A skeptical look at the common advice to ‘buy term insurance and invest the difference’
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Anyone who knows me knows that I don’t follow “conventional financial wisdom” until after I’ve asked a lot of questions. Call me skeptical, contrarian, scrupulous, whatever! It’s my nature to question any and all schemes that involve my hard-earned money.
The result? I’ve come to the conclusion that a lot of the “free” financial advice floating around is worth exactly what we pay for it. Take, for instance, this commonly held belief:
After you retire, your basic expenses will be much lower.
This may sound soothing, but it’s not the way life works for most retirees in the real world. A report by the Employee Benefit Research Institute found that 46 percent of seniors polled said they spent more money during their first two years of retirement than during their working years, and 33 percent continued spending more six years into retirement.
I’ve written about some of the reasons you shouldn’t expect your expenses to be lower in retirement, with higher medical costs being chief among them. In fact, we all should be saving more rather than less to cover higher expenses when we are retired.
There’s a lot of bad advice and nonsensical financial “wisdom” floating around on how to do that (not unlike the “less spent in retirement” theme). In my view, there’s no worse piece of this widely accepted but baseless balderdash than this:
Buy term insurance and invest the difference.
We’ve all heard this pearl of wisdom: that we should buy “cheap” term insurance, rather than “expensive” permanent (cash value) insurance, and invest the money we save, usually into the stock market. This idea is so common it even has its own acronym: BTID.
The BTID strategy promises to carry young Americans to their old age, to safeguard their loved ones and to build a large retirement portfolio along the way. But it’s based on a faulty assumption — in fact, several false assumptions.
Those faulty assumptions
First, what’s happened to the “difference” that Americans have supposedly invested? The typical investor lost 49 percent or more of his or her savings — twice — just since 2000. The typical equity mutual fund investor, meanwhile, has earned 3.98 percent annually for the past 30 years, beating inflation by only 1.3 percent a year, according to the latest analysis by Dalbar.
Another idea behind BTID is that by the time term policyholders reach their 50s and 60s, they’ll no longer need their term policies. Their investment portfolios will have ballooned to such massive size that they won’t need life insurance anymore: They will be self-insured by their own wealth.
But that’s not how things are working out for most Americans. According to the Center for Retirement Research at Boston College, 52 percent of households are at risk of not being able to maintain their standard of living in retirement, and 50 percent have no savings at all. Among those who do manage to save, the typical couple nearing retirement will receive only $600 per month from their 401(k)s and IRAs combined, according to the Federal Reserve Survey of Consumer Finances.
Since the majority of pre-retirees aren’t wealthy enough to self-insure, those who have followed that BTID advice face an agonizing choice: Do they continue to shovel cash into those term policies to get the death benefits their families will someday need? Or do they drop their insurance, exposing loved ones to potential financial disaster in the event of their death?
Term life insurance has its place, but it is not the best option to carry you and your family safely to your golden years. That cheap insurance isn’t so cheap as we get older. Although young and healthy policyholders can purchase hundreds of thousands of dollars of coverage for less than $100 a month, as you age, your rates rise and ultimately become astronomical.
Case in point: I own a 15-year term life policy for business purposes that will expire in two years. I just checked the policy to see how much more it would cost me to continue that policy, in case I am unable to qualify for a new policy for health reasons two years from now.
Turns out I could continue paying to keep that policy in force — if I wanted to pay a premium that’s 15 times higher than what I’m paying now. And ten years later, that premium will be almost 40 times higher than I’m paying — a 4,000 percent increase!
Why buying term life insurance is like renting a home
No matter how many years or decades you pay rent, you get no credit for prior payments if you can’t pay this month’s rent. If you stop paying your premium, the term insurance company will cancel your coverage in 31 days.
Here’s another problem: The term life policies many of us purchased decades ago are worth far less today in inflation-adjusted dollars. Most term policies have a level death benefit for the term of the policy. If you buy (actually rent) a $250,000, 20-year term policy, and inflation averages 4 percent per year, your policy will lose 56 percent of its value over its 20-year term.
Even worse, most people who put money into a term life policy have nothing to show for it. According to a Penn State University study, 99 percent of all term policies never pay out a claim. Proponents of term life say this is because most people let their policies lapse. But even if you keep your policy in force, you are still “renting,” and just one payment away from having nothing to show for it. Is there anything more expensive than paying for something that most likely holds no benefit for you?
Pricing a whole life and term policy, then investing the difference
Who actually invests the difference between what he or she would pay for term life versus paying for permanent insurance with an equivalent death benefit?
According to David Babbel, a professor at The Wharton School of the University of Pennsylvania, “People don’t buy term insurance and invest the difference. They most likely rent the term, lapse it and spend the difference.”
Many people realize these pitfalls, so they avoid buying life insurance altogether. That can be a huge mistake, especially considering the largely unheralded or forgotten advantages of dividend-paying whole life insurance.
I’ve spent years researching — and testing with my own money — a little-known type of high-cash-value dividend-paying whole life insurance. It’s true that in their early years these policies require more out-of-pocket cash than term life policies. But after a decade or two, people who own this type of insurance (as opposed to renting term life) have a great deal to show for their patience.
Four Advantages of this type of insurance over term life:
1. Your premium never increases. Because you own rather than rent your policies, your premiums are being converted into safe and liquid savings, and your rates don’t ratchet upward, ever.
2. Built-in protection against inflation. Premiums on this type of policy are guaranteed never to increase. This means that as policyholders age, they pay the same amount, but in inflation-diminished dollars. While the costs for term policy owners soar over time, the cost for whole life policyholders effectively shrinks with age as both cash value and the death benefit of these policies increase exponentially over time.
3. Living benefits. By the time owners of this type of dividend-paying whole life policies near retirement, many have built substantial nest eggs they can draw upon as needed. They don’t need to die in order to benefit, and they continue to benefit no matter how long they live.
4. Guaranteed predictable growth every year. With a high-cash-value dividend-paying whole life policy, you can actually know the guaranteed minimum value of your plan on the day you want to tap into it, and at every step along the way. These policies have a 160-plus year track record of positive growth and have never had a losing year. That’s a far cry from the risk and volatility we see in the stock market and other investments. (Read my article “7 Reasons that Dividend-Paying Whole Life is Legitimate.”.)
So keep an open mind and investigate this proven safe wealth-building strategy for yourself. As General George S. Patton once noted, “If everyone’s thinking the same thing, then someone isn’t thinking.”