The potential pitfalls of “buy term and invest the difference.”
BTID is the acronym for the long-debated life insurance strategy, “buy term and invest the difference.” The second part of that approach—for numerous reasons we’ll touch on here—can prove to be problematic.
Let’s first explain what “the difference” actually represents. Permanent life insurance, for example whole life policies, have higher premiums than term policies, often by a factor of 10 or more. Whole life offers benefits not available on term policies, such as a tax-advantaged cash value account that builds up inside the policy and the potential to receive dividends. It’s the difference in premium payments which could hypothetically be invested by the term policyholder, with the investment returns compensating for the cash value accumulation potential of the permanent insurance policy.
Now before we dive into BTID, let’s do a quick side-by-side comparison of term and permanent insurance.
Term life insurance.
Basic comparisons of term and permanent insurance are abundant—though most are incomplete. The reason is simple: The main criteria for term policies are the cost of premiums, term length (typically around 20 years), and coverage amount (typically between $100,000 and $250,000).
Of course, you can purchase term insurance with a conversion privilege for permanent life insurance. This convertible term insurance will allow the policyholder to convert the lower-cost term insurance into permanent insurance without additional proof of insurability and possibly while locking in the rate class of the insured at the inception of the policy.
The policy carries no cash value, and only pays out if the policyholder dies during the term. That’s essentially it—lower-cost life insurance protection. There are fewer variables to factor in, which makes one side of the comparison rather convenient. But what about the other side: permanent insurance?
Permanent life insurance features.
- Guaranteed premiums.
- Tax-advantaged cash value accumulation.
- An option to surrender the policy for its cash value. Note, that accessing the cash value through loans or withdrawals will reduce the cash value and death benefit.
- An option to surrender the policy for paid-up insurance, extended term insurance, or in some cases, an annuity, with premiums guaranteed at the time the original contract is issued, available with the purchase of optional policy riders.
- If the need for insurance changes, the policyholder would have an option to borrow nearly all of the cash surrender value at an interest rate that is subject to a contractual maximum.
- Optional modes of death claim’s payment (e.g., lifetime income or a lump-sum payout).
- For a participating policy such as whole life insurance, the ability to be eligible for dividends when declared by the company and optional methods by which dividends can be received. The payment of dividends is not guaranteed, however.
These can be considered the main benefits, but you can still tweak your permanent insurance policy to suit your particular needs and situation in the form of policy riders. The most common rider—term rider—can be linked to a permanent policy to enhance short-term coverage or be converted to its own permanent policy. Riders are optional and generally involve a separate charge.
The combination approach of buying whole life insurance and supplementing it with term insurance, especially during the early years, can work well for some people. In fact, in most scenarios studied for consumers age 35 to 50, the optimal combination of insurance involved both term and whole life.1
If the average investor performed like Warren Buffet, BTID would be a no-brainer. Unfortunately, the reality is much different: According to MarketWatch, the average investor even trailed cash (represented by 3-month Treasuries) over a 20-year period, with average annual returns of just over 2%.2
A main culprit for this sobering statistic is the “emotional investor,“ who reacts to the market, eagerly buying when stocks are soaring, and anxiously selling when they’re falling—the exact opposite of the timeworn and often elusive “buy low-sell high” adage.
A New York Life-supported study, “Buy Term and Invest the Difference Revisited,” by David F. Babbel and Oliver D. Hahl, August 14, 2014,1 detailed in the following section, addresses other potential limitations for BTID. The study found that the BTID approach makes three basic assumptions about human behavior and consumers’ ability to identify and manage risk that are at odds with the observed financial behavior and tendencies of most people.
- Customer selection. Behavioral finance shows that the very people to whom BTID appeals most are those least able to do it successfully. BTID requires unusual discipline in spending habits so the savings from the lower premiums really will be amassed. Most investors will then need to incur the expense of investment advisory fees or investment management fees and expenses to make up for their own deficiencies in strategic investing. The cost of professional advice, when factored into the BTID system, reduces its attractiveness. Of course, it is also true that permanent life insurance involves insurance fees and charges, which affect cash value accumulation.
- Most people are not good at identifying, measuring, and comparing short- and long-term risks, or understanding the true value of preparing for them. The economic literature refers to this as “hyperbolic discounting,” but it boils down to people’s tendency toward impatience—what we want or need right now seems much more important than what we might need years or decades from now. It takes an extraordinary amount of discipline to overcome this tendency.
- People who choose BTID don’t often stick to the program. In fact, those who buy term insurance are more than twice as likely to let their policies lapse as those who purchase whole life. Even those who do keep their policies may find they can’t buy more term life once the policy expires after the term ends, because either their age or health problems have made it too expensive. Not coincidentally, term life policies tend to become prohibitively expensive to consumers as they approach the time of life when the policies are most likely to return a payoff.1
So, what’s a good alternative strategy?
In addition to whole life, there are two other permanent policies that provide insurance buyers with varying degrees of flexibility and investment options.
Universal life insurance is a flexible life insurance policy that combines the benefits of permanent life insurance protection and cash value accumulation with the convenience of adjustable premiums and payment schedules.3,4 And, within a universal life insurance policy, cash value accumulations grow tax-deferred at competitive fixed interest rates.
Generally less expensive than other permanent life insurance but more expensive than term insurance, universal life gives you the flexibility to choose the amount of protection that best suits your family or business, and it enables you to increase or decrease your coverage level as your business or personal insurance needs change.3
Variable universal life.
Variable universal life insurance includes an investment component with its death benefit feature—essentially combining the dual functions of BTID into one product. A major component of variable universal life which distinguishes it from BTID is that the cash value of your investment grows tax-deferred. The policy’s investment options may not be as comprehensive as the overall market, so it’s important to research those options before committing to a policy. The cash value in a variable universal life policy rises and declines, and investment losses are possible.
New York Life Insurance and Annuity Corporation (NYLIAC), which is an issuer of variable universal life policies, offers in its Variable Universal Life policies, a New York Life-affiliated family of investment divisions called the Mainstay funds, but NYLIAC’s Variable Universal Life policies also offer investment divisions managed by some of the more popular brands in the mutual fund industry, including Fidelity, BlackRock, PIMCO, and American Funds. Those who are knowledgeable about investing and comfortable picking their own funds can do so. Those who are not can take advantage of the model portfolios New York Life offers for every investment style.
You can learn more about New York Life’s Variable Universal Life Accumulator Plus and Survivorship Variable Universal Life Accumulator policies at www.newyorklife.com/products/vul-accumulation-series. The VUL Accumulator policy is offered only by prospectus. Please consider the investment objectives, risks, charges and expenses of a VUL policy carefully before investing. This and other important information is contained in the prospectus, which you can obtain from your NYLIFE Securities LLC Registered Representative. Please read the prospectus carefully before investing.
1 David F. Babbel and Oliver D. Hahl, “Buy Term and Invest the Difference Revisited,”
August 14, 2014.
2 “1 Chart Shows Just How Badly Average Investor Lags—Even Cash,” MarketWatch.com, August 13, 2014 @ http://blogs.marketwatch.com/thetell/2014/08/13/1-chart-shows-just-how-badly-average-investor-lags-even-cash/
3 Increases are subject to underwriting.
4The policy will terminate if at any time the cash surrender value is insufficient to pay the monthly deductions. This can happen due to insufficient premium payments, if loans or partial surrenders are made, or if current interest rates or charges fluctuate.
NYLIFE Distributors LLC is distributor of the New York Life VUL Accumulator Plus policy.
The New York Life Variable Universal Life Accumulator Plus policy form number is ICC 13313-30.