The following post is written by Brian So from Brian So Insurance
When it comes to life insurance, many of you may have heard of the strategy ‘buy term and invest the difference.’ Before I get into the concept behind the strategy, you should know the basic differences between term and whole life insurance. With term, you purchase temporary insurance that expires at a age 80 or 85, with premium increases at every term renewal, most common being 10 and 20 years. Whole life, on the other hand, has a fixed premium but never expires as long as the insured continues to pay the premium. The premium for term insurance starts out much more manageable, but its price increases exponentially and eventually outpaces whole life.
Whole life insurance also has a cash value that is guaranteed and increases every year. Contrary to popular belief, there is no investment involved with whole life insurance. The cash value is actually a reserve of premium kept on the side by the insurance company due to overpayment of premium in the early years.
Buying term and investing the difference means that you purchase term insurance and invest the difference in premiums between term and whole life. The hope is that when you cancel the policy at age 65, your portfolio will be larger than the cash value in a whole life policy.
For example, let’s consider a 35 year old non-smoking male looking for $500,000 of coverage. His options are a term-30 policy, which would take him to age 65 at renewal, and a whole life policy. The annual premium for the term-30 policy is $750, while the annual premium for the whole life policy is $3,395, for a savings of $2,645. Assuming he invests this amount at the beginning of each year for 30 years with a 6% return, he will have $221,655 when he turns 65. The cash value of the whole life policy at age 65 will equal $131,500.
Clearly, buying term and investing the difference is better than buying whole life and cashing out at a later date. Or is it? Are there other factors that affect the comparison? Let’s take a look at the pros and cons of the strategy.
- Savings on insurance premium: The premium for whole life insurance is several times more expensive than term insurance. If you subsequently decide to only execute the first part of the strategy (buy term) and not the second (invest the difference), you’ll save lots of money on life insurance costs.
- Flexibility of investment: You have the choice of making your own investments, which is a huge perk for DIY investors like yourselves. A 65 year old will likely have a different risk tolerance than a 35 year old, and one of the biggest advantages to choosing your own investments is that you can change your asset mix to reflect your risk tolerance.
- Flexibility of cash flow: You have the option of stopping and restarting the investment at any time. For instance, if you experience a shortage of cash flow in one year, you can lower or stop your contribution that year. Later on when your budget allows, you can resume contributions to your investment.
- Immediate availability of investments: The cash value of whole life insurance is generally not available until the fifth year and in some policies aren’t available until after the tenth year. With your own portfolio, you can withdraw the cash at any time, assuming your investment is liquid.
- Receive death benefit and investment growth: If you pass away and own a whole life policy, your beneficiary only receives the death benefit, and the cash value is lost to the insurance company. When you buy term and invest the difference, your beneficiary will receive the death benefit plus the value of your investment account.
- Continuation of coverage: Your insurance needs may not end at age 65. You may still be working and need to provide for your spouse, or you may want to leave a legacy for your grandchildren. Insurance objectives do not remain constant for life and in fact, change more often than you realize. If you want to maintain your insurance coverage, you’ll have to renew your term policy at a much higher cost. Using the example above, the initial term premium of $750 increases to $30,020 in year 31, which is an absurd amount. A better option would be to convert a portion of it to permanent insurance or try to be approved for a new policy, both of which would yield a lower premium but are still not optimal compared to whole life.
- Discipline required: While flexibility can be listed under pro, it can also be a con if you lack the discipline to invest the difference year after year, through the ups and downs of the market. Some people who are easily tempted by spending the difference may prefer the forced savings aspect of whole life insurance.
- No guarantees: With investing the difference yourself, there’s no guarantee you can achieve the 6% return in the example. Although history would suggest that it is attainable over the long term, individual returns can differ vastly from market returns. Remember that since the cash value is the reserve of prepaid premiums and not an investment, it is guaranteed and known from the outset. In the above example, the breakeven point for buying term and investing the difference is 3.08%.
- Taxation of investment returns: Unless you hold your investments inside a tax-deferred or tax-free account such as the RRSP or TFSA, your investment returns are subject to annual taxation. The cash value within a whole life policy grows tax-sheltered, only being subject to a minimal amount of tax at withdrawal.
As you can see, it’s not as straightforward as saying one strategy is better than the other. A more active investor would likely prefer to utilize the buy term and invest the difference strategy, while someone who is conservative and values guarantees may prefer to use whole life insurance. Either one may work for you, depending on your current situation and your needs.
Brian So, CFP, CHS, is an insurance broker and blogger at briansoinsurance.com. Follow him on Twitter for his musings on life insurance and why the Vancouver Canucks will win the Stanley Cup next season (Seriously).
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