Canadian Finance Blog

Posted: 27 Jun 2011 02:00 AM PDT

Here’s a concept that most readers of financial blogs will be familiar with – buy term and invest the difference. It’s a concept that came in to fashion in the 1980′s and is still going strong in some corners of the financial world. The end decision in all cases behind this concept though, is that term insurance is the best life insurance product.

Now think about that for a second. Do you believe that term insurance and investing the difference is the best product for everyone, 100% of the time? I think most folks will agree that this can’t be the case. And yet buy term invest the difference proponents ALWAYS arrive at the conclusion that term life insurance is your best buy. Doesn’t that smell a little bit funny? Like it’s a foregone conclusion?

Sure enough, there’s some holes in the story. And like many ideologies, finding these holes happens when we start looking at assumptions and guarantees. The math doesn’t show the whole story in this case.

Basic concept

Buy term and invest the difference works like this; you compare the costs of term life insurance with permanent life insurance, where the permanent insurance typically has a cash surrender value. The concept shows how if you bought the cheaper term life insurance now and invested the savings you’ve kept over buying permanent, about age 65 when you don’t need life insurance anymore, you’ll actually have more money. Cool! Let’s run the numbers.

Example:

I ran a whole life insurance quote using Compulife (R) (Compulife is the standard life insurance company rate database used by agents in the US and Canada). Let’s say you’re a male age 40 nonsmoker. For an amount of $100,000 I grabbed the least expensive 20 year term (turned out to be Equitable Life’s 20 year term) and compared it with the least expensive whole life product in the comparison (turns out to be Empire Life’s Solution 100 with values).

The next step is to cancel both products at age 65 and see which product gives us the most money. We’re doing this because the concept says we don’t need life insurance past age 65 – by that point our savings will have left us self insured.

I’ve assumed a nice conservative interest rate of 3%. Based on that, if you had bought the cheaper term life insurance you’d have saved $7,941.86. If you bought the whole life insurance policy and cancelled it at age 65, you’d have $13,200. Wait, what?

I’m reminded of the 5 P’s. Prior Planning Prevents Poor Performance. Because if I was in front of a client convincing them how important it was to buy term insurance, I would be very embarrassed right now. I’ve just shown that you would be better off buying the whole life insurance policy and cancelling. Whoops.

So comparing the least expensive 20 year term with the least expensive whole life doesn’t work. So what are they comparing to make this work so well? What am I doing ‘wrong’?

Do you know what assume spells?

It spells assumptions. Like all good theologies, the flaws lie in the unquestioned assumptions. Let’s have a look at some of them, see if you agree with them.

Problems with my comparison

First, while that comparison I just quoted shows that the whole life policy is better, what I didn’t mention is that the $13,200 of cash surrender value would actually be subject to taxation. Only a small portion of it would be taxable, but you would be unlikely to receive the full $13,200. However, even after taxes I’m pretty sure you’d still have more money with the whole life, using those assumptions.

Speaking of taxes, we assumed a 3% rate of return. Depending on what that’s invested in, the 3% could be subject to taxes as well. Easy enough to avoid those taxes, but if you don’t, that makes the whole life policy even more favourable.

Secondly, we’ve assumed that we’ve kept the 20 year term policy for 25 years – 5 years past the 20 year renewal. I can’t imagine someone would keep a term policy these days past the renewal. Renewal premiums are simply too high. Most consumers would either buy a new term policy at renewal or convert to permanent (despite the fact we’re trying to disparage permanent insurance with this concept). So fair enough, if you bought a new term policy in year 21, you’d have lower term premiums in years 21-25 than what I used, helping the term cause a bit. Is this something a consumer would catch?

Interest rate

I believe interest rates are the biggest single concern with this concept. If I have assumed 3%, the whole life policy looks better. If I assume 6% and no taxes on earning, then the term insurance policy is about break even. If I assume 10%, now the term life insurance policy is about $29,000 better.

So what interest rate do you think you should be using? 3% or 10%?

Now if an insurance agent wants to sell you a life insurance policy plus their miracle-gro investment strategy, what rate do you think they’re going to use? 3% or 10%?

But lets say we’re OK with the 6%. Nice fair comparison over 25 years and the term insurance wins by about $4500. I’m going to assume that $4500 over 25 years is close enough that we’ll call it a tie.

Cancelling at age 65

But is it a tie at 65 if we used 6% rate of return? We bought a whole life policy, or bought a term and earned 6%, and in both cases we just cancelled and ended up pretty close to the same financially.

But what if we don’t want to cancel the life insurance? Yeah, I know, the concept doesn’t allow for this possibility. But let’s say at 63 you had a cancer scare. The now-65 year old that had cancer two years ago that bought the term policy – how do they feel about their term life insurance policy? Not too good. The policy has ever increasing premiums and eventually it actually expires.

