One of the most ubiquitous financial planning one-liners is “Buy Term—Invest the Difference.” The implication is that instead of buying “expensive” permanent Whole Life insurance you should buy term coverage for less money and place the excess in investments such as stocks. In the interest of brevity, I’ll call this the BTID strategy.
I have two reasons for highlighting BTID. The first is that purchasing Term insurance is the better choice for most households. The second is that just because it is often the better choice, doesn’t mean it is always the better choice. We have a tendency to resort to reflexive one-liners and blanket statements. Instead we should always recognize nuances that may be relevant for some households even if not for the majority. In the following discussion I use the BTID debate to emphasize that reflexive exhortations often bulldoze over, and ignore, important educational opportunities.
Fans of the BTID strategy often perform calculations and then declare, predictably, that buying Term and investing the rest in stocks yields a higher expected return.
Why is this a predictable result?
It's predictable because a typical Whole Life permanent policy may offer 3% to 4% interest plus dividends on the order of around 1% to 1.5%. This implies a total annual return on cash value of around 4% to 5.5%. Stock investments are assumed to yield around 10% annually. Thus, it’s inevitable that BTID will look better in such comparisons.
But in creating this comparison the BTID camp relies on several flawed arguments. These may not reverse the earlier conclusion that most households should avoid permanent policies, but it’s important to review them through an intellectually honest lens.
The first flaw is the assumption that stock markets will always yield on average 10% returns annually. This assumption relies on the idea that stock market returns won’t let us down in future. It’s taken as gospel that markets will continue to offer average returns on the order of 10% annually.
Ask yourself some basic questions: what if those historical averages don’t hold up over the next twenty to thirty years? Are there reasonable scenarios under which we’ll be seeing lower returns? Is there some divine edict that guarantees us such high returns? Any responsible individual should acknowledge that there are no such guarantees.
Furthermore, I’ve already provided a legitimate argument for why future American stock returns may not be as high as they have been in the past. (See the section, “Thoughts on American Stock Market Returns")
The second flaw in the BTID argument is the comparison of cash value account returns to stock returns. A Whole Life cash value account accrues a guaranteed interest rate. It does not swing in value like a stock investment, nor does it enjoy the unlimited upside available through stocks. Thus, the cash value account is more like a fixed income instrument and its performance should be compared only to investments that share those fixed income cash flow and risk characteristics—namely, bonds. Unlike stocks, which can average around 10% annually, bond investments gain on average 3% to 6% annually.
Suppose you’ve committed to a basic asset allocation: 80% in stocks, 15% in bonds, and 5% in cash. Next, you consider purchasing permanent life insurance. The BTID adherents assume the cash value in permanent life insurance is displacing or reducing your 80% allocation to stock investments. According to them, you’re depriving yourself of 10% annual returns on your money. But since the cash value account in Whole Life insurance is more like a fixed income instrument, you should really be considering it as part of your 15% allocation to bonds, which yield on the order of 3% to 6% annually. Thus, you can still maintain your original 80% commitment to stocks and their higher expected returns, and you diversify your fixed income holdings.
Recognition that lower future equity market returns are possible, and that stocks are not the correct benchmark for Whole Life cash value growth, strike deeply into the heart of the BTID camp.
The third flaw arises from lack of appreciation for the state of interest rates. In a low interest rate environment bond yields decline. Instead of 6% they may yield as little as 3% or even 2%. A 4% guaranteed cash value return on a permanent insurance policy doesn’t look so bad compared to these low numbers.
Over the past decade we’ve experienced unusually low interest rates. Many experts insisted such low rates could not persist for extended periods. Nevertheless, American interest rates have remained very low and several economies around the world exhibit what economists considered unthinkable—negative interest rates. At press time for this edition, global debt with negative yields surpassed $17 trillion! Most experts expect rates will recover within a few years, but if rates remain low for another decade or more, permanent insurance policies offering 4% (or higher) guaranteed interest on cash value will not seem so bad in comparison.
A fourth potential flaw is the BTID statement, usually delivered with great indignation, that commissions on Whole Life policies are as high as 80 to 100 percent of the first year’s premium. Yes, this is true, and yes, of course, it’s harmful, in the sense that it may incentivize agents to push such products. But commission rates on Term policies can also be high. They tend to cluster around 30 to 70 percent (clearly superior to Whole Life) but may range as high as 100 percent in some cases. It’s legitimate to be unhappy with high commissions, but then you must make sure that you are well and truly avoiding them.
The fifth and final flaw comes from the notion that Whole and Term life are somehow comparable and can therefore be judged based only on their annual costs, with the former deemed more expensive than the other and therefore always inferior or wrong for the consumer.
The Combination Pill Analogy
Term and Whole Life are not two versions of the same product, differing only on price. They’re different products offering a different set of benefits. In fact, they’re comparable in only one way: both provide a death benefit in the event the insured dies. In every other way they’re different.
To emphasize these differences, I like to use a pharmaceutical analogy: Suppose a patient is susceptible to five ailments. As a physician you can prescribe 5 separate pills, with efficacy rates ranging from 80 to 100 percent per ailment. This requires the patient to take five separate treatments, with all the associated inconvenience and cost. Instead, suppose you could prescribe a single combination pill that addresses all five ailments, with efficacy rates of 70 to 100 percent per ailment.
