“Buy term and invest the difference” is a commonly promoted life insurance strategy.
The alternative is to buy some form of permanent life insurance, or cash value life insurance.
If a person can only afford term insurance, they may want to buy term and invest the difference. However, the wealthy prefer to use permanent life insurance.
More specifically, whole life insurance is preferred by the wealthy, for many reasons.
In our book, What Would the Rockefellers Do?, Garrett Gunderson and I explain these reasons in detail. Get your FREE hardcover copy now to learn more.
Term Life Insurance vs. Permanent Life Insurance
Term life insurance provides a death benefit for a certain period of time. It carries no cash value within the policy and has no tangible living benefits.
In contrast, permanent life insurance provides coverage for your entire lifetime, not just a specified term. It includes a cash value that accrues with premiums paid. It also provides many other benefits that a policyholder has access to while they are living.
Before we continue, I must stress that the proper amount of insurance must always be considered before the right type. This should be determined using the human life value approach.
If you can’t afford permanent life insurance now, you should first buy convertible term. This is term life insurance that can later be converted to permanent life insurance.
Why Term Life Insurance is the Most Expensive
There’s one main reason why some advisors recommend buy term and invest the difference. This is because the premiums on term insurance are much cheaper than permanent policy premiums. At least, this is true in the early years of a policy.
For example, a 30-year-old male could get a $1 million term death benefit for 30 years for as cheap as $750 per year ($63/month), if not cheaper. That same person would pay about $9,000 per year ($750/month) with a whole life insurance policy.
But there’s a major problem with term life insurance. That is that the cost of insurance raises dramatically over a person’s lifetime. But the cost of insurance within a permanent policy remains the same over a person’s lifetime.
After term life insurance policies expire, their rates can be more than 10 times the original premium. Term policies become prohibitively expensive over a person’s lifetime.
Consider the following example from one company illustration we considered:
A 30-year-old male buys a convertible, 30-year term policy with a death benefit of $1 million. The annual premium is $1,320. However, the premium increases to $46,490 when the term expires. By age 74, he has paid $767,930 in premiums for his $1 million death benefit. By age 84, he has paid $2.78 million for his $1 million death benefit.
In your retirement years, you will find that your term life premium payments exceed the death benefit. This nullifies the purpose of carrying the coverage.
When considered over a person’s entire lifetime, term life insurance is actually the most expensive.
Proponents of buy term and invest the difference don’t see this as a problem, however. This is because they advocate dropping your life insurance coverage as your assets build.
Term life insurance is actually one of the most profitable types of insurance for insurance companies. This is because the chance they will ever pay a death claim is less than one percent.
The Fallacy of “Self-Insurance”
Term policies are designed specifically to be dropped eventually. The reasoning is that when a person retires, they have plenty of assets to take care of them. Their kids are out of the house and self-reliant. They will quit their job, so their income will stop.
But does your human life value disappear just because your job income stops? Are you no longer contributing to the world just because you quit your job?
Term insurance is based solely on protecting income, not human life value. But human life value is the source and creator of all property value. Producers use life insurance to protect their human life value, not their income.
What we’re discussing is what people refer to as being self-insured. This is a phrase often used by proponents of buy term and invest the difference.
But self-insurance is a catastrophic fallacy. Either you are insured, or you are not. You either transfer your risk and provide means of indemnification in the case of loss, or you retain your risk.
The entire reasoning is based on a complete misunderstanding of the purposes of insurance.
Buy term and invest the difference is promoted by people who see insurance as a necessary evil at best. They do everything they can to lower or avoid premiums.
But the truth is that the more assets you have, the more you want insurance protection.
With buy term and invest the difference, you lose insurance coverage precisely when you need it the most. This is when you have the most risk of lost production.
The Fallacy of Internal Rate of Return
Proponents of buy term and invest the difference have a typical response to this. They say to use the money you would have spent on a permanent policy to invest in other assets. They assume you can get a higher rate of return than you can get with a permanent policy.
The internal rate of return in a permanent policy is the interest rate on the cash value. This is guaranteed by the life insurance company. This is in addition to any dividends the company may pay.
