Should you buy term and invest the difference?

How often do you hear the recommendation to "Buy Term and Invest the Difference" when the subject of permanent life insurance comes up? Should you accept this statement at face value? Or are you like me and you need to see some proof?

Here on BP, you'll see this nearly any time life insurance is mentioned in a post. But as with any forum, you don't know if the person offering advice has any knowledge of the subject matter.

Let's dive into this subject...

The Premise

The premise behind "Buy Term and Invest the Difference" is this:

If you purchase a 30-year term policy when you are young and invest the "difference" that you would have spent on a whole life policy premium, by the time that the term policy expires, your need for insurance will be reduced because your kids are grown up and your house is paid off. Your investment account is assumed to be greater than the cash value of a life insurance policy would have been because life insurance is such a rip-off.

This premise is based on numerous assumptions:

1. That you are young,

2. That your need for insurance will be lower in the future than now,

3. That the investment account will have grown to be more than the cash value of the policy,

And the biggest assumption of all...

4. That the individual will ACTUALLY SET ASIDE THE "DIFFERENCE" IN A SEPARATE SAVINGS ACCOUNT.

Permananet Life Insurance IS "Buying Term & Investing the Difference"

It is important to understand that the insurance company is already buying term and investing the difference. No, really. That is how a permanent life insurance policy works under the hood.

All permanent life insurance needs to be able to pay a claim some day. So how would you do that if you were the insurance company? Well, for starters, if I were an insurance company, I would want to ensure that the premiums are high enough that the policy owner will save up their own death benefit over their lifetime given an extremely conservative earning rate assumption (aka "The Guaranteed Rate").

I'd also want to purchase some sort of short "term" insurance that I would keep renewing each year just in case the policy owner dies early. As the amount of savings increases, the amount at risk will go down. And the better the savings does, the faster the risk is eliminated. The combination of both of these would ensure that I would have the ability to pay the claim whenever needed.

This is exactly what happens under the hood of every permanent life insurance policy: Whole Life or Universal Life/Indexed UL. The premiums are simply designed so that the policy owner saves up their own death benefit over their lifetimes. That is the cash value. The insurance companies invest the cash to take advantage of compounding growth over a very long time. They are investing the difference.

Please see my Blog Post "Life Insurance 101" for a more in-depth discussion of the inner workings of permanent life insurance.

So Which Is Better?

Well, since both solutions rely on buying term and investing the difference, which is better? Well, what is the problem we are trying to solve? What are you going to do with the difference that you have saved up?

I think it comes down to two primary things:

1. Death Benefit Protection when you are young and need it most. [Term]

2. Assets that can be used for Retirement Income [Difference]

Let's quickly address the first and then devote the rest of the paper to the second.

Both Term and Permanent Insurance will provide death benefit protection when you are young and need it most. Assuming, of course, that the need for death protection will be lower in the future... a debatable assumption.

But which solution will provide the most retirement income?

Retirement Income Comparison

The common belief is that life insurance is full of commissions and fees and is not a good "investment".

There are two big differences between simply buying term and investing the difference and buying a permanent life insurance policy.

The first is the tax benefit of the cash value of the life insurance.

The second benefit, that is almost universally misunderstood by agents and critics alike, is that you can get about 2 to 3 times the after tax income from the cash value of a life insurance policy that you can get from a typical brokerage account or IRA/401(k).

Tax Benefit

While a permanent life insurance policy is certainly hit with high upfront charges, the cash value within the policy accumulates tax-free. Money in a typical brokerage account will be hit with lower annual fees (but forever), taxes on the interest and dividends, and capital gains taxes on the increases in value. Money in a Roth is already taxed as are the premium dollars used for the life insurance policy. Money in a Roth also grows tax free, but the contributions are limited whereas life insurance has no limits. And you will not get nearly as much income from the Roth as you will from the cash value.

Assets in a Traditional IRA/401(k) will grow tax free, but you will pay ordinary income taxes on every dollar that is distributed.

Income Benefit

This is the beautiful thing about permanent insurance. And especially Indexed Universal Life (which I'll explain below). All 50 states in this country have language written into their insurance statutes that requires that life insurance companies make loans to their policy owners that are secured by the cash value of the policy. It doesn't state that the policy owners can borrow their own cash value. It states that they must make loans to the policy owner.

The way that a life insurance retirement plan works is this: you borrow against the policy's cash value to get tax free income. At the end of the year, when the interest is due, the insurance company, knowing that the collateral securing the loan also went up in value, loans you the money to pay themselves the interest and tacks it onto the loan balance. This continues year after year with the loan balance getting ever larger each year, but the loan balance is always secured by the offsetting increases in cash value.

