We've all heard the saying of 'buy term and invest the difference' when it comes to making the financial decision of how to protect your loved ones all while maximizing the amount of savings you can accrue. But is this phrase really sound advice when you compare it to the long-term benefits of a permanent insurance policy? In this episode of Money Script Monday, Jordan tackles the ever-popular recommendation of 'buy term and invest the difference' and puts the theory to the test.

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Video transcription

Hi, my name is Jordan Arias, and welcome to today's Money Script Monday. Today we're going to be talking about does "buy term and invest the difference" work for you, and, really, what we're going to look at are a couple different things.

We've all heard "buy term and invest the difference", so we have to think about where did that information come from, who is soliciting that information, and does it really make sense for us.

So, with today's report, we're going to be looking at three different things. The first thing that we're going to look at is question one. Does "buy term and invest the difference" really work? Is it a plausible financial strategy that we can use? Second, we're going to look at, how does permanent insurance compare to "buy term and invest the difference"? Is the alternative better, buying permanent insurance versus buying term and investing the difference? And third, what we want to look at is, what is the average rate of return we will need in order to equal that permanent insurance and that death benefit? So, if we invest the difference, how much of a rate of return do we have to receive in order to amount to that same death benefit and permanent insurance strategy?

With that, let's get into it.

Question #1: Does buying term and investing the difference really work?

So, what you're looking at here is a side-by-side comparison of does it make sense to buy permanent insurance or does it make sense to "buy term and invest the difference" in some type of equity account?

In the first column, this is our permanent insurance premium, so a rather large case example, but keep in mind that this can be broken down and the same type of concept is still going to apply with any type of premium amount.

In Column 1, $512,000 is the permanent insurance premium that we would be paying for 10 years. Column 2 is the term insurance, so we're after $30 million of insurance.

Obviously, buying term versus permanent, much cheaper to buy term insurance, $89,000 of annual premium versus $512,000 of annual premium on a 10-year basis. So, what we would do then is take the difference between our permanent and our term, and that's the money that we're going to invest in a side fund.

Question #2: How does permanent insurance compare to the ‘buy term and invest the difference’ model?

Now, for comparison purposes, we said that side fund is going to earn 6.75%, along with our permanent life insurance earning 6.75%, and our tax rates are all the same as well. When we look at this comparison, what we see here in these columns, Four, Five, and Six, Column Four is our equity account, or our side fund that we're taking the difference from the permanent premiums. And we're investing that, and we're earning 6.75%.

Again, for the sake of argument, it's average. So, every single year, we're getting that credit, and we have that term insurance death benefit of $30 million.

So, when we combine those two accounts, every single year you could see that account growing because our equity is growing, our equity account is growing. Our term insurance does not. So, that policy works well, out of pocket, a little bit more liquidity earlier on as you can see, because our equity account value has assets inside of it.

When we look at our permanent insurance, it takes time to fund that contract. And so, yes, we don't have cash value liquid money, but what we're focused on in this type of play is long-term. So, short-term, yes, we may have some more benefits on "buy term and invest the difference" because we have more money available in our equity account.

But when we look at long-term, that's what I want us to focus on.

After 10 years, when we're done paying our permanent insurance, we still have to pay our term premium. We can't front load our term premium. That's an expense that continues to come out of our contract, all the way through.

We’re going to fast forward to some...later on during life expectancy. Again, we're done paying our permanent insurance, so let's just take a look in Year 21, at age 74. We have an account balance in that equity of $7 million. Our level term insurance is still $30 million, so we've grown the asset to $37 million in terms of transfer.

Well, with that permanent insurance, because of the benefits that we get, that we've talked about in the past, of maximum funded life insurance, that cash value continues to grow as well as the permanent death benefit. So, up front, we're getting more benefit from the "buy term and invest the difference".

In the long run, it pays to have more permanent insurance, even though we have to pay much more out of pocket in those first 10 years.

But, when we look at insurance concepts, we're looking at long-term. We are not looking at short-term gains or short-term strategies here.

Let’s fast forward to a little bit more toward, let's say, life expectancy. What we're looking at for life expectancy is what you can see here in Year 31. This is the biggest downfall of term insurance, is after 30 years, that was a 30-year term, that $30 million of death benefit drops off.

Now, is that a gamble that we want to pay when looking at wealth transfer scenarios, or to pass on the most efficient money possible, or be able to access the most money possible in retirement?

All things equal, that term insurance is now expired, so the only thing that we're left with, even though we saved premiums up front by investing the difference, the only thing we are left with at that point in time is the equity account.

So now, our combined death benefit, or wealth to heirs, or liquidity in terms of retirement assets, is only our Column 4, our year-end equity account value. And again, that's assuming our 6.75% year-in, year-out, conservative rate of return.

If we look at our permanent insurance, because we've invested earlier on and we structured the permanent insurance properly, it cost us more up front but, in the long run, we now have cash value that we could potentially borrow from in excess of $35 million, along with a death benefit that has helped us grow along with inflation.

So, not only do we have this level death benefit of $30 million for 30 years. With our permanent, the way that it's structured conceptually, trying to grow that death benefit to account for inflation, that death benefit is going to grow along with the cash value as well.

Coming back to life expectancy, let's just say life expectancy is 84. We’re in a much different situation with permanent insurance versus combined death benefit along with our term and our equity account value.

Keep in mind, term insurance is a great vehicle to use when supplementing for additional protection needs certain periods of time. But also, keep in mind that term insurance has about a 1% to 2% payout, and the reason that is is because the likelihood of dying within that specific term is very unlikely, and the insurance companies know that, and the actuaries know that.

And that's why term insurance is so inexpensive, is because that likelihood is very, very low.

So you may be feeling like you're saving money by just buying term, but when it comes to life expectancy and having the adequate coverage that you need, that is not going to suffice along with wealth transfers, protection of needs, and accessing your money for supplemental retirement needs as well.

One of the other things that you want to look at, too, is this is a great comparison report to say, what would that equity line, as well as that term, need to earn in order to match our permanent death benefit?

Question #3: What average interest rate do we need to receive in order to match the permanent insurance?

In order to match the cash value, we would have to earn 11.63% year-in, year-out, in order to match the value of that permanent life insurance structure.

From a death benefit standpoint, it would have to earn a little bit more, 11.75%, and that's also after tax. So, we're applying gains on that, having to pay taxes, and then netting that return, year-in, year-out, in some type of equity account.

I don't know anything out there that can average that year-in, year-out, without any type of volatility that would reduce those accounts. So, it's a quick snapshot that you can see, that's going to give us why permanent insurance does have a place, there is an argument for it as well.

When it comes to looking at "buy term and invest the difference", these types of reports will show us that.

And that wraps it up for today's episode of Money Script Monday. As you can see, it doesn't always make sense for "buy term and invest the difference". But, what I would encourage you to do is, if you want to see your own situation with your own report, use the information on this page to move forward. Thank you.