There is a difference between investing and insuring. Neither is better or worse than the other. They each have a purpose. For example:
- Insurance is buying money today at a discount so that when you need it most (death, illness, disability etc) the insurance provider promises to pay the provision of money agreed upon at the issuance of the policy. We buy insurance because we want a guarantee. We don’t have a crystal ball to give us a glimpse into the future. The fact is we don’t know when misfortune strikes and those who experience misfortune will tell us that it usually rears its ugly head when we least expect it. To protect ourselves and the value of our investments, we provide ourselves a guarantee that we can fall on. Think of insurance as the back-up electrical generator a hospital would have in case of a power outage.
- Investing involves converting money to a different form of capital with the expectation that it will appreciate in value over time. We invest our money to make a large purchase (a house), prepare for future needs (children’s education, buying a house) or even to provide provisions to sustain us in our retirement years. Think of investing as a planting a seed. We plant it and nourish it with nutrients and sunlight with the expectation that it will flower and be fruitful.
While buying term and investing the difference may work, it is contingent on the the risk and return of the investments. Therefore what may work in theory, may not work in practice because investments are usually not guaranteed.
“What may work in theory, may not work in practice.”
Here are two different scenarios. The first scenario is an example of when buying term and investing the difference would work really well. The second scenario is an example of when buying term and investing the difference would not work very well.
Scenario 1
John Smith is a 35 year old male. His brother passed away at the age of 37. He is concerned that the same might happen to him. After shopping around funeral homes, he determined that his funeral cost is $10,000. John asked his financial advisor if he should proceed with the transaction. They determined that the best course of action in his particular case was to buy a term policy and invest the difference. John tolerates risk reasonably well.
Table 1- Describes the guaranteed premium a 35 year old male will pay into a $10,000 Permanent Whole Life Paid-up additions policy
| Age | Guaranteed Premium | Guaranteed Face Value | Non-Guaranteed Face Value + Paid-up additions
|
| 45 | $5,150.10 | $10,000 | $11,508 |
| 55 | $0 | $10,000 | $13,946 |
| 65 | $0 | $10,000 | $17,538 |
| 75 | $0 | $10,000 | $22,105 |
| 85 | $0 | $10,000 | $28,422 |
| 95 | $0 | $10,000 | $36,648 |
| 100* | $0 | $10,000 | $42,212 |
| Total Cash Outlay | $5,150.10 |
*Insurance policy is cashed out at age 100 regardless of living or dead
Table 2- Describes the amount invested in a Tax-free savings account for the same 35 year old male above, over the course of his life, plus the cost of a term 20 life insurance policy
| Age | Amount Invested | Investment return at 4.5% | Term 20 Insurance cost
|
Total Insurance + Investment |
| 45 | $5105.10 | $7,719.53 | $870.00 | $17,719.53 |
| 55 | $0 | $11,224.37 | $870.00 | $21,224.37 |
| 65 | $0 | $17,587 | $0 | $17,587 |
| 75 | $0 | $27,560.27 | $0 | $27,560.27 |
| 85 | $0 | $43,186 | $0 | $43,186 |
| 95 | $0 | $67,672.15 | $0 | $67,672.15 |
| 100* | $0 | 106,041.54 | $0 | 106,041.54 |
| Total Cash Outlay | $6,845 | |||
*Insurance policy is cashed out at age 100 regardless of living or dead
Clearly for John, in this particular scenario, buying term and investing the difference is the better solution (compare Table 1 with Table 2). In the first 20 years he has more than enough funds to fund his funeral should he die. When the insurance coverage subsides, assuming that the market does well, he will also have more than enough money to cover his funeral expense. Alternatively, if he feels uncomfortable with keeping the money in the market, he can opt for a lower return that would keep his funds safe. In either case, based on both Tables, John is saving money.
Scenario 2
John Smith is 45 years old. He owns a restaurant with his business partner Ranjit Patel. When he dies his 50% share of the restaurant will go to his spouse. John Smith’s spouse has no intention in taking over the restaurant if John dies. John is very conservative. His father has had a bad experience with the market and has lost his shirt in a big market downturn. He does not feel comfortable taking any risks. He just wants guarantees that his spouse will have the cash in exchange for her share of the business when he passes. His spouse has been out of work for a long time and would have a lot of difficulty finding another job. In this particular case, it is blatantly obvious that buying term and investing the difference is just not the right fit for John. John is looking for peace of mind and guarantees, something that a permanent life insurance policy might be a better fit for.
In conclusion, buying term and investing the difference is neither a good nor bad strategy. People, their lives and their situations are unique. We believe strongly that people’s financial well being deserves serious consideration. Tailored plans combined with an accurate analysis of needs are imperative to understand the different and unique situations that occur. General catchy adages made-up to meet marketing needs of companies that want your money are no replacement for adequate financial planning. So before you hear the adage buy term and invest the difference and go on to buy a term policy, speak with a professional to determine whether it really is the proper course of action for you.