Buy term and invest the difference
Insurance
==Cases for and against implementing the strategy==
The advantage 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.
Obviate the need for permanent insurance
Pros
This viewpoint assumes consumers want to self insure and will eventually be able to obviate or eliminate the need for permanent insurance. They believe the responsibilities for which they purchase life insurance are temporary in nature. For example, consumers purchase life insurance to pay off their mortgage, consumer debts, provide education for dependants, and create cash reserves that replace the income of the breadwinner (this is called creating an instant estate.) In the event of the insured's death, most 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 may self insure (assuming they prefer $100,000 of cash to $100,000 of insurance). Insurance terms may be a number of years in length (1, 5, 10, 20 years or more) which (in theory) should provide significant 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 qualifications, or underwriting, as a new insured person. The cumulative costs of renewing term insurance, however, can eventually cost much more than the cumulative cost of purchasing permanent life insurance once.
Cons
First of all, "Self Insure" is a misnomer, since a financial loss is not indemnified. Anyone adopting this strategy is simply retaining the risk and, ultimately, would be willing to accept a loss. For example, someone with a home worth $500,000 who has $1 Million in cash could cancel their fire insurance and self insure. If their house burns down, they have enough money to build another or buy another. They will still suffer a cash loss, however, since they have chosen to retain their own risk. If they have no claims that would have been settled by property insurance, they have saved the premiums they would have paid, along with the earnings on those premiums. In this case, it can be proven that they came out ahead by not buying insurance, but the risk was enormous.
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 enought 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.
Term and Permanent Insurance both exist because a need for both exists. When selecting the proper type of insurance, it is necessary to take into account needs, wants, goals and means. Those who lean toward the "Buy Term and Invest The Difference" way of thinking are often looking at blanket solution to all financial problems related to life insurance and are not focused on everything that can be achieved by the use of life insurance.
Some people may have a permanent need for life insurance, especially when it comes to paying estate taxes. For those with substantial estates, the survivors may have to give up cash or sell off assets to pay the government. Life Insurance provides a very efficient way to pay estate taxes, especially with policies that pay out (at death) the initial amount of insurance and return all premiums paid as well. Most proponents of Term + Investment are using this strategy to build up a large estate, but do not protect it for the next generation. It can be agreed that this is not necessarily a "need" but a "want." However, a want is a legitimate concern, since someone who builds an estate has the right to see it preserved if they see fit.
Immediate accumulation of investment money
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, loan 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 accumulates 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 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.
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 somone who quits smoking thinking of all the money they'll save. looking at things a few years later, it is a rare ocurrence for anyone to actually have a large amount of money in their special "non-smoking" investment account.
Investment options
Pros
This practice leaves the insured open to utilize whatever investment options they see fit. However to take full advantage of the tax benefits of permanent programs they should first be understood. Life insurance death benefits are never taxable, 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. It is often thought that 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). Depending on how the insured structures themselves premiums may be paid with pretax dollars (as a business obligation in a corporation for example), but are most often paid with after tax money. 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 vehicles, 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 the insurance death benefit is not impacted by accessing it.
Cons
Again this requires the implimenter to research investments and how to best take advantage of them.
Return of Cash Accumulation
Pros
Proponents of BTAID (Buy Term And Invest the Difference) indicate the greatest advantage of this concept is the return of cash accumulation. Many permanent policies are "cash surrender" life insurance, due to the fact that the cash accumulation always goes to the benefit of the insurance company who then uses the cash accumulation to pay a portion of the death benefit (this may vary per program see below). 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 (see below).
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 generally reduced by the amount of the loan. If the policy is cancelled, the loan is deducted from the cash accumulation 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. If the insured dies when the policy is no longer in force, the beneficiary of the investment receives it, but no benefit from the insurance policy (which is in effect the same as canceling a permanent program).
Some permanent programs offer "Plus Fund" or "Return of Premiums" as options for receiving the death benefit and cash accumulation or premium. In these programs where the cash accumulation is "paid out" in essence the insurance company creates an additional insurance policy and fee on the cash accumulation. The accumulation insurance benefit and death benefit then pay out as the cash is still surrendered. The insured can attain the same effect by investing this small fee at the same rate as the company in their own account.
Cons
Most tax-favoured investment vehicles have a cap as to the contributions that can be made on an annual basis. Individuals in some jurisdictions, though, may have maximized all available programs that can provide tax deferral or tax relief. Overfunding A Universal Life policy may provide an additional shelter. The proceeds may be passed on to their survivors and is also resistant to penalties brought from lawsuits. This has sometimes been criticized, since the insured person must die in order to pass on the savings with no tax consequences.
In recent years, strategies have evolved to increase the attractiveness of using a life insurance policy for investment. The IRP or "Insured Retirement Plan" is a program where a life insurance policy is overfunded for several years. When the cash value is to be accessed, the policyholder may assign the policy to a lending institution in exchange for a loan or line of credit. The plan is monitored so that the loan principal and interest accumulation can never exceed the proceeds payable on death of the insured. Upon death, the loan is repaid and the remainder can still be paid out tax-free to the beneficiary or the estate of the insured. This means that an insurance policy can be used to tax shelter money. Even this has a limit, though, since there will be a maximum annual contribution to the policy based on the age of the insured and the face amount.
The IRP, also known as "Life Insurance Leveraging" is a sophisticated strategy that is usually used with paid-up policies that have large face amounts and large amounts of cash within them. The plans need to monitored carefully, but many financial institutions now have agreements with insurance companies to provide administration of such plans.
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.
Universal Life policies can now be structured with several different death benefit options such as:
Level Death Benefit - Where the face amount never changes regardless of cash accumulation within the plan
Indexed Death Benefit - Where the death benefit rises by a specific percentage each year (limits apply)
Level + Fund - Where the payout on death consists of the initial amount plus the cash or fund value
Level + ROP - Where the payout on death consists of the initial amount plus the return of all premiums paid
External links
- What's wrong with your life insurance, ISBN 0025293508.
- Experts
- Smart Money
- Financial Literacy