Insurance Tip #8: Buying term insurance and investing the difference may be a dumb move
Filed under: Insurance, Investing
This post is part of a series where personal finance expert Dan Solin provides 10 insurance tips no one else will tell you. See all 10, plus one bonus tip!I agree with the traditional advice that term insurance is appropriate for most people. It is relatively inexpensive if purchased at a young age. It's simple to understand and it makes it easy for most people to obtain enough coverage to protect their families in the event the primary breadwinner dies prematurely.
Insurance that builds cash value (often called "permanent" insurance) comes in a dizzying array of options. There is whole life insurance, adjustable life, universal life and variants of each of those policies.
So why not just "buy term and invest the difference" in the cost between term and the higher cost of cash value insurance?
The primary reason is that few people have the discipline to invest the difference. Most likely, this money will be spent just staying afloat.
Even if you do "invest the difference," how will you do it? The data indicates that Americans are terrible investors. The projections that are so casually tossed around usually assume that your investments will achieve at least market returns. The reality is that the average stock investor earns around one-third of market returns. When you consider inflation and taxes, these investors lose money! This is one of the big secrets of the securities industry. Market returns are yours for the taking, but they don't want you to know how easy it is to do it. Hint: It does not involve using their services.
If you are in it for the long haul, buying term and investing the difference can be a dumb move for many reasons.
Cash-value insurance (as long as it remains in force) means that your loved ones will receive a death benefit. With term insurance, it is likely that the policy will not be in force when death occurs.
Because the earnings within the cash-value policy are tax-deferred (and potentially tax-free if held until death), you may have to take additional risk with your investments in order to match the long-term performance of high-quality cash-value insurance.
With a permanent policy, you can borrow against the cash value. You may not even have to pay off the loan. The amount of the loan plus accrued interest will be deducted from the death benefit.
Some financial advisors believe that it is prudent to consider cash-value insurance as a substitute for that portion of your investment portfolio that should be allocated to liquid investments, like bonds. However, since this advice may result in lower assets under management (and fees) to them, they often do not objectively consider the benefits of cash-value insurance.
Finally, permanent insurance has major estate planning benefits, since policies on your life, owned by your beneficiaries, may not be subject to estate tax.
There is no "one size fits all" when it comes to insurance. However, buying term and investing the difference is not the "no brainer" it is often made out to be.
See 10 more insurance tips from Dan.
Dan Solin is the author of The Smartest Investment Book You'll Ever Read (Perigee Books, 2006) and The Smartest 401(k) Book You'll Ever Read (Perigee Books, 2008).
Reader Comments (Page 1 of 1)
9-07-2008 @ 11:27PM
Bert said...
A little education will go a long way. In regards to saying that "buying term and investing the difference" is a dumb move, well Mr. Solin, I think you are wrong. Investing, or better yet, spending your hard earned money on a cash value policy is the biggest mistake that any American make. First, yes, term insurance is by far cheaper than a whole life policy. Second, even if the "investor earns [only] one-third of market returns", investing in a cash value policy will only yield between 3% to 5%. Third, yes, you "can borrow against the cash value policy", but when you do, you are assessed a fee of 5% to 8%, a fee that is greater than the actual earnings. And if you fail to "pay off the loan"(a loan on your money), plus interest and any other fee's associated with said loan, this will all be deducted from the death benefit. So, the beneficiary gets the face value minus the "loan". Fourth, Mr. Solin fails to mention that borrowing against the cash value policy can legaly take up to six months to be paid out. Fifth, when a cash value policy matures, the beneficiary will NOT receive both the death benefit and cash value total. You get only the greater of the two, which in most cases is the death benefit. Compared to a term policy, a cash value policy is very expensive and owning one does not make sense. It makes sense to buy a term policy and invest the difference in an investment vehicle that will benefit you directly.
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9-08-2008 @ 3:34AM
Abraham said...
