Buy term and invest the difference
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Buying term and investing the difference is a concept involving term life insurance and investment strategies that provide individuals an alternative to permanent life insurance. Generally speaking term insurance premiums are considerably less expensive in the short term than permanent life insurance for an individual for the same benefit amount. Permanent programs are more expensive because they typically combine some form of cash accumulation with the insurance program as a single package. Consumers making use of the "buy term invest the difference" concept, separate their investments from their insurance by setting aside money every month equal to the premium that a permanent plan would require, then use a portion of this money for the term premium and place the rest in a tax-deferred investment vehicle.
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[edit] Cases for and against implementing the strategy
The advantages of this strategy, if implemented correctly, are obviation of insurance, immediate accumulation of investment moneys, more investment options that allow for similar tax advantages, and return of cash accumulation. Other advantages include elimination of loans and stability in the death benefit.
[edit] Obviate the need for permanent insurance
[edit] Pros
This viewpoint assumes consumers believe that they can self insure and will eventually be able to eliminate the need for permanent insurance. They believe the responsibilities for which they purchase life insurance are temporary in nature (paying off mortgage and/or debts, provide education for dependants and create cash reserves to replace the income of the breadwinner.) In the event of the insured's death, many or all of these responsibilities can be resolved using the proceeds from the policy or policies. When the consumer has cash reserves large enough, they consider themselves to be "self insured". Insurance terms may be a number of years in length (1, 5, 10, 20 years or more) which, in theory, should provide enough time for the insured to invest and eliminate these responsibilities.
In the event these responsibilities are not eliminated at the end of the term, many insurers will allow the insured to renew their current policy (guaranteed renewal) or purchase a new policy (conversion) without being subject to the same medical and financial qualifications as a new applicant.
[edit] Cons
Those who believe in buying Term Insurance and investing the difference in premium between a Term and Permanent policy must intend to obviate their need for life insurance, since the Term policy will eventually expire or become too expensive. If they are not disciplined enough to invest, pay off their debts, or assist their dependants in becoming independent, they still have a need for insurance. For individuals with additional responsibilities or an indefinite responsibility, this strategy would not be beneficial.
[edit] Immediate accumulation of investment money
[edit] Pros
Permanent or whole life insurance (life insurance that typically provides a death benefit for the lifetime of an insured person up to age 100) policies usually direct a portion of the premium payment to a sub-account within the policy, called cash value and the other portion to insurance. There are many different permanent life insurance products available with a range of options involving the cash value of the policy, including the ability to withdraw the cash value, borrow against it, and to allow it to be drawn on to pay the insurance portion without additional premium payments. Ultimately, most permanent life insurance policies are combination of term insurance with a savings vehicle. Insurers may break down a policy into 2 components, the term insurance portion (the net amount at risk) and the cash value (the guaranteed amount).
The cash value in the sub-account can accumulate over the life of the policy depending on the policy, however it is not always available for the first several years of the program.
Universal and Variable or Variable Universal policies typically have immediate accumulation in the sub-account, but are typically not available for loans and are most often subject to a surrender charges for the first several years of the program (in the case of plans paying a premium close to the minimum, this is frequently in excess of the accumulation).
With the concept of buying term instead of permanent insurance, more investments vehicles are available, all of which are independent of the insurance program and remain in control of the insured if the insurance portion is canceled.
[edit] Cons
The con again is this approach requires discipline. As with budgeting, many consumers who reduce expenditures fail to invest the money saved, and simply allow it to be reabsorbed to become part of their monthly spending. An example is someone who quits smoking thinking of all the money they'll save. looking at things a few years later, it is a rare occurrence for anyone to actually have a large amount of money in their special "non-smoking" investment account.
[edit] Investment options
[edit] Pros
This practice leaves the insured open to utilize whatever investment options they see fit. Permanent programs require the policy holder to use only the investment options available through the policy. Life insurance death benefits are never taxable Term or Permanent, and cash value growth on permanent plans are tax-deferred as long as the policy is in force. If the policy is canceled (because the need for insurance is obviated) any accumulation in excess of Adjusted Cost Base (ACB) will be taxable. In most cases the only way to avoid these taxes is for the insured to die while the policy is in force (essentially making these monies unavailable to them). Premiums are most often paid with after tax dollars, though there are exceptions where the policy holder can use pretax dollars (as a business obligation in a corporation for example). Variable plans provide the insured the opportunity to choose the investments, though the investment vehicle is still within the life insurance plan.
