Why you should not “Buy Term and Invest the Difference” [guest post]

Disclosure: I recently wrote an article titled, 3 Reasons whole life insurance is not better than term life, in which I referenced an ongoing debate with a family friend. He has written a rebuttal argument for whole life insurance. While Rabbit Funds does not endorse the material presented in this article, I am happy to present it in order to be fair.

Buy term and invest the difference is a very popular piece of financial advice, but is it really a good idea? Here are a few things you should consider before practicing this strategy.

#1 It sounds good now, but how about later when it really matters?

Over half of all new permanent universal life policies are sold to people over age 65. Why? Well it depends on the situation, but there are some very compelling reasons to have life insurance in force for your entire life. One of the most frequent comments from older clients, even the very wealthy, is something to the effect of “I wish I’d done this when I was younger”.

#2 What do the pros say?

I’m not sure how “buy term and invest the difference” got so popular: I don’t know a single financial advisor that recommends this as a long term strategy to clients, and I work with a lot of them (the fee based kind that charge $15,000 for a financial plan, not the college kids that drop out after 3 months). And in discussing the issue with them, not a single one of them knew any advisors that advocated this idea either.You don’t often hear these advisors publically speaking out against it though, because they can’t. There are heavy restrictions on the ways advisors communicate financial advice. If an individual follows an advisors ideas and something goes wrong, that advisor can be sued and lose a license and/or job. As a result, very few advisors will publicly give out information, but instead will only deal with clients face to face. So if you are hearing financial ideas on the radio or web, it’s almost a guarantee that the ideas are someone’s opinion, someone who is not legally licensed to provide financial advice. In other words, not an expert. The person may have some great ideas, but they are not liable for anything they say. An advisor though, is on the hook and can be sued for every piece of advice he or she gives.

#3 It has nothing to do with commissions

In fact, most advisors would rather have the money go to investments, at least from a commission standpoint. In the long run investments pay significantly more in commissions than life insurance. And term insurance pays higher commission percentages.

#4 You don’t know when you’ll die

What if you can’t save enough money before your term policy expires? Once the initial term expires, prices can skyrocket and there is no guarantee you will qualify for a new policy. Even if you do, the price is likely to be around 7 times more expensive than the first policy. If you continue to pay your original policy, it will take about 5 years for the price to increase 10 fold. Another 10 years later and it will have increased by another factor of 10. Can you afford that?

#5 It’s a long term strategy in a short term time

The buy term and invest the difference strategy potentially forces you to live with the decision for the rest of your life, especially if you become uninsurable. Do you want to lock yourself into a financial strategy at an early age, not knowing what the future holds?

#6 Average vs. Actual

Many people focus way too much on the average return. If you have  $1,000 and get a 100% return in year 1, you have $2,000. If you have a 50% loss in year 2, you are back to your original $1,000, but you earned an average return of 25%. See the difference? Even though a fund may get an average return that looks good, the actual return will be worth roughly 60-70% of that.

#7 12% returns, are you kidding?

The notion that you easily get a 12% return out of the market, which is purported by many “buy term and invest the difference” guru’s like Dave Ramsey, is utterly false and should be criminal. From 1930-1979, the market averaged .22% each year. Yes, .22%. From 1980-1999 the average was about 12.7%. The last decade has been around 3%. Meaning the long term average is around 6%.

#8 Taxes

Roth 401k’s are relatively new and still rare. Most money is accumulated in taxable 401k’s. This means that if you have $1 million and are in a 25% tax bracket, Uncle Sam is entitled to $250,000 of that sooner or later. Right now, we are seeing some of the lowest taxes ever. But with the government spending money at the current rate, taxes aren’t likely to remain low. Factor in taxes of 33%, which is likely to be conservative, and all of a sudden, your actual return loses 1/3 of its value and is now down to 4%. That’s worse than many permanent life insurance policies.

A Real Life Example: I compared the actual cash value in a whole life policy for a top company to what would have happened had the same dollars been invested in the Dow Jones. The time period was 1981-2010. Keep in mind that this was the best 30 year period the market has seen. The results: cash value, a tax free $718,000 guaranteed not to lose value. The investment account: a taxable $1,050,000. Factor in taxes and those numbers aren’t too far off. Now I’m not saying you should invest all your money into a life insurance policy, but to ignore it as a resource would be a mistake.

