, why not utilize a combination strategy? Buy a mix of Term and Permanent life, with term being the larger portion. Set aside a limited amount of low-interest money in the bank for emergency funds. Invest discretionary funds in your 401(k), and make aggressive choices here. The savings and life insurance cash values may eliminate the necessity of borrowing against the 401(k).
In this scenario, assume that your temporary needs (children's dependency, home mortgage) will be covered by low-premium term life. Perhaps you would allocate 3/4 of your insurance purchase to cover these needs, and 1/4 to longer range needs. Hedge your bet by adding Waiver of Premium for Disability to the insurance. Life insurance and savings are more vulnerable to inflation, whereas equity-heavy retirement accounts may offer the best hedge against loss of purchasing power.
- What's wrong with your life insurance, ISBN 0-02-529350-8.