A Realistic View of Buy-Term-and-Invest-the-Difference

A longstanding debate is whether consumers are better off with whole life or with term insurance and investing the difference. There are many ways to analyze this, but in my experience, the analyses are often too academic and fail to recognize how someone would actually navigate this situation.

So let’s take a look at a realistic scenario and see how it shakes out.

Ground Rules and Assumptions

1. We focused solely on a 35-year-old best class non-smoking male for the sake of demonstration. We assumed that the individual had an initial $1 million death benefit need and no death benefit need after age 65.

2. We assumed that this individual would in fact “invest the difference” of the whole life and term premium each year.

3. For the $1 million whole life policy, we set the premium at a whole life level ($14,201) but blended the policy to reduce agent compensation and make it more accumulation-efficient. We could have tilted the scales even more in favor of the whole life policy by increasing the premiums close to the Modified Endowment Contract limit, but elected not to do that as someone choosing between these options may not be willing to fund even more into a whole life policy. This results in a whole life policy that is illustrated to be level for the first 26 years and then begins climbing due to the cash value growth. After 30 years, we contractually eliminated the premiums by taking the policy to reduced paid-up status.

4. We used a whole life policy from a top mutual company, and we set the dividend interest rate to 5%. When you factor in that such a company invests a portion of its portfolio in risky assets but also is subject to investment expenses and tax/surplus charges, it’s fair to say that a 5% dividend interest rate is roughly consistent with a world where gross bond performance is around 5%. Said another way, if the bond world is returning 5%, there is a very good chance that major mutual life insurers will be able to support at least a 5% dividend interest rate.

5. For term insurance, we used a tiered approach with two “cheap” $500,000 policies - no bells and whistles and from a cheap term carrier. One policy was fully guaranteed for 20 years with premiums of $235 annually, and one policy was guaranteed for 30 years with premiums of $400 annually. In total, this provides $1 million of death benefit protection for the first 20 years, $500,000 of death benefit protection in years 21-30, and no protection after age 65. Keep in mind that upon death, the term scenario will also have the after-tax side fund available as a quasi-death benefit.

6. We assumed that the consumer would want to pull money out of the policy in retirement. We solved for the max income that could be pulled out of the life insurance policy from ages 70 to 84 ($72,195), and we assumed that the same amount would be pulled out of the term scenario.

7. We then solved for the pre-tax gross return under various assumed tax rates that would equalize the residual death benefit at life expectancy (age 87). For the side fund analysis, we looked at two different scenarios - a do-it-yourself scenario where the consumer only incurs 0.10% (10 bps) of investment expense and a managed money scenario where the consumer incurs 1% (100 bps) of total investment expense.

8. The term scenario generally has a higher total death benefit in years 1-30 (where there is less than a 5% chance that death occurs), and then that advantage shifts to the whole life scenario until life expectancy. It would be theoretically possible to attempt to equate these with theoretical term insurance purchases, but those are not realistic for how a consumer would actually manage the situation.

Analysis

The whole life scenario serves as the baseline. In this case, $14,201 annual premiums are put into the whole life policy for 30 years, and then $72,195 is pulled out for 15 years (ages 70 to 84). The illustrated residual death benefit at age 87 is $416,646. All of those values are after-tax. The after-tax rate of return on the lifetime of cash flows is 4.10%, which suggests that the total “drag” due to mortality and expense charges for the whole life policy is 0.90%, or 90 bps.

The term scenario assumes that $14,201 is also spent each year, but a portion of that money must be used to purchase term insurance. For the first 20 years, the total term premium is $635, leaving $13,566 to invest in the side fund. In years 21-30, the term premium is $400, leaving $13,801 to invest in the side fund. The same annual income of $72,195 is pulled out of the policy from ages 70 to 84, and the remaining side fund at age 87 serves as the point of comparison.

Here are the breakeven side fund returns under various tax rate assumptions and investment approaches:

For the given tax rate, if a consumer can earn a higher pre-tax rate than what is listed above, then they will end up ahead at life expectancy with the term approach. If they earn less than the breakeven rate, then the whole life approach is better at life expectancy.

Caveats

Here are some factors to note regarding the terms of the analysis.

Not all whole life policies are created equal - there is a big difference between a great whole life policy and an average whole life policy. There can even be a big difference in whole life policies sold by the same company. Proceed with caution if you don’t know what kind of whole life policy you are thinking about buying!

Whole life dividends are not guaranteed. We used an illustration that has a lower-than-current illustrated rate, but future whole life performance will be a function of future dividend performance, the largest component of which is the dividend interest rate.

Conclusions

The results of the analysis imply the following conclusions:

• Whole life looks great compared to the term scenario if we assume that the term scenario will invest in conservative assets like bonds. It especially looks great for high tax bracket individuals.
• If one is willing to take enough investment risk to boost expected returns, it is possible for the term scenario to outpace the whole life policy - but in that case, the comparison is no longer an apples-to-apples comparison.
• When someone claims that buy-term-and-invest-the-difference is superior, what they really mean is that if you are willing to take substantially more investment risk than is present in the whole life policy, then it may be possible to eventually outpace the whole life scenario.

Does your client need help with a life insurance decision?

Casual conversations or debates on this subject can be very misleading for consumers. If you or your client are wondering whether or not to buy term and invest the difference, there is no shortcut to finding the answer. The only way a proper decision can be reached is to carry out a full-scale analysis like the one we outlined in this piece.

I am an Actuary and a Consumer Advocate (not an insurance agent) who helps high-net-worth individuals with $100,000 or more invested in cash value life insurance or annuities to maximize the value of their policies.

High-net-worth individuals and their advisors hire me to help:

• Analyze existing life insurance policies and annuities to provide customized recommendations for optimizing value
• Consider impact of objectives, longevity, tax considerations, and opportunity cost on life insurance and annuity decisions
• Access/design life insurance policies and annuities that eliminate (or reduce) agent compensation and maximize policy value
• Provide an unbiased perspective free from any conflicts of interest
• Avoid making critical mistakes and provide peace of mind
• Provide a qualified appraisal on life insurance policies
• Assess whether to buy term and invest the difference or buy a cash value policy

To learn more, please contact me.

Disclaimer

Witt Actuarial Services does not guarantee any specific level of performance, the success of any strategy that Witt Actuarial Services may use, or the success of any program. Information contained herein may become out of date; Witt Actuarial Services is under no obligation to advise users of subsequent changes to statements or information contained herein. There is no guarantee that the information contained herein is accurate. This information is general in nature; specific advice applicable to your current situation is only available through an engagement. Any perceived similarity with persons living or deceased is entirely coincidental.