Why "Buy Term and Invest the Difference" Is a Risk

Now that you've done your tax return, you know how little things can really add up. A deduction for mortgage interest? Good. A childcare deduction? Great. The choices you make in your everyday life do more than impact your checking account. They also have an impact on the big picture of your finances.

The same is true with life insurance.

Did you know that the kind of life insurance you buy can have a big effect on how much money you have during retirement? Let me show you how.

Buy Term...

The most popular type of life insurance is "term," a policy that covers you for a specific amount of time. If you pass away during the term, your insurer pays your family a death benefit. If you're alive at the end of your term, the policy expires. You have the option to renew, but because you're older now (and your age/health contributes greatly to the policy cost), it's going to be a lot more expensive.

So why do people choose a term policy? Because it's affordable. It provides basic coverage at a rate that won't break the bank. That's why many financial talk show hosts recommend it—you've probably heard one or more of them advise callers to "buy term and invest the difference." But what does that really mean?

...Invest the Difference

Term life insurance is less expensive than permanent life insurance (a policy that covers you for your entire life). Permanent policies also come with a cash value account, funded with a part of each payment you make. That money earns interest and grows tax-deferred over time. Later, perhaps during retirement, you can withdraw that money and use it for anything you like.

However, because a permanent policy costs more, you'll hear people like Dave Ramsey suggest you buy a cheaper term policy and invest the cash you saved in a mutual fund. The idea here is that your mutual fund will grow faster than your cash value. But will it?

...and Take on Too Much Risk?

Let's say you bought a 20-year term policy and invested the difference (a few hundred bucks a month) in a mutual fund. Even if you chose a diversified fund based on the S&P 500, you're still subject to the ups-and-downs of the stock market.

For example, if you first bought into a mutual fund in 1999, you had to weather two big downturns—one in 2002 and one in 2009. If you purchased the stock in early 2000, when the S&P 500 was at roughly 1,500, you would have seen a big dip in 2002, when the index lost almost half of its value and dropped below 800.

You would have had to wait until 2007 for the index to rise above 1,500 again. But then the real estate bubble burst, and the index's value dropped again. You would have had to wait until early 2013 to see the index rise over 1,500 again. Overall, that's a wait of almost 13 years just to break even.

The Alternative: Permanent Life Insurance

On the other hand, if you'd bought a permanent policy in 2000, it would have built solid cash value every year, no matter what the market did. That's an increase in value every year between 2000 and today. According to New York Life, over 15 years, the average whole life policy returns about 3.7%. Other estimates place this value as high as 6.5%, all tax-free. In the example above, the original investment in the S&P 500 index earned about 1.3%. When you compare guaranteed gains with the uncertain future of the stock market, it's easy to see why a lot of my clients are opting for the secure, guaranteed gains.

But What about a Bull Market?

Here's the thing about a bull market - it doesn't last forever. There is always a downturn, even if it's 10 or 15 years after the start of the current bull market. Plus, a steadily rising market doesn't take inflation into account. For example, from January 1, 2000, to December 31, 2018, the S&P 500 had an average return of 4.37%. Adjusted for inflation, that drops to 2.17%.* If you invested $1.00 in 2000, you'd have had $1.14 at the end of 2018. And that's during a bull market.

On the other hand, a cash value life insurance policy is guaranteed to offer a return. For example, in 2018, Mass Mutual offered a 6.40% dividend on its participating whole life policies.** That's not a bad option if you want to avoid all the risks that come along with investing.

Are you interested in a secure source of supplementary retirement income? Permanent life insurance may be right for you.

First and foremost, thought, life insurance is about the peace of mind it offers. As you're making a decision, be sure you take this into consideration, too!

To get started, give me a call or send me an email today!

*Stats from http://www.moneychimp.com/features/market_cagr.htm, using S&P 500 data provided by Robert Shiller at econ.yale.edu.
**https://www.massmutual.com/about-us/news-and-press-releases/press-releases/2017/11/02/18/43/massmutual-approves-2018-policyowner-dividend-payout