To attain similar tax advantages, the insured may make investments through a tax deferred vehicle, such as an annuity, variable annuity, IRA, Roth IRA or even 529. Monies applied to a traditional IRA are pretax dollars while those applied to a Roth IRA are after tax. Both investment vehicles grow tax-deferred, similar to cash accumulation; however money withdrawn from a Roth are not taxed. 529s are educational accounts, and annuities are another form of life insurance account. (see http://www.irs.gov/pub/irs-pdf/p590.pdf http://www.irs.gov/retirement/article/0,,id=136868,00.html)
Each program has provisions for accessing monies invested early as does permanent insurance; however as a separate investment the term insurance death benefit is not impacted by accessing it.
[edit] Cons
Again this requires the implementer to research investments and how to best take advantage of them.
[edit] Return of Cash Accumulation
[edit] Pros
Proponents of BTAID (Buy Term And Invest the Difference) indicate the greatest advantage of this concept is the return of cash accumulation. Each permanent program handles treatment of the cash value differently, but in the end the cash accumulation is always surrendered, even in return of premium policies or universal life plans that elect to pay the cash value option as well as the death benefit.
To illustrate this, consumers may review the loan provisions on their policy. The cash accumulation could be drawn out of a permanent program as a loan, to be paid back with interest to the program. However, in the event of the insured's death, the death benefit is reduced by the amount of the loan. If the policy is cancelled, the loan is deducted from the cash value and the net paid to the insured.
To contrast this with the BTAID strategy, the accumulation is in a separate investment owned by the insured. In the event the insured dies while the insurance policy is in force, the beneficiary of the investment receives the investment as well as the death benefit of insurance policy. There may or may not be tax due on the investment account depending on whether the investments are in a gain or loss position. If the insured dies when the policy is no longer in force, the beneficiary of the investment receives the value of the investment account, again after any applicable taxes, but no benefit from the insurance policy.
Some permanent insurance contracts offer "Plus Fund" or "Return of Premiums" as options for receiving the death benefit. In these plans, the initial amount is paid out, plus the cash accumulation or all premiums paid. In these programs that appear to pay out the cash accumulation, the insurance company, in essence, creates an additional policy. Premiums are generally higher for these types of policies, so consumers who are considering the BTAID strategy should take this into account as well when calculating the opportunity cost.
[edit] Cons
Most tax-favoured investment vehicles have a cap as to the contributions that can be made on an annual basis, though in most cases this is a non issue. According to wikipedia the average married household annual income in 2005 according to the department of Labor and statistics was $66,067. According to the IRS maximum contributions in 2007 for 401k’s, 403b’s, and SEP’s for employees is $15,000, and IRA’s traditional and Roth is $5,000. Assuming the husband and wife both work for a company with a 401k, they could contribute 59% of their income which is $40,000 to their retirement. This does not include options available through education savings which includes Educational IRA’s (coverdales) at $2000 or 529’s at $11,000 or UGMA’s.
Other options are also available in the form of Annuities which allow essentially unlimited contributions, and greater flexibility in the even the annuitant does not allow the program to annuitize and keeps it in the accumulation period by setting up systematic withdraws.
[edit] Other
Because of the increased premium at attained (then current) age, additional consideration should be given renewal or conversion of term insurance at the end of the original term. Also, purchasing annual renewable term insurance can add complexity to long-term investment strategies because premiums increase as the insured ages.
The basic forms of permanent insurance include:
- Simple whole life insurance is essentially decreasing benefit term insurance, as the net amount at risk decreases at the same rate as cash value accumulates. Eventually, the cash value equals the benefit amount.
- Universal life insurance is a form of whole life insurance in which, at a certain point, the cash value may be used to pay premiums and keep the policy active, or in force.
- Variable life insurance and variable universal life insurance are permanent insurances in which some or all of the cash value in the sub-account may be invested in mutual funds, money markets, bonds, cash or other investment strategies.
Insurance companies now market Universal Life policies with several different death benefit options in an attempt to make them more attractive such as:
Level Death Benefit - Where the face amount never changes regardless of cash accumulation within the plan which is still surrendered
Indexed Death Benefit - Where the death benefit rises by a specific percentage each year (limits apply) and the cash accumulation is still surrendered
Level + Fund - Where the payout on death consists of the initial amount plus the cash or fund value. However the cash fund amount will still be smaller as a larger portion of the premium is directed to the cost of insurance making it more expensive.
Level + ROP - Where the payout on death consists of the initial amount plus the return of all premiums paid, where again a larger portion of the premium is directed to the cost of insurance and maintenance over the cash accumulation.