The guaranteed interest rate in a whole life policy, for example, can be up to about 5%. So why not put those premium dollars into real estate or a mutual fund and earn 10-12% instead?
Basing insurance decisions on internal rate of return alone is unwise. It ignores many other factors that must be included in a holistic decision-making process. Promoters of buy term and invest the difference don’t include these factors in their calculations.
It fails to take into consideration, for example, the lost opportunity cost of term insurance.
Suppose person buys a 30-year term policy for $750/year. He then drops it after the term. He will have spent $22,500 on premiums. This is money lost that can never be recovered.
The premium dollars aren’t the only thing that’s lost. So is what that $22,500 could have been had it been invested instead.
Worse than this, the lost opportunity cost also includes the amount of the death benefit that is lost. Also, the person may not be able to qualify for insurance coverage again, which is incalculable.
Buy Term and Invest the Difference Doesn’t Give You Living Benefits
Permanent life insurance policies also provide living benefits beyond the internal rate of return. These give them infinite value over term policies, which have no living benefits.
The living benefits within permanent policies include:
- Tax protection.
- Waiver of premium riders.
- Disability protection.
- Lawsuit protection.
- The ability to utilize the cash value.
- The freedom to leverage assets without worrying about lost principal.
- And more.
Permanent policies also provide the economic value of certainty. You can be certain that permanent policies will be there to protect your human life value the day after you die.
Buy term and invest the difference assumes a person leaves their cash value inside the permanent policy. But the cash value is available to the policyholder to be used for things outside of the policy. In contrast, no premiums on term policies are available for use.
Comparing buy term and invest the difference with permanent insurance based on internal rate of return alone simply doesn’t work. It’s comparing apples to oranges. It doesn’t tell us anything about reality.
Consider Price vs. Cost with Buy Term and Invest the Difference
Basing insurance decisions on internal rate of return is a classic case of price versus cost.
Most planners and policyholders see the price of permanent insurance. They ignore the cost of not mitigating their risk and creating as much certainty in their life as possible.
It’s also ironic that term carries a much higher price than permanent insurance in the long run anyway.
For McDonald’s, the menu item with the highest profit margin is fountain drinks. The lowest profit margin item is hamburgers. But what would happen if they eliminated everything on the menu except for the highest profit margin item?
The answer is obviously that they would fail because they can’t base a business on fountain drinks alone. They must look at their entire bottom line. All aspects of the business must be taken into consideration, and not profit margin of individual items solely. Hamburgers give them the ability to sell drinks.
The same principle holds true with permanent insurance versus buy term and invest the difference.
Another useful analogy is to consider the cell phone bill of a businessman. The internal rate of return for his cell phone is -100%. The phone company doesn’t pay him anything—he pays the cell phone company.
But it’s obvious to see how ridiculous it would be to base the decision of purchasing the cell phone on its internal rate of return. The incalculable external rate of return more than justifies the lost return internally. To only consider what the phone costs is to completely ignore all of the benefits the phone provides.
Such is the case with whole life insurance versus buy term and invest the difference. Whole life insurance may not give you the highest internal rate of return. But its certainty and its other living benefits give you the ability to be infinitely more productive in all other areas of your life.
As Solomon Huebner wrote in his book The Economics of Life Insurance,
“Life insurance must not be regarded as an expense to be grudgingly borne. To the thoughtful policyholder its creative aspects, by way of personal initiative and productiveness, much more than counterbalances the cost involved.”
Comparing Buy Term and Invest the Difference with Whole Life Insurance
The illustration below shows how permanent life insurance gives you a “permission slip” to utilize your assets after retirement.
Person A has term insurance, Person B has whole life insurance. They have both retire at age 65 and begin to draw income from their assets.
The number one fear of retirees is running out of money. Person A will only want to live off of his interest. Because if he spends his principal, he runs the risk of running out of money and disinheriting his heirs.
Also, if he spends down his principal while he is alive, he can only leave his heirs is $1 million. That is if his term policy is still in force, which is questionable at best.
