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Is “Buy Term and Invest The Difference” Really Better?

In this post I’m going to be discussing the concept of “Buy Term and Invest the Difference“. If you’ve been researching permanent Life Insurance you’ve likely found people who advocate for this approach. Financial pundits like Susie Orman and Dave Ramsey often tell their listeners to avoid buying permanent life insurance and buy term and investing the difference. You may have also heard it from many others.

Have you ever seen any of these pundits actually show you some supporting evidence? That’s what I intend to do in this article.

Goal 

The goal of this post is to simply and convincingly show you that a permanent Life Insurance Policy should generate more retirement income than “Investing the Difference”. If your goal is to protect your family and  create future Retirement Income, then a permanent Life Insurance policy, specifically an Indexed Universal Life, will likely be a better option. I’m going to provide some background information and then we will take a deep dive into the numbers.

The Keys to Understanding 

Before we dive in and start comparing the numbers, it will be helpful to make sure we’re all on the same page. In order to make a case for Life Insurance, I’ll use this outline:

  1. What is “Buy Term and Invest the Difference?”

I just want to briefly explain what people mean when they say “Buy Term and Invest the Difference”. I will also cover the assumptions I’m using in my comparison.

  1. Anatomy of a Permanent Life Insurance Policy

        Since not everyone understands the intricacies of a permanent Life Insurance policy, I also want to go over the basics of Life Insurance.[1]

  1. Retirement Income Comparison

  This will be a side-by-side comparison of the results of each approach with apples-to-apples inputs

What is “Buy Term and Invest the Difference?” 

The idea behind “Buy Term and Invest the Difference” is straightforward: advocates believe that an individual would be better off taking the savings between the cost of a term and permanent Life Insurance policy and investing it. This, supposedly, will result in more retirement income than a permanent Life Insurance policy.

The problem is that these advocates are incorrectly equating the cash value of a policy with the value of a separate investment account. They are not the same and I will elaborate as we continue.

Assumptions: 

I just want to briefly cover some of the assumptions that must be true for “Buy Term and Invest the Difference”.

  1. The interested party must be young. You should be aware that the price of term insurance increases as you get older. That means that when a term policy expires, it will be much more expensive to get a new one. Longer term policies are also much more expensive. The reason is that the risk of dying increases as the insured gets older.
  2. The interested party must not have any need for the Death Benefit in the future. Most term policies have a fixed term of 10, 20, or 30 years. Again, the cost of getting a new policy will be much more expensive at the end of the term. Many people find the cost of renewing a policy to be prohibitive.
  3. A presumption that an investment in “The Difference” is going to perform better than the Life Insurance policy’s Cash Value. But it is important to keep in mind that the markets go up and the markets go down. You will never know if you will have the money that you need at the time that you need it.
  4. Finally, there is a presumption that the interested party will actually set aside the difference into a savings account. Young couples often face competing requirements for resources. They may want to purchase a new house or begin having kids. Life has a way of using up the resources that you have at your disposal.

Anatomy of a Permanent Life Insurance Policy 

It would be helpful to begin by taking a look at the anatomy of a permanent Life Insurance policy. It is important to realize that in any permanent Life Insurance policy, the Cash Value is literally the Policy Owner saving up the Death Benefit for the insured over the insured’s natural life expectancy. The following graph shows the relationship between the Death Benefit and the Cash Value over time in a traditionally-designed Life Insurance policy.[2]

The Orange line at the top represents the Death Benefit of the policy. In this case it is $1 million for the life of the policy. The Blue line represents the growth of the Cash Value over time. You can see that the Cash Value ultimately bumps into the Death Benefit around the 113-year mark. The Insurance Company uses the Cash Value to reduce the risk over time.

Net Amount at Risk 

The gap between the Death Benefit and the Cash Value is known as the Net Amount at Risk. Recall that the Cash Value represents the Policy Owner saving up the Death Benefit. This means the Insurance Company could be on the hook for nearly the full $1 Million dollars if the insured were to die at age 46. But, on the other hand, if the insured died at age 79, the Insurance Company would only be on the hook for the remaining $500,000 of risk in the policy

The important question for us to address is “how does the Life Insurance company plan for the unexpected liability”? One thing that is important to point out is that Life Insurance companies only look at risk on an Annual basis. What I mean by that is, if you are a 45-year-old, you are put into a risk pool with all other 45-year-olds.[3] Actuarial tables are used to determine how many 45-year-olds will not make it to age 46.

What this means is that the Insurance Company must take cash from every policy each year and put it in a pool to cover the risk of paying the Death Benefit. This is known as the Cost of Insurance. The money that is pooled must be enough to cover all of the expected claims.

