Insurance Tip #8: Buying term insurance and investing the difference may be a dumb move
I agree with the traditional advice that term insurance is appropriate for most people. It is relatively inexpensive if purchased at a young age. It's simple to understand and it makes it easy for most people to obtain enough coverage to protect their families in the event the primary breadwinner dies prematurely.
Insurance that builds cash value (often called "permanent" insurance) comes in a dizzying array of options. There is whole life insurance, adjustable life, universal life and variants of each of those policies.
So why not just "buy term and invest the difference" in the cost between term and the higher cost of cash value insurance?
The primary reason is that few people have the discipline to invest the difference. Most likely, this money will be spent just staying afloat.
Even if you do "invest the difference," how will you do it? The data indicates that Americans are terrible investors. The projections that are so casually tossed around usually assume that your investments will achieve at least market returns. The reality is that the average stock investor earns around one-third of market returns. When you consider inflation and taxes, these investors lose money! This is one of the big secrets of the securities industry. Market returns are yours for the taking, but they don't want you to know how easy it is to do it. Hint: It does not involve using their services.
If you are in it for the long haul, buying term and investing the difference can be a dumb move for many reasons.
Cash-value insurance (as long as it remains in force) means that your loved ones will receive a death benefit. With term insurance, it is likely that the policy will not be in force when death occurs.
Because the earnings within the cash-value policy are tax-deferred (and potentially tax-free if held until death), you may have to take additional risk with your investments in order to match the long-term performance of high-quality cash-value insurance.
With a permanent policy, you can borrow against the cash value. You may not even have to pay off the loan. The amount of the loan plus accrued interest will be deducted from the death benefit.
Some financial advisors believe that it is prudent to consider cash-value insurance as a substitute for that portion of your investment portfolio that should be allocated to liquid investments, like bonds. However, since this advice may result in lower assets under management (and fees) to them, they often do not objectively consider the benefits of cash-value insurance.
Finally, permanent insurance has major estate planning benefits, since policies on your life, owned by your beneficiaries, may not be subject to estate tax.
There is no "one size fits all" when it comes to insurance. However, buying term and investing the difference is not the "no brainer" it is often made out to be.
Dan Solin is the author of The Smartest Investment Book You'll Ever Read (Perigee Books, 2006) and The Smartest 401(k) Book You'll Ever Read (Perigee Books, 2008).