Contrary to Bert and Paul, I strongly agree with Mr. Solis. Buying term insurance and investing the difference is really a dumb move and Bert is the one that need a little education. First of all buying term is NOT cheaper than buying whole life when you consider the long term cost associated with both products. A 35 years old with a 30 years term policy policy will loose all the premium paid into the policy if he or she didn't die at age 65. Along with the lost premium dollars is lost opportunity cost for that premiums dollars - $1,000 per year on 30 years term premium equals $69,761 in lost wealth assuming modest rate of return of 5%. With whole life policy for the same 30 years period (though you pay much more than term) you will have the opportunity to take your modest guaranty 3 to 5% or more rate of return depending on the insurance company. At the end, you have GUARANTY RETURN & NO COST transaction compare to term insurance where you have no living option and you loose all the premium dollars. So on the long run whole life is far more cheaper than term. Second, after tax return of 3% to 5% with virtually no risk in today economic will be a prudent investment for those of us that are conservative. Third, that loan not paid will be deducted from your death benefit. I look at it as another way to enjoy your death benefit while you are alive. Fourth, that borrowing against your cash value legally takes six month to be paid out. I don't know what company Bert was referring to, you can borrow up to 100% of you cash value with most insurance company out there and you will get your check in mail within 3 to 5 business days with no paper work. Again, when it comes to buying whole life insurance, the choice of insurance company is very important. Mutually owned companies should be a preferred choice. Fifth, Bert, when the whole life policy matures like you said, you have the option of taking all your cash value with it modest return and surrender the policy or keep the higher death benefit in your estate for your beneficiaries. Finally to Bert and Paul, diversification is the key here, certain part of your financial portfolio should be in permanent life insurance with highly rated mutual insurance company. For further education Bert and Paul, you will be amazed how many billions of dollars worth of whole life insurance policies your banks and other financial institutions buys annually on their CEO and other executives. They know the value. You should try and find out. Again Mr. Solis couldn't be more right.
9-08-2008 @ 1:41AM
Paul said...
I strongly disagree with Mr. Solin, buying term insurance and investing the difference is the better move in all cases. The reasons posted in comments by Bert I will agree with and couldn't say it any better. A good financial planner should advise clients to take term insurance and an IRA or an annuity plan to invest the difference at the same time. No money will be left afloat. These kinds of investments may also have major estate planning benefits also.
Finally I don't know why someone would want to invest their "hard earned money" in an insurance policy for the long haul.One should keep it separate and simple. You have more benefits and more control of the two.
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9-08-2008 @ 7:18AM
Peg said...
Selling whole life as a savings vehicle is ILLEGAL folks... Mr Solin has neglected to tell you that.
Also, look for a representitive that will tell you that. Why should you pay higher premiums for whole life when you can get term invest the difference in a market that histoically has been anywhere from 8 - 14% over the past 80 years. Whole life make insurance companies the most money. Sure ... they'll give you the pittance return if you surrender the policy.. but where do you think they have put that money while they are giving you that rate???? They are investing in the market and making a killing on your buck.. when you could have done that through a reputable financial advisor who knows about both! I am sorry.. the author has much to learn.. and to Abraham .. you sound like a true "whole" life agent. YOu insult the average American with your comments that they are not good at investing.. I wonder why? Could it be all the lies that have been told to them by whole life reps? Find someone you know and trust.. ask a friend... but.. be your own advocate in all things.
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9-08-2008 @ 12:04PM
TRO said...
Well Mr. Abraham, to the average person who doesn't know the difference between term life and whole life your argument may seem like the wiser choice. But to a person who knows a thing or two about life insurance, well, that choice will never be in my playbook. Some of the most prominent financial advisors, ie., Suzy Ormon, and Clark Howard, would also agree with me. Mr. Abraham, the reason that we purchase life insurance is to, in the event of a tragedy, supply our immediate family, ie., significant other and minor children, with a means of providing for themselves and paying the bills after our unexpected departure. Consider this: A thirty year old who is married with a home and children should, at the most, purchase a policy that will pay off the house and current bills and supply income for children till they mature. Anything else is great, but uneccessary. The children of the average homeowner will be adults by the time the house is paid off and therefore eliminating the need for these now adult children to rely on a parents death benefit. Now, if this same 30 year old had purchased a 30 year term policy and invested the difference in the market, well, by the time the policy expires, he would have a pretty penny to personally benefit from at retirement considering the 8% to 14% return that Mrs. Peg wrote of. Furthermore, how many Americans actually live to see 100 years of age? With a whole life policy, "IF", if you live to see the age of 100 it is the only time that you can personally benefit from the policy. Oh, one last thing, if I where the owner of a billion dollar a year company, I too would purchase a huge policy on my key employees. Why, because these "key" employees are the reason the company is prospering and in the event that they pass, their loss won't that much of a financial loss to the company. And because, long after they have gone, my company will continue to benefit from the policy.