His term life death benefit cannot grow. It’s almost guaranteed that he will drop the policy anyway as the premiums become prohibitively expensive. So we can also add the lost opportunity cost of all that irrecoverable premium money to the equation.
Person B, on the other hand, has the freedom to utilize his principal and interest. This is because whole life insurance prevents him from having to worry about any of those things.
His death benefit is still growing even as he spends down the principal of his assets and his cash value. Furthermore, his death benefit is guaranteed to be there the day after he dies.
By using permanent life insurance, Person B has a much higher retirement income than Person A. This is because whole life insurance has given him a permission slip to spend down his principal. He can spend down his assets and still leave his family in excess of $2 million in death benefit (because it grew as he aged). And his death benefit is certain.
This is not possible with the buy term and invest the difference strategy.
The power of permanent life insurance is such that it unlocks the potential of all a person’s other assets. This is a benefit external to the internal rate of return. Hence, to compare policies on internal rate of return alone is nonsensical and pointless.
We get what we pay for. Term life insurance is cheap in the early years for a reason. It provides relatively little value. And the value that it does provide is almost guaranteed to go away before it is even used.
This is why the wealthy don’t buy term and invest the difference.
The AIS Triangle vs. Buy Term and Invest the Difference
Buy term and invest the difference is a strategy that ignores deeper principles. We architect wealth for our clients using a core philosophy based on sound financial principles.
This is encapsulated in the three points of the AIS triangle: Asset, Investment, Strategy.
Your #1 ASSET is You
Your primary asset isn’t your business or any investment—it’s YOU. This is the first asset we prioritize for both protection and growth.
Your human life value is not just your future economic worth. It also encompasses your knowledge, character, values, mindset, and skills applied productively to create value for others.
To build greater wealth, start by enhancing your human life value by investing in yourself.
Start now by claiming your free hardcover copy of What Would the Rockefellers Do? by Garrett Gunderson and myself.
This principle alone explains why we’re opposed to buy term and invest the difference. Buy term and invest the difference is based on protecting your income for a certain period of time. In contrast, we take the human life value approach to life insurance.
Your #1 INVESTMENT is Your Business
For entrepreneurs, your business is the main source of your cash flow and wealth. This is where you have the most passion, knowledge, and control. It’s also where you have the most opportunities for wealth creation.
We recommend that if you’re going to take any risk, do it in your business. But don’t do it with any other outside investments.
Buy term and invest the difference exposes you to too much risk.
Your #1 STRATEGY is Guaranteed, Protected, and Liquid
The ideal financial strategy for the wealthy is to store extra cash in places that are guaranteed, protected, and liquid. The wealthy do not gamble or speculate.
This means using whole life insurance, not buy term and invest the difference.
This is like locking your money in a vault. You still have access to it for other investments. But you have a solid foundation for wealth with certainty and control. You don’t get this with buy term and invest the difference.
Conclusion
Either a person loves insurance and understands why, or they don’t. A person who loves insurance wants the best policy that money can buy. They want certainty by transferring as much risk away from them as possible.
Buy term and invest the difference does not give you this certainty.
Producers base their decisions on holistic cost, not micro price. They want a policy that provides them with the most benefits in a macroeconomic sense, beyond mere internal rate of return alone. They want a policy that will make them more effective with the creation and utilization of every other asset inside their plan.
You can’t get this with buy term and invest the difference. This can only be achieved through living benefits provided by permanent life insurance.
It is almost guaranteed that a term policy will never pay a death claim. This is a violation of a Producer’s commitment to create value in any situation, and to mitigate their risk to near zero.
Why would anyone want insurance at one point in their life, and then want to drop it at a later point? Either you want it or you don’t. If you want it, then you want it for your entire life. This rules out buy term and invest the difference as an option by default.
“Buy term and invest the difference” is based on the misguided belief that insurance is a necessary evil and that we should find the cheapest method of insurance possible. There is never a time when a Producer does not have human life value.
As long a person has human life value, there is always a need for insurance to indemnify lost production when they die or get disabled. That need for protection is best fulfilled by permanent life insurance, not buy term and invest the difference.