Buy Term and Invest the Difference?

Comments from me, Tony Kendzior: For many years, my primary income resulted from my license to sell life insurance, health insurance and annuities in the State of Florida. But like so much over these many years, the markets changed, the rules changed, the perception of need by consumers changed. And then came the internet.

One change that led to the headline of this article was driven by the fabulous return on investments during the years from 1987-2000. Roughly 93% of every trading day saw a positive result. Which meant that putting lots of money into a permanent life insurance policy was dumb, since you could buy term, invest the difference and come out way ahead.

Until you couldn’t. Which is what folks are facing now. My children now own the life insurance policy on my life that is essentially a term to age 120 policy. A level premium, very little cash value, but my family will get a payday to offset the fact that my savings got decimated during the 2008-2009 crash. Unless I live past 120 which means all bets are off.

by Jeff Reed on March 27, 2014

In the last year, one of the major tenets of financial planning came under fire. Studies uncovered that the 4 percent withdrawal rule for retirement may not be sustainable. As significant as that news is, perhaps the more important part of the exercise is questioning the conventional wisdom in the first place. That process leads to any number of other tried and true “rules” of financial planning that could also come into question, and maybe even be exposed as unreliable.

One that was in the news recently was the concept of “buy term and invest the difference.” This long-held belief by many CPAs and CFPs may be crumbling as retirement age is pushed further and further out for many individuals, and their term insurance expires while they still have an earned income to protect.

Truly, the Achilles heel of the strategy has always been, “What if things don’t go according to plan?” In this article, I try to answer that question.

It’s about risk management, not cash value

The historical battle lines of this issue have had the life insurance professional recommending permanent insurance on one side and the CPA or CFP recommending term insurance on the other. One of the major elements of the insurance professional’s argument has been the presence of cash value to offset premium or provide an income. But what if that is really the wrong battle? What if the real issue comes down to providing coverage with a finite termination point to cover a risk that has proven to have a duration of unknown length?

That’s really a square peg being driven into a round hole. If a more effective strategy is to match the risk profile with the right risk management tool, then we need to look at the problem completely differently. We need a risk management tool that has the ability to extend its useful life if we need it to, and at a price that is reasonable. The reality is that the best-suited product for this risk may not be term insurance. It’s simply too rigid.

The problem with averages

This issue comes up time and time again in our business. Put frankly, averages create a false sense of security. In 2013, according to Gallup’s annual Economy and Personal Finance survey, the average retirement age rose to 61, up from 57 back in 1993. Seems like a reasonable rate of increase, and today’s 45-year-old could expect, on average, to retire at age 65. The issue, however, is that means that 50 percent of current retirees, more or less, were over age 61 when they retired — some of them probably quite a bit older.

A portion of that 50 percent almost assuredly had to make some tough decisions about their life insurance coverage as they aged, particularly if their contract reached its natural expiry. So, too, will the cohort turning age 65, 20 years from now if they need to push their retirement age out beyond the norm.

Underwriting class drift

The obvious solution is to buy a new term insurance contract. Unfortunately, we all know that our clients’ health changes as they age. That exacerbates the problem with term insurance as an income protector, as just when these clients may need to make a new insurance purchase, their health may put the price out of reach, or they may not be able to qualify. How real is this issue? We pulled some data from one of our insurance companies about the changes in underwriting results as clients age.

The trend is obvious, with the percentage of applicants approved at standard rates increasing by 25 percent from age 40 to 65. This only represents applicants approved at standard or better, and there are almost assuredly a significant percentage of declines as well as clients who simply do not apply, knowing that they either can’t afford or can’t qualify for new insurance. The assumption that the client will be in the same health as they were at the time of their original underwriting and that today’s products are indicative of pricing that will be available 10, 20 or even 30 years from now is simply not realistic.

Based on the above, that is not a bet I would take, nor would most informed clients.

What’s the alternative?

This is the real question: Is there a life insurance product out there that matches this risk profile more closely than term insurance? Yes, there is, and it turns out that everybody may have been wrong about this one.

The issues with term insurance have been explored above, but what about the cash-value life insurance side of the argument? The accumulation solution works, but only if the client has the income to fund it. Logically then, it would follow that the people who successfully execute on that strategy are also likely to be retiring at or before the average retirement age. Where this issue really rears its ugly head is within a standard deviation or two of the mean, where retirement is much less secure. These clients are likely to have issues over-funding a policy on a consistent basis, or may have started to save for retirement at too-late an age to really utilize the income-generating potential of a life insurance contract. Whatever the reason, this group’s retirement is much less certain than their peers. And these people at the fat part of the bell curve need a different solution.

What they need is efficiently priced coverage that has flexible premiums and does not have a set expiration date, which sounds an awful lot like some of the efficient, low-cost insurance products discussed in previous posts. So much so, in fact, that we took a look at how that might play out by comparing the cost of term insurance versus permanent insurance utilizing low-cost permanent products that are not used to accumulate cash. Rather, they’re used to effectively match the risk we’re attempting to insure by eliminating the set expiration date of term insurance.