When the policy owner dies, the death benefit (which includes the small term payout plus ALL of the cash value) first satisfies all of the policy loans and then the balance is paid to the beneficiary.

The magic is that the overall balance is not reduced as it is with every other type of retirement savings. When you remove money from a brokerage account, it is no longer there and no longer appreciating in value. That is not the case with loans against the cash value. 

THIS is the reason why you can get more income from a Life Insurance Retirement Plan.

The 4%-Rule

Look up the 4% Rule. Most financial advisors recommend not taking any more than 4% of your retirement saving each year as income. This reduces the risk that you will run out of money before you die.

So...

If you have $1 Million in a traditional IRA or 401(k), you can reasonably expect to take distributions of $40,000. BUT, that money hasn't been taxed yet. In the 25% tax bracket, the US Treasury will get $10,000 of that and you will net only $30,000.

If you have $1 Million in a Roth IRA, congratulations! You don't have any taxes to pay. Your annual income will be $40,000 per year. (The 4%-Rule)

If you have $1 Million of Cash Value, you can safely take about $80,000 per year in loans against your policy's cash value. That is damn near 3X the income from the traditional IRA and 2X the income from the Roth.

The following chart compares the income projections for a 40 year old client saving $12,000/yr to age 65. The Orange line shows the annual income available at any given retirement age. The growth rate on the cash value was assumed to be 6.38%, which matches the current published dividend rates for Penn Mutual and Mass Mutual Whole Life and is reasonable for any Indexed UL. The Blue line is based on a projected 9% growth assumption with a weighted average tax factor to account for taxes on interest and capital gains.

What this shows is the annual income the client could take if the client retired at that age. Retirement at age 65, for example, would allow retirement income of around $52,000 per year TAX-FREE from the cash value versus perhaps $30,000 of income from the brokerage account.

If that same client waited until age 70 to access the cash value of their policy, then the amount they could safely take each year would be about $75,000.

Here is what the accumulation looks like over time...

Yep. The brokerage account has more money in it at retirement age. So what? It may have a higher account balance, BUT you can still get more Income from the life insurance policy. You can take your quarterly account statement from your Brokerage to Starbucks and it won't buy you a cup of coffee.

Income is what matters.

You can't simply compare the cash value of a policy to the market value of a brokerage account. You must account for the income generating capacity of the assets.

The Indexed UL Advantage

In my Life Insurance 101 Blog Post, I showed how the cash value of an Indexed Universal Life is capable of capturing a portion of the "Equity premium", that is, the extent by which the return on the Equity Markets (Stocks) should exceed the return on the Debt Markets (Bonds and other Debt Instruments).

The cash value of a Whole Life or a true Univeral Life should be expected to match the Debt Market rate of return. A reasonable proxy for the Debt Market return is the Moody's Corporate Bond Index.

If you are borrowing against your cash value to create tax-free retirement income, the slight difference in returns means higher income from the Indexed UL.

Since lending rates are a function of the interest rates in the Debt Markets, we can reasonably expect that the policy loan rate on a Whole Life will be the same as the Dividend/Interest rate. In other words, policy loans, and the financed interest, will be EXACTLY offset by increases in the cash value that secures the loan.

For example, if you borrow $100,000 from the insurance company in the first year of retirement, there is also $100,000 of your cash value that is serving as the collateral for that loan. (Think of a lien on your house to secure a mortgage loan.)

At the end of the year, 5% interest is due on the loan. And, at the same time, the policy's cash value is credited with 5% interest. So the $100,000 that is securing the loan is now worth $105,000. The insurance company loans you $5,000 and tacks it onto your loan balance.

So now you have a loan balance of $105,000 and the cash value collateral is $105,000. The loan balance is exactly offset by the cash value securing it.

Now, consider what it looks like if the cash value earns 6% while the policy loan rate is 5%. THAT is the benefit of an Indexed Universal Life policy.

Note: Buyer beware - There are companies with policy loan rates set above the dividend/interest rate. The negative interest rate arbitrage consumes the cash value collateral and can cause the policy to eventually lapse because there is not enough collateral to secure all the loans.

Because the cash value growth exceeds the loan balance, the policy owner is able to get more retirement income from their policy.

Summary

The conventional wisdom that buying term and investing the difference is better than purchasing a permanent life insurance policy is simply wrong. Both solutions will provide death benefit protection, but a properly-designed, over-funded, permanent life insurance policy will more than likely provide much greater retirement income with less risk.