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Financial Insights

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In Practice, This Theory Doesn't Work

30 November, 2015

In financial circles, perhaps no debate generates more heat than permanent life insurance (PLI) versus buying term and investing the difference (BTID). It may be more of a Coke-vs-Pepsi discussion for consumers, but experts can really get worked up. So when an Investment Newsarticle titled, “New Life Insurance Study Debunks ‘Buy Term, Invest the Difference’ ” was posted on July 28, 2015, the comments section was perhaps more interesting than the article. Here’s what it sounds like when insurance experts ‘trash talk’:

“Anyone that looks at this as a ‘study,’ and not a piece of marketing propaganda, is an absolute idiot.”
“If the public actually knew how powerful, specially-designed whole life insurance policies were, they wouldn't put their money in the market. The market is for suckers.”
“In an article on life insurance for the general public, there really should be no mention of permanent insurance. Regardless its claimed virtues, it is complicated and confusing and is one reason so many people don't get any life insurance at all.”
“Term and permanent life insurance are substitutes as much as milk and beer are.” 

Okaaayyy…passionate opinions, but probably not the basis for a reality show. However:

The article, referencing a study from David Babbel and Oliver Hahl published in the May 2015 issue of Journal of Financial Service Professionals, has some interesting observations, not so much about the two approaches, but about human behavior. Titled “Buy Term and Invest the Difference Revisited,” the article says that while BTID might be theoretically plausible, it doesn’t deliver in the real world. A little context:

The premium for a $1 million whole life policy on a healthy 45-year-old male non-smoker from a highly-rated carrier is about $20,000/yr. This premium is guaranteed to remain the same for one’s lifetime, and includes an accumulation component, i.e., the cash value.

In contrast, the premium for a $1 million 20-year level term policy for the same applicant is about $2,000/yr. In a BTID comparison, this leaves $18,000/yr. to be invested for 20 years to replace the insurance benefit that will terminate.

Historically, certain investment strategies have produced accumulations that exceed the actual performance of some whole life policies. But the results of any PLI/BTID comparison tend to hinge on the assumptions used. Rates of return, tax treatment, and length of time can all be manipulated to produce a favorable result – for either strategy. 

While either approach is theoretically valid, Babbel and Hahl’s research tends to say the real-world performance of a BTID approach doesn’t deliver. Babbel provides this succinct summary:

“People don’t buy term and invest the difference. They most likely rent the term, lapse it, and spend the difference. Our study sheds light on Wall Street guidance that has been taken as an article of faith, but that clearly underperforms for many who follow it.”     

Babbel’s pronouncements reflect two real-world challenges to the successful execution of BTID.

Practically, the desire to leave a lifetime financial legacy to a surviving spouse, children, or other beneficiaries is an expensive undertaking. In the example referenced earlier, the 45-year-old male, who we might assume has a stable career path and emotional motivation to provide for a family, has to allocate $20,000/yr. to provide a $1 million legacy. It might also be reasonable to assume he needs to save for retirement and would like to help with the college education of his children. It would take a sizable chunk of savings to adequately address each of these objectives. 

So no matter how it’s configured – as BTID or PLI – many Americans, especially early in their financial lives, don’t have the money for a fully-funded permanent insurance benefit. They buy term because they believe it’s all they can afford, given other savings objectives. And eventually, when the term gets too expensive, they let it go.

There are psychological hiccups in the BTID approach as well. When term is presented as a shortcut to a “cheaper” permanent life insurance benefit, the same thinking says it is possible to shortcut the accumulation process as well.

Remember, the principal argument for BTID is that the individual can achieve an equal or better return with the difference. Support for this belief involves a projection of future returns, and projections can be manipulated to meet objectives. So if you don’t have the difference to invest, just use a lower amount with a higher projected rate of return. Or assume you will “catch up” by increasing deposits in the later years. BTID permits the individual the illusion of believing they don’t have to invest the difference, just something, maybe, when they can. So they don’t.

In a whole life policy, the cash values represent the equity in an insurance benefit owned by the policyholder. Withdrawing or borrowing against this equity impacts the insurance benefit, both immediately and long term. Psychologically, every premium payment (which includes the part of the premium allocated to cash values) is part of the insurance benefit.

But with BTID, the insurance and accumulation are two distinct components, and tend not be seen as connected to one another. As one commenter put it, “My experience has been that no one actually invests the difference and leaves their hands off it until death.” 

The twist: BTID “successes” end up with PLI?

There are people who have the practical and psychological profile to make BTID work: diligent savers. People with good saving habits often have both the resources and motivation to establish and maintain a financial legacy in their financial program.

But ironically, these very same people may also often end up choosing permanent life insurance – not only because they can afford it, but because they value other benefits that are part of a whole life insurance policy, such as guarantees*, loan provisions, tax advantages, creditor protection, etc. Several commenters in the IN article referenced their experiences with older, wealthier individuals who decided to purchase permanent life insurance late in life; they understood the value, were healthy enough to be approved, and could afford it.

A practical starting point – for everyone

Too often for consumers, the BTID/PLI debate gets presented as an irrevocable, either-or decision, typically in one of their first encounters with a financial professional. But at the beginning of our financial journey, how many of us are truly able to make an informed decision about life insurance for the rest of our lives? At the same time, many younger households would suffer significant financial harm if a breadwinner died unexpectedly. Term or permanent, many households have an immediate need for life insurance.

Given these realities, a practical starting point is obtaining as much convertible term life insurance as possible. This provides financial protection today, as well as the option to incrementally transition to permanent life insurance at a later date, regardless of future health. As good savers come to realize the value of permanent life insurance, convertible term makes sure they can maximize this strategy. As your savings accumulate and perspectives mature, the option of transitioning to a permanent life insurance program could be a valuable legacy asset.   

Have you maximized your insurability with convertible term insurance?  

*All whole life insurance policy guarantees are subject to the timely payment of all required premiums and the claims paying ability of the issuing insurance company.