Is Buy term and invest the rest really the best plan?

June 1, 2018

The concept of term insurance really took hold in the United States in the 1970s after insurance broker AL Williams popularized the idea. A.L. Williams & Associates later became known as Primerica, and pitched the idea that you should cancel your old and expensive whole life insurance policy for newer and cheaper term life insurance. Primerica did this in a multi-level sales format which allowed them to grow exceptionally quickly by hiring thousands and eventually millions of every day folks as agents. Unfortunately, many of these individual sales representatives never had the training nor the experience necessary to properly analyze their client’s financial situations and give them a proper analysis of their life insurance needs. The agents were focused on selling a product. I have no problem with Primerica specifically, but this article attempts to look at the reality behind the “buy term and invest the difference” debate.

Is term insurance better than cash value insurance?

Term insurance is an extremely valuable tool in financial planning. With term insurance, you are purchasing insurance protection for a specified period. If you make no claims against the insurance, if you don’t die, then the insurance company keeps the premiums paid.

It’s the same as purchasing insurance on your automobile – if you don’t get into an accident in the next year, you don’t get those premiums back. So, the obvious negative to term is that the chance of receiving any benefit from it is extremely small. Why would you hand over perfectly good money to an insurance company knowing you are going to lose it?

The reality is, for each dollar of protection needed, term is much cheaper compared to the same amount of death benefit in a cash value insurance policy. (Take a look at my article on how much insurance you need). Let’s say you are a 35-year-old male with a young child. You would like to make sure, if you die prematurely, your child can at least get through college, so you decide to purchase $250,000 of life insurance protection, and you want fixed premiums for 20 years. The following graphic is based on real quotes provided by an A+ rated insurance company who has been around for over 50 years.

For a non-smoker in good health, you can see that the 20-year term is much cheaper on an annual basis compared to the cash value policy. $210 a year compared to $1,940 a year. Look at the cumulative premiums over 20 years, $4,200 for the term and $38,800 for the cash value. Why would anyone pay $34,600 more in premiums over a 20 years period? The answer is in the last column, the cash value policy has a surrender value of $39,830 in year 20, and that is at the insurance companies guaranteed interest rate. Assuming you don’t need insurance anymore, you can cash that value out and you have basically received a full refund of your whole premium. Additionally, with the cash value policy, you have the choice to continue the policy and your protection after the 20th year.

So, what’s better? It depends. If you can’t afford the extra premium per year, the decision is easy, get the term. The difference is like the decision to buy versus rent when choosing where to live. Rent is typically a little cheaper than payments on a mortgage, especially considering maintenance and upkeep of a home. Renting though gives you greater flexibility and less responsibility. What if the plumbing breaks? What if you want to move across town or across the world? The down side? Once you move out, you have nothing. Making the commitment to buy comes with responsibility and risk, but you build equity. I lived in the first home I ever bought for 8 years. I sold the property for $70,000 more than I bought it for, almost exactly what my cumulative after-tax mortgage payments were for those 8 years. Basically, I lived there for free. If I had been renting I would have simply made my landlord rich.

So why buy term?

By no means am I saying term is a bad thing. I have used term insurance when my children were younger because I wanted a large amount of protection for a small amount of money. Term is cheaper and when you need a lot of protection and don’t have a lot of money to spend, it can give you tremendous piece of mind knowing you are protecting your family.

So why buy cash value?

Projecting life’s needs decades in advance is a risky proposition by itself. Is it possible that you will still need insurance protection beyond the 20 years? Is it possible that, if that turns out to be the case, that you will no longer be able to qualify for life insurance due to some future health concern? Cash value policies are designed to continue for decades, many extend past age 100 with some modern policies extending through age 120.

The real benefit of buy term and invest the rest.

A.L. Williams didn’t say “buy term”. He said, “buy term and invest the rest”. In doing a proper comparison between term and cash value insurance, you need to remember the “invest the rest” portion of the statement.

Take the $210 annual premium term versus the $1,940 annual premium cash value example above. The buy term concept is valid if you are willing to annually invest the $1,720 difference between the two premiums consistently every year for the 20-year period. Look at the graphic below:

Investing the $1,730 difference in premium at 6% tax free will leave you with $67,457 at the end of the 20th year. This is where “buy term and invest the rest” comes from. You’re going to lose the $4,200 (total term premiums), but your net portfolio is still $ 63,257.42 ($67,457 – $4,200). That’s a lot better than just a refund of your own money and while we’ve ignored investment fees, it is still most likely better than the cash account of a permanent life insurance policy since life insurance investment accounts tend to have much higher fees compared to mutual funds or other investment alternatives.

From a cash growth perspective, the one benefit a cash value policy has is with taxes. Cash values can be accessed through the policies loan provision giving you a true tax free return. The only viable alternative would be a Roth IRA but it would not be liquid at age 55 and there are limitations as to the amounts and timing of contributions.

Additionally, in the current investment environment, 6% may be optimistic, but certainly possible. Just remember there are risks associated with using this type of strategy.

Here’s the bottom line.

There’s nothing wrong with using cheap term insurance to cover a temporary need. The premiums are typically so low, that you can afford the eventual loss in premium for the protection.

Buy term and invest the rest can make a lot of sense if you have the extra money to invest. Avoid companies that try to package buy term and invest the rest into one premium. It’s too easy to hide high fees. Do your homework and get a minimum of 3 quotes from highly rated term insurance companies, and then choose the correct investment for your situation for the invest the rest portion.

Additionally, term insurance should always be purchased from a company that also has descent rates on cash value life insurance. The reason is, most term insurance is convertible without proof of insurability. What happens if, in the 20th year, you contract a terminal illness and you are given only a year to live? Yes, it happened to someone I know. With convertibility, you can purchase a permanent policy without taking a physical. Your premiums will be based on your new 20-year higher age, but you’ll be able to keep your insurance for a little longer. It is a small thing, and you probably won’t convert, but it’s nice to know you can if your life situation changes.