Is the Insurance Company Buying Term and Investing the Difference? 

I also want to stress that Term Insurance works the same way. While the premium may be level for 20 years, the Insurance Company is still pooling money each year to cover the Death Benefit claims for that year for that age group. The Cost of Insurance is the same for Term as for Permanent Life Insurance.[4]

One way to think of it is that the Insurance Company is purchasing a 1-year Term Life Insurance. Their goal is to cover the Net Amount at Risk. I should point out that a one-year term policy would function the same way. This means that the Insurance Company would take the entire premium and put it into a pool to cover the risk of the insured passing away during that year.

Does it sound like the Insurance Company is “buying term and investing the difference”? It should. It’s exactly the same process as “buy term and invest the difference”. The only difference is that it is a much more efficient process because the Insurance Company is only purchasing the exact amount of “Term” necessary to pay claims each year. The Cash Value is equivalent to the “Difference”. That savings reduces the net amount at risk.

Retirement Income Comparison

Now that I’ve established that inside a permanent Life Insurance policy, the Insurance Company is “Buying Term and Investing the Difference”, we need to ask “What are you going to do with “The Difference”?

What are you doing with the difference? 

Since you can’t take it with you when you die, I’m going to presume the primary reason for investing the difference is to create future retirement income. So let’s see which solution will provide more income when you retire.

Assumptions for the comparison

We are going to compare a brokerage account growing at an annual rate of 9% to a Life Insurance policy growing at only 6%. The brokerage account IS NOT taking market volatility into account. This means that it is simply a straight 9% year-over-year compounding return. Wouldn’t that be amazing? What is also amazing is that I am assuming that 100% of the contribution is going straight to the investment with no fees or commissions. I’m not even accounting for the cost of the term insurance. I’m throwing it in for free.

The Life Insurance policy is assuming only 6% annual growth rate. This is certainly a reasonable rate to use for projections. It is lower than the rates insurance companies are currently using for their illustrations.[5] You should also be aware that the premium is reduced by the amount of fees taken by the Insurance Company. The remainder is the Cash Value. It is important to know that the Cash Value is credited with interest/dividends based on the returns of the Insurance Company’s investments.[6]

Accumulation vs Income 

At this point it doesn’t even seem like a fair comparison does it? 9% vs 6%.

It’s not a trick question. It is important to realize that INCOME is what matters, not the amount of overall savings. As you keep reading, you’ll learn how the Life Insurance policy will still generate more income.

It’s important to understand that the Cash Value is not an “investment”. It is an integral part of a Life Insurance policy. Since its not an investment, it means that the Cash Value growth is not taxed.[7] This alone brings the two returns much closer together. But we still have the fees of the Life Insurance policy that are not shared by the brokerage account in this scenario. The fees in a maximum over-funded policy sum to approximately 15% of the premium.

The following table shows the calculations based on an annual contribution of $12,000:

The section to the left under the orange header is the Life Insurance. I am simply showing the growth of the Cash Value over time based on $12,000 per year of premium. You can see that the Cash Value is greater than 85% of the Premium[8] The Death Benefit is not shown. It will be different for every person based on their age, rating and the amount of premium.

The section to the right under the blue header shows the accumulation of a hypothetical brokerage account earning 9% annually. The column on the right shows the cumulative value.

Looking at the same data in a graph, we can clearly see that the brokerage account grows at a faster pace. The following graph highlights the difference in Accumulation:

The Blue line labeled “Status Quo” is the accumulation in the brokerage account. The Orange line shows the accumulation of the Cash Value. You can see that the brokerage account value is only slightly higher at a normal retirement age of 65 years.

How much income can we get from each? 

Unfortunately, this is where most financial advisors and financial pundits stop their analysis. They see that  the value of “Their” solution is higher, so they think their solution is superior. But as stated earlier, we need to look at Income. Income is what keeps the lights on and food on the table in retirement.

So let’s start comparing retirement income.  

Brokerage Account 

The common rule of thumb for determining the safe withdrawal rate from your retirement savings is the 4%-Rule.[9]  The idea behind the 4%-Rule is that you should be able to safely take up to 4% of the value of your portfolio each year without risking running out of money before you die.

For example, if you had a 401(k) with a $1M value at retirement, you should be able to safely take withdrawals of $40,000 for the rest of your life. The withdrawal rate takes the volatility of the market into account.

It’s also important to consider that distributions from an IRA or 401(k) are typically taxed at ordinary income tax rates. Just remember that the contributions were excluded from your income. Continuing our example from above, if your effective tax rate is 25%, you would write a check to the IRS for $10,000 and your net income would be only $30,000 per year.

Now that we know that you can only get $30,000 of annual income for every million dollars in a 401(k), let’s see what Life Insurance can do.