#9 Emotions get in the way

The markets go up and down every day. Pulling out of the market because you’re afraid of losing money is too common. And it costs investors a lot in potential gains.

#10 The pitch is sexy, but…

Getting completely out of debt is a great goal, and self insuring sounds pretty appealing. But very few people have the financial discipline to do so. Not always because they are careless, but because life gets in the way of our plans. Is your life just like you pictured it 5 years ago? 10? How about 40 years from now?

#11 Money isn’t Math, and Math isn’t Money

Only 1 in 400 people retire with over $1,000,000. The worst part though is this: the average American salary is $45,000 per year. A typical employer 401k will put in 3% when you do 5%. A normal work-life span is around 45 years. This means that an average salary with a typical 401k plan and normal work-life expectancy will yield almost $1.4 million at 8% interest. Yet somehow only 1 in 400 can hit $1 million. Why? Real life gets in the way of the plans we make on paper.

#12 The death benefit itself

Unnecessary in the eyes of the self-insurance guru’s. But what if you are wealthy and have an estate tax due? Worst case scenario, a 401k could lose as much as 70-80% of its value in various taxes before the heirs get it, while a death benefit is less susceptible to this issue.

#13 Estate equalization

Few people have significant liquid wealth; it’s usually tied up in properties, homes, or businesses. What if you have a valuable asset to pass on to multiple heirs? What if one wants to keep and run the family business while the others want it sold to get their share? What if one wants to keep the family home but the rest demand it’s sold? This leads to fire sales and destroyed family relationships that could have been spared with some liquid cash from permanent life insurance.

#14 You want to spend your money

If you opted for buy term and invest the difference, you probably broke the number one rule of investing: diversification. You probably have all of your money in the market inside a 401k. If the market tanks, you are toast. For every $1 million you have saved, you can spend about $30,000 per year if you are living off the interest. Which you will have to do since it is the only bucket of money you have to pull from. Worse though, is that your money has to stay exposed to the market to keep up with the demands placed on it. This money has to provide an income, keep up with inflation, pay taxes, buy your next car, fund your vacations and on and on. All of a sudden this $1 million isn’t doing much for you because you don’t know how long the money has to last. Now you have a mediocre retirement income and are constantly worried about the market while you are retired.

#15 You want to enjoy your retirement

Here’s a retirement strategy that, fully explained and professionally executed, is worth several thousand dollars in fees. You want several different buckets of money to pull from in retirement – you want to be diversified. Having a Roth and a 401k is not diversification. If the market tanks you are out a lot of money. You want these buckets yes, but you want some locations to pull from that are not susceptible to the market losses. The only financial product I’m aware of that provides guaranteed growth every year, as well as guaranteed principle, is whole life insurance. At a 5-6%return or so, once paid up, the right kind of whole life policy can be a vital tool in your retirement plan. It is likely to out-perform even your investments in retirement.

Another Real Life Example: From 1973-1987, the S&P averaged almost 11.3%. If you had a $2 million nest egg and pulled $150,000 per year for 15 years starting in 1973, by the time 1987 rolls around you would be down to $900,000 because of average vs. actual returns.However, if you had a backup fund that was not tied to the market and, following down years, pulled money from your backup fund instead of your investments, you would have $3.35 million instead of $900,000. There are several retirement strategies that will allow an individual to spend a considerable amount more money in retirement and be less exposed to market risk. Permanent life insurance is a vital component of these strategies.

Conclusion

“Buy term and invest the difference” is a strategy that is widely known, but little understood. Those promoting it are typically good intentioned, but not dealing with individual financial situations. Instead they are promoting good, one size fits all philosophies, but not dealing with the intricacies of real life. In other words, the recommendations sound good on paper, but complex life situations get in the way sometimes.

On the other hand, a good, professional financial advisor deals with the what-if’s in life, creates a plan for them, and often understands complexities that would otherwise be overlooked. So before you make any financial decisions that could impact you for the rest of your life, do your homework, understand the issues, educate yourself, and talk to a few different professional advisors. In the end, the time you spend now could be worth millions later.