By Brian Swerdlow
Many people want to balance their need for life insurance with their need to save and grow their wealth as much as possible. In the 1970s, an insurance agent came up with what proved to be a popular but possibly flawed solution- “buy term and invest the difference.”
Buy term and invest the difference, also known as “BTID,” was first articulated by agent A.L Williams. Williams reasoned that since many younger people with families may need more insurance than they could afford to buy with permanent insurance, a better solution would be for them to purchase term life insurance (which typically costs much less than permanent life) and use the money they’ve saved to invest in the stock market or cash-flowing businesses or real estate.
Williams’ idea looked pretty good in the 1980s when it took off. You could find agents touting the strategy nearly everywhere, mainly because the market was performing well and people who followed BTID were making solid returns.
BTID, however, was not without its detractors. Many financial professionals quickly pointed out some of BTID’s most glaring shortcomings. For one thing, buy term and invest the difference is built on the assumption that market returns will beat any returns you’d get otherwise. The second assumption, sometimes called the “theory of decreasing responsibility,” is that you won’t need death benefits after a certain age, so it won’t matter if your term policy expires. These assumptions, appealing though they may be, often don’t hold out in real life.
Beyond these assumptions, there are a few other reasons why BTID tends to fall short for many people.
Most people lack the necessary discipline and financial literacy for BTID.
One of the main reasons why the “buy term and invest the difference” (BTID) strategy fails is that most people lack discipline and a decent financial education. While proponents of BTID assume that people will invest the savings from lower-term insurance premiums wisely, the reality is that many individuals struggle to set aside funds for investments consistently. Instead, they will usually spend the money. This lack of discipline probably comes, in great part, from not possessing the right skills and tools, including financial literacy, that lead to solid money decisions. Becoming a successful investor without a proper understanding of financial products and market dynamics is virtually impossible. As a result, individuals may miss out on potential growth opportunities.
BTID doesn’t account for market volatility and risk
Investing the saved difference from term insurance premiums into the market exposes a person to inherent volatility and risk. The markets often experience significant fluctuations, leading to unexpected losses and diminishing anticipated returns. For risk-averse individuals or those with shorter investment horizons, the unpredictability of the market may not align with their financial goals. It may lead to disillusionment and frustration with the BTID approach.
BTID may cause you to overlook tax benefits or miss tax-deferred growth opportunities:
A remarkable and often underestimated advantage of permanent life insurance is its substantial tax benefits. Unlike term insurance, which provides only a death benefit with no tax advantages, permanent life insurance offers a unique combination of tax-deferred growth, tax-free withdrawals, and potential estate tax savings. Such tax-mitigating benefits make permanent life insurance a highly attractive tool for individuals seeking to optimize their financial planning and protect their wealth.
Some advantages of permanent life insurance include tax-deferred growth, tax-free withdrawals (depending on the type of permanent life chosen), tax-free loans against the policy’s face value, and possible estate tax savings.
The cash value feature of whole or universal life policies grows on a tax-deferred basis. As policyholders pay premiums, some of these funds are allocated to the cash value account, accumulating over time without incurring taxes on the earnings.
One of permanent life insurance’s most exceptional tax benefits is the ability to access the cash value through tax-free withdrawals. Policyholders can use their policy’s cash value for many different purposes, such as supplementing retirement income, funding educational expenses, or covering unexpected emergencies, without triggering a tax liability.
This tax-free access to funds offers valuable financial flexibility and can be a powerful tool for managing unexpected financial needs without incurring additional tax burdens.
In addition to tax-free withdrawals, permanent life insurance policies often allow policyholders to take out policy loans against the cash value. These loans are also tax-free, meaning the borrowed funds do not count as taxable income. Policyholders can use these policy loans to address various financial needs, and repayments can be structured flexibly according to individual preferences.
For individuals with substantial estates, permanent life insurance may be an effective estate planning tool to mitigate potential estate taxes. The death benefit of a life insurance policy generally passes to beneficiaries tax-free, providing a means to create liquidity in the estate. This liquidity can pay estate taxes, ensuring that the estate’s total value is transferred to heirs and beneficiaries without being diminished by tax obligations.
BTID may give you inadequate coverage as you get older.
The appeal of term insurance is its initial affordability, especially for younger individuals. However, as a policyholder ages and their term policies expire, obtaining new coverage becomes increasingly cost prohibitive. Premiums for new term policies rise significantly with age, making it challenging for older individuals to maintain the same level of coverage at a reasonable price. This situation results in a gap in protection, often when financial obligations and family responsibilities are at their peak.
BTID has a somewhat limited utility in financial planning.
The BTID strategy often focuses solely on accumulating wealth through investments outside of insurance. While investing is a critical component of retirement planning, permanent life insurance offers a broader range of financial benefits. Permanent policies with living benefits, such as cash value whole life and indexed universal life insurance, provide policyholders with additional financial tools and flexibility. Access to the cash value allows policyholders to address diverse financial needs, including funding education, supplementing retirement income, and even acting as a source of emergency funds.
Conclusion:
Although the “buy term and invest the difference” strategy might seem appealing at first glance, its shortcomings become evident upon closer examination. For most people, the lack of discipline and financial education can hinder successful execution, and market volatility introduces risks that may not align with individual financial goals. Moreover, the missed tax-deferred growth opportunities and inadequate coverage as policyholders age further diminishes the potential benefits of BTID.
In contrast, permanent life insurance with its living benefits offers a more comprehensive and robust approach to financial planning. The cash value accumulation, tax advantages, and access to funds provide policyholders with a versatile and valuable tool for long-term financial security. As with any financial decision, working with a knowledgeable financial advisor who can assess individual circumstances and goals to determine the most suitable life insurance strategy is essential.
Embracing the potential of permanent life insurance and understanding its living benefits can lead individuals to a more secure and prosperous financial future. Rather than settling for a simplistic BTID strategy, individuals and their advisors could make more informed decisions and leverage the full range of benefits that permanent life insurance provides.