Let’s take this to the financial context, where the five “ailments” are the following financial dangers:
Each of these has its own individual or standalone remedy (downsides are noted in parentheses):
1) The individual remedy is to purchase Term life insurance. Term insurance costs less than permanent insurance. (There is the downside of outliving the term policy and ending up without any coverage thereafter)
2) The individual remedy is to maintain a rainy-day fund, use a credit card or obtain a bank loan. (The downsides are that credit card loans have very high interest rates, and it may take too long to qualify for a bank loan)
3) The individual remedy is to start saving early and invest in financial securities offering growth and income. (The downside is that markets may turn against you, leading to deep losses)
4) The individual remedy is investment in tax-deferred vehicles such as IRA, 401(k), or 403(b) accounts. (The downsides are that there are: limits to how much you can put into tax-deductible accounts each year, and penalties for early withdrawals or failure to take distributions after age 72)
5) The individual remedy is to put your money into protected assets—those that are outside the reach of creditors. An alternative response is to hope and pray that no one will ever sue you—the risk management equivalent of an ostrich sticking its head in the ground. (The downsides are that while scrambling to protect assets, you may deprive your family or yourself of access to those assets or expose yourself to unfavorable tax implications)
A permanent Whole Life insurance policy is analogous to the combination pill, as it offers all of the following simultaneously:
Those in favor of the BTID strategy tend to focus on item 3, arguing that they can build up much larger amounts of cash by investing directly in stock markets. For the reasons already stated, comparison to stock return performance is incorrect, and in any case there is no guarantee that stock returns will continue to average 10% annually.
Recent retirement plan legislation provides further reinforcement that dogmatic defense of BTID can be misguided. The recently passed SECURE Act takes away tax avoidance benefits of the so-called Stretch IRA strategy, in which IRA accounts could be passed on to non-spouse heirs with required distributions from the accounts stretched over the remaining life of the heir. The SECURE Act forces most non-spouse heirs, in particular children, to empty such accounts within ten years, potentially triggering significant taxes. Stretch IRAs have been used by wealthier families as a way to pass money across generations with minimal tax implications.
The demise of the Stretch IRA makes life insurance one of the few options available for tax efficient intergenerational wealth transfer. While this does not instantly make permanent policies such as Whole Life the best choice for most families, it is an example of a scenario where more families could have benefitted from considering it, rather than rejecting it out of hand.
It’s easy to criticize any one feature of the combo pill. But the point is that the combo pill is much more than any one feature. It’s all of them combined. Just because one feature of the combo treatment doesn’t look as favorable as some other focused treatment, that doesn’t invalidate all the other benefits of the combo treatment. They are still there, ready whenever the need arises. If you know with certainty that you’ll never need those other features, and you’re comfortable with the likelihood of outliving your Term insurance, then by all means, you should go with Term. For most readers, that is the correct choice. If, on the other hand, you see value and convenience in the combination treatment, permanent insurance may be appropriate for you and your family. In such (rare) cases, I still recommend restricting your permanent insurance purchase to a small death benefit, on the order of a few hundred thousand dollars. This will yield some asset diversification without a commitment to pay exorbitant premiums each year.
From a financial engineering perspective, one could say that the multiple features of permanent life insurance provide options for the policyholder, and each option has a value. Thus, focusing on just one feature is effectively ignoring the option values of all other features.
Can you be sure that you won’t need these options in future? At the very least, taking these option values into account makes the permanent policy less unfavorable. The permanent policy tends to appear even more appealing if you’ve already maxed out all your usual tax-deferral vehicles, are in a high tax bracket, and feel a need for some asset protection. With each of these arguments the reflexive BTID strategy seems less convincing. And as noted above, a Whole Life policy with a guaranteed interest rate of 4% plus dividends looks even more favorable in a very low interest rate environment, when other very safe assets pay at most 2% per year.
Of course, if you try to obtain permanent insurance when interest rates are very low, your guaranteed rate will likely be lower than 4%. My comment refers to those people who could have purchased permanent policies ten years ago, when 4% was realistic, but were told not to do so by BTID adherents.
To be clear, I’m not urging you to run out and buy permanent life insurance. As already noted, for most consumers a good Term policy is a solid, and better, choice. Rather, I’m using this as a case study where the eureka moment is the realization that intellectual honesty is very important. It’s easy to wrap ourselves in blanket statements, but it’s not necessarily correct to do so.
A Brighter Future for Permanent Insurance Policies?
Understandably, reflexive generalizations regarding permanent policies often come from people who have been burned by insurance products and or agents. While our anger is justified, it’s still important to remain intellectually honest.
Why? Because the general concept of permanent insurance is actually quite reasonable. Our concerns stem primarily from: lack of transparency, excessive commissions and other hidden costs, and our annoyance at being pursued by shady agents. A world in which these concerns are addressed is one in which fairly priced permanent insurance could be useful for more households.
There are some encouraging signs. Insurance companies are increasingly aware of our concerns, and they have some of their own. It’s costly for them to maintain large agent networks. And agent ineptitude and dishonesty cause them liability and reputational issues.
The Internet Age may provide relief for both consumers and insurers by ushering in an era of direct-sold policies. By selling standardized policies online directly to consumers, insurers will be able to say goodbye to large and expensive agent networks, and to offer simpler, cheaper policies. Consumers will benefit from lower-priced, standardized, more transparent policies, and from not having to deal with commission-based agents.
When this change happens, and I remain hopeful that it will, we should be ready to consider such tools rather than being reflexively biased against them.