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9-08-2008 @ 10:41PM
Billy said...
TRO, please tell me you did not reference Suzy Orman. The women that speaks to people that are squeezed by credit cards and then asks them to purchase her financial tools on a credit card, but this is not a discussion about Suzy Orman. Buy owning a permanent insurance policy, you the owner will be able to spend 15-30% more money over your lifetime. Also, topics that have not been discussed, if the owner of a permanent policy becomes disabbled, if designed properly, will have disability protection. If I buy term and invest the difference, I can assure you that my term policy will be covered with the disability provision, as for investing the difference, that will immediately stop even with a strong income protection policy. You spoke about corporations owning permanent policies. Not many Key persons to a company stick around for more than 30 years, why not just own a huge term policy. Corporations recognize that permanent insurance is the best option, hence why they do not own term.
9-09-2008 @ 6:21AM
WBuffet said...
It seems that most of you did not read the entire article.
Let's be clear: For some, buy term and invest the difference is the best choice because they are knowledgable/disciplined enough to actually invest the difference. For some, buy some form of whole life is the best choice because they are either not disciplined enough to invest the difference OR do not have the knowledge/desire to seek a professional advisor. The truth is; folks who are wise enough to buy term and invest the difference don't usually need to be told that, that is the best plan. For the ones that need to be told, they usually buy term and blow the difference. An honest and competent Life Insurance/Investment Advisor should help each client determine which is best for them. If you made a blanket statement as in, ALL, ALWAYS, etc, you are not a professional. Each clients needs must be evaluated individually. There is no blanket statement that works for 100% of the people 100% of the time.
I tell my clients that Buy Term and invest the difference is a philosophy that I agree with PROVIDED that they actually invest the difference. I also tell them that if they are not disciplined enough to commit to investing the difference, that they should probably at least consider a blend of the two. I like to make sure that a Final Expense policy of say $50,000 is in place, then fill in the gap with term. If they don't "invest the difference" down the road, at least their families have enough to bury them.
If they choose the Invest the difference option, I usually set them up immediately with a couple of high quality Mutual Funds on Bank Draft.
Stop being so one sided and arrogant about your philosophy and just do what is best for your clients. Most people want a valid strategy, not to be forced into your narrow opinion.
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9-10-2008 @ 5:43PM
Craig said...
For all of you who think cash value insurance is perfect for the "undisciplined" I have two words for you...MONTHLY DRAFT! The most undiscipline person could let 50 bucks be drafted their check or saving account go to an IRA or even a money market account if they needed immediate access to money. Any dope could do that. And once your borrow 100% of the cash value...YOU HAVE TO SURRENDER THE POLICY AND THERE IS NO DEATH BENEFIT ONCE ALL OF THE CASH VALUE HAS BEEN WITHDRAWN. Try reading a cash value policy or take it from some one who actually had that crap!
9-09-2008 @ 9:34PM
justsaying said...
What I usually recommend for my clients is for them to buy the longest term product they can afford that gives them the most coverage baed on our needs assessment profile. Then we will get them into an annuity or mutual fund program that allows them to have the funds taken from their account, along with the insurance premium. This way, they still get the best usage of their money and they get BOTH the savings and the LIFE insurance, contrary to a whole life policy where the cash vakue that you pay extra for is also a part of the face value of the policy. Don't believe me? How many checks do your survivors get when the loved ones die? Is it larger than the face value or equal to the face value? What happened to the cash value?
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9-11-2008 @ 12:41AM
Dave said...
Buy term and invest the difference is a great plan but can you do me just one little favor....
DIE ON TIME!!!!
Because if you die when the market is down and your past 80 years old I would hate to be the person to tell your family they need to chip in for the plain wood coffin
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9-17-2008 @ 10:56AM
Mixer said...
Tell me folks, what is wrong with earning 3-5% when my portfolio is down 25% for the year 2008?
Most life insurance policies mature at age 99. If you live that long without disability, I'd say you did pretty darn good regardless. I see that argument against whole life as worthless.
You can get a loan check in 3-5 days, not 6 months. Don't know where that came from.
No one is saying sink 100% of your portfolio into whole life insurance, but I believe it is part of a diverse portfolio.
Although these insurance companies are investing your money and possibly making more money, you should realize that WE as the individual investor are the ones getting screwed while the big money guys are making money on the way up or the way down.
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