Maximum Over-funded IUL 

The most important thing that you need to know about Life Insurance is that you don’t actually take money OUT of your account to generate income. This means that you use policy loans to access your Cash Value for income. While that may seem a little crazy on first glance, It’s important to know that policy loans are loans AGAINST the Cash Value. This means they are much like a Home Equity Loan.

Policy Loans

It will be helpful to spend more time discussing policy loans. They are easy to understand when you compare them to a home equity loan. When you get a HELOC, the bank loans you money with your house as collateral. If you default on the loan, the bank will take your house to pay themselves back. Policy Loans are the same. It’s super important to realize that the Insurance Company is loaning you THEIR money with your Cash Value as collateral. This means that your Cash Value never leaves the policy and continues to be credited with interest or dividends. Everything functions as if you never took a loan.[10]

The loans you take for income will eventually be paid off by the Death Benefit of the policy. You will never make a payment. Instead, the Insurance company will loan you the money to pay themselves the interest. You should also realize that the loan balance will be growing and compounding. While that may seem a little intimidating, just remember that the Cash Value is growing and compounding simultaneously.

This may not be immediately intuitive. I had to build a spreadsheet to prove to myself just how a Life Insurance policy could generate so much income!

The 8%-Rule 

How much income? The rule of thumb for Life Insurance is more like 8%. And to make it even sweeter, remember that these are loans, not distributions. That means that the “income” is not taxable. A policy with a Million Dollars of Cash Value can be reasonably expected to sustain loans of $80,000 per year for the rest of your life. That is nearly 3-times the $30,000/year you can get from a 401(k) with $1,000,000!

Side by Side Income Comparison 

The following graph illustrates the advantage of a Life Insurance policy with an 8% income rate versus our hypothetical brokerage account using the 4%-Rule:

Unlike the earlier graph showing accumulation, this one is looking at the income each option can generate. I’ve simply multiplied the values in the Table above times 4% for the hypothetical brokerage account and by 8% for the Life Insurance policy. You can quickly and easily see that the Life Insurance Cash Value can generate substantially more retirement income.

The curves are showing the amount of retirement income that can be taken at various retirement ages. Turn your attention to where the Blue and Orange lines intersect with Age 65. You can see that this person could pull about $37,000 per year in loans from their Life Insurance policy. The hypothetical brokerage account, with more money in it, will generate a little less than $25,000.

The Life Insurance Retirement Plan can generate over 50% more income from the same $12,000 per year contributions.

Conclusion 

The bottom line is that a Buy Term and Invest the Difference approach IS NOT better than a maximum over-funded Life Insurance Policy. It’s important to realize that a maximum over-funded Life Insurance policy can generate about 2 to 3 times the retirement income as other solutions. The reason for this is that you are not taking money out of the policy when you take income. 100% of the Cash Value stays in the policy earning interest or dividend crediting.

Dollar for dollar, you’ll get more income from a properly-designed Life Insurance policy than traditional retirement planning vehicles.


[1] Download my “How Life Insurance Works” or “Life Insurance 101” papers for more background information.

[2] This design is a Traditionally-design policy with Death Benefit protection as the main goal. A Maximum Over-funded policy is what we would actually use for a Life Insurance Retirement Plan.

[3] Age isn’t the only category. Insurance company underwriters will assign a rating to every insured during the application process: Special Risk, Standard, Preferred, etc. They are further broken down by Gender and Tobacco usage. Everyone in one risk pool should be fairly homogeneous. Male, Preferred Non-tobacco, Age 45, for example.

[4] The cost of insurance is the same for Whole Life and Universal Life too. Both types of policies work the same under the hood.

[5] It is December, 2023 at the time of writing.

[6] You can think of the dividend or interest-crediting as the policyowner’s share of the Insurance Company’s reserve investments. It’s fair to think of it as the net return on the Cash Value, though there is a little more complexity to it.

[7] If you surrender a policy that where the Cash Value exceeds the premium contributions, that excess would be taxed at as a capital gain. But as long as the policy remains in force, the policy charges are the only fees hampering the Cash Value accumulation.

[8] It’s important to point out that illustrations include the 1st year dividend and interest crediting in the cash value. This is why the cash value is closer to 90%, not 85% as I stated.

[9] Don’t take my word for it. Google it!https://www.marketwatch.com/story/dont-rely-on-the-4-rule-for-your-retirement-2016-04-14

[10] Check out the language regarding policy loans in the Florida Statutes.

Clearly:

  1. Insurance Companies MUST make loans to Policy Owners secured by the Cash Value, and
  2. If the interest is not paid when due, the Insurance Company will loan you the money to pay themselves the interest.

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