Some financial advisers are rethinking the idea of: Buy term insurance and invest the difference.
That old saw refers to purchasing term life insurance instead of buying the more expensive permanent coverage such as whole life and encouraging customers to invest the money saved.
Following that investing maxim, however, likely didn't work out well for investors when the market cratered.
Term life may end up being more expensive than originally thought in another way, too.
MASSIVE PREMIUM OUTLAY
“The good news is, in year one, when you start, the premium for life insurance will be inexpensive,” said Richard M. Weber, founder and president of The Ethical Edge Inc., a Pleasant Hill, Calif.-based insurance consulting firm.
But he said that as clients age and continue to maintain a term policy beyond its time limit, they face a massive premium outlay as the cost of the policy skyrockets. This is the sort of problem that clients face if they purchase a policy — even if the premium is guaranteed to stay level — for a 10-year duration but end up keeping it beyond that time frame, Mr. Weber said.
For example, a 33-year-old man who pays $355 in annual premiums for a 10-year term life insurance policy can face a “renewal” premium of $3,865 in the 11th year, according to a white paper, “Life Insurance as an Asset Class: A Value-added Component of an Asset Allocation,” that Mr. Weber wrote.
The increasing probability of the insured's death as time progresses raises the premium of the policy once the term is up, Mr. Weber said.
Clients also get a double wham-my if they purchase term insurance and use the savings to invest in the stock market — all the while holding the policy beyond its intended limit.
In one example used in the white paper, a 33-year-old man pays an annual premium of $939 for a 30-year term policy, instead of the steady annual $11,290 premium for a whole-life policy. He invests the $10,351 annual difference in a portfolio with a net after-tax return of 5.19%.
In year 30, the invested money grows to $746,997, but then the amount plummets as the policyholder shells out $29,589 for premiums in year 31. The size of the premiums grows until the investment account is fully depleted when he turns 81, according to the white paper.
Advisers disagree on whether choosing a whole-life policy over a term policy with an investment plan is the best idea as it seemed to be in the white paper's example. Both plans have their flaws, they contend.
“I've seen "buy term and invest the difference' fail in times like this when the markets go down,” said James D. Cantrell, president of Financial Strategies Inc. in Brookfield, Wis. “People decide that they don't want to invest in the stock market, when that's the best time, because dollar cost averaging works best when markets are down.”
ASSESSING RISK TOLERANCE
Similarly, investors get wrapped up in hitting their investment goal within the period limits of their term life policy, so they will shell out for a renewal premium if they haven't reached their goal by the end of the policy's duration, Mr. Cantrell said.
To keep clients on track, he emphasizes assessing clients' risk tolerance to determine whether they are likely to sabotage a “buy term and invest the difference” strategy or whether they might be tempted to stop paying premiums on a permanent policy in a moment of panic.
Mr. Cantrell recommends convertible term life, which gives clients the flexibility to switch to permanent coverage if they think they are unable to stomach a market downturn and insurability becomes a concern due to age.
Still, some advisers pointed out that “buy term and invest the difference” can work in the face of a downturn if clients invest conservatively.
“If you want something safe, then replicate what the insurers do,” said Kirk Kinder, president and owner of Picket Fence Financial in Bel Air, Md. “Look at how they invest for whole life.”
Insurers themselves generally invest in investment-grade bonds and other conservative instruments to match their long-term liabilities.
With a portfolio that has an 80% to 90% concentration in bonds and cash instruments, and the remainder in equities, investors can get steady growth with low volatility, Mr. Kinder said.
Although his strategy tries to mimic a whole-life policy without the same level of fees, he and other advisers noted that there is a time and place for permanent coverage, such as in an irrevocable life insurance
trust or in a “key-person” business plan.
“Life insurance is there to protect against a situation that an individual cannot afford to take the risk on their own,” Mr. Kinder said. “They are not investments.”
E-mail Darla Mercado at [email protected].