So what if I said to this 65 year old, hey, I can not only get you healthy rates for life insurance, but I’m going to lock it in for the rest of your life level. And I’m not going to give you the rates of a 65 year old. I’m going to give you the healthy rates of a 45 year old. Would you be interested?

If you made it through all of that sales speak, the point is that at 6% your the same financially if you cancel, but if you decide not to cancel, the whole life insurance policy is going to be a real deal breaker.

I appreciate that the rabid buy term and invest the difference advocates will refuse to entertain the idea that one could want insurance past 65. And perhaps my cancer scare example is a bit overboard. But two things are true – even if you don’t want permanent insurance now, there’s some possibility you may change your mind in the next 25 years and secondly, if you do change your mind, having bought the whole life policy in this example is going to be a much better solution. More choice in 25 years, for about the same cost.

The other aspect about cancelling at 65 is that in my experience, many people around retirement age want some permanent insurance. They want to cover final expenses. Some want to leave money behind for kids or grandkids that doesn’t come from the estate. Whatever the reason is, it’s been my experience that some people’s idea of the financial value of life insurance changes as they get older. That may not be you, but you should leave yourself open to the possibility that it could be.

Still not convinced? Would you believe that many people are interested in a smaller life insurance policy after retirement? That’s probably obvious. And with a 25 year old whole life policy already in force, all you need to do is drop your face amount down when you hit 65 – instant small life insurance policy, guaranteed.

Self Insured

This is an easy one to debunk, just take it to the extreme. It’s clear that people with high net worth can run into tax complications at death. If they don’t want their beneficiaries or family to have to sell assets at fire sale prices or dip into liquid cash to pay these taxes, then life insurance is an easy answer.

So if you do become self insured to the point of being really well off, there’s a reasonable chance that you are going to want permanent life insurance. Again, it’s not 100%, but it’s a possibility you shouldn’t exclude.

Guaranteed vs. Not guaranteed.

At our 6% rate of return, the term life insurance and whole life insurance products were basically even. But they’re not. We just compared a guaranteed result with a non-guaranteed result.

That 6% rate of return you earned on your ‘savings’ from buying the term policy – was that guaranteed? Not even close.

The $13,200 of cash surrender value on the whole life policy? That is guaranteed. And frankly, an agent should be ashamed of themselves if they’re comparing guaranteed vs non-guaranteed in front of a consumer and neglect to mention it to them.

So how does the term look now? The person that bought the whole life insurance policy is guaranteed $13,200 less some taxes at age 65 if they cancel. To get the the same results from a term policy, you’d have to earn more than 6%. That’s almost like saying you can get a guaranteed 6% interest rate. I’m not saying that! But at what point do you need to be before a guarantee matters? For many Canadians, having to invest in something that will earn more than 6% to beat a guaranteed option is going to be a no brainer. They’ll let someone else take the risk.

And that’s only if you cancel. We’ve already covered how the whole life insurance compared better by giving you better coverage cheaper if you decide to keep your insurance after 65.

Other considerations

So how do we make these comparisons ‘work’ to favour the term insurance.

First, use a higher non-guaranteed interest rate and compare it to a guaranteed cash surrender value. (and then lead into a discussion of sale of investment products rather than mentioning the non-guaranteed aspect ).

Secondly, don’t compare least expensive with least expensive. If you have a non-competitive whole life product and compare it with a current term premium, of course the term policy is going to look better. Try comparing the term product with a competitive permanent product. Or comparing your existing permanent with a new, competitive permanent product. (I compared a 20 year term with a competitive Universal Life policy and the total cost difference at 3% over 25 years was only $5100).

Thirdly, use optimistic health class on the ‘new’ term policy when comparing against your existing insurance where you didn’t receive those optimistic rates. In other words, compare ‘preferred’ term rates with ‘regular’ permanent insurance rates. Of course, if the insurance company gave you a regular health class when you bought your permanent insurance and now you’rea couple years older, what’s the chances that you’re going to spring into those preferred rates with your new term policy?

Summary

Despite how it may have read, I’m not proposing that buying term insurance is bad, or that whole life is good. I’m suggesting that at a minimum, sales techniques that start with a predetermined conclusion are not suitable for all circumstances. The right way to start a conversation on the merits of term insurance vs. permanent is to ask the question "How long do you want the insurance for?".

Secondly, when comparing insurance products, be very mindful of guarantees and non-guarantees.

And thirdly, be mindful of salespeople who are biased on only one product type.

Author Bio: Glenn Cooke is a life insurance broker in Canada and president of InsureCan Inc. He owns a healthy mix of term insurance and permanent insurance.