When debating their options for financial and life insurance needs, some families may ask, “Why should I buy permanent insurance when I can buy term and invest the difference?”
As you may already know, ‘buying term and investing the difference’ refers to the strategy of comparing the cost of a cash value life insurance policy to a term life insurance policy with the same death benefit, and investing the cost difference in the stock market rather than allowing it to accumulate as cash value within the life policy.
The key features and variations to these two planning strategies may make them attractive to different families or young professionals depending on their personal situation.
Difference Between Term vs. IUL
Indexed Universal Life (IUL) insurance is a type of permanent life insurance. An IUL policy allows you to “earn” a market return on your cash value based on an index, thereby mimicking the performance of the overall stock market. This tool may be used to accumulate substantial savings as well as provide for beneficiaries should the owner die prematurely.
Although you can purchase a term policy with the same death benefit at a substantially cheaper cost, the coverage of the policy only lasts for a specified period of time. Whereas with an IUL policy, as long as the owner properly manages the policy and does not allow it to lapse, will have a permanent death benefit.
Additionally, if a term policyholder wishes to continue receiving insurance coverage after their term period has ended, they can expect much higher premiums due to their change in age and overall health. Moreover, they may even be denied coverage if their health has deteriorated significantly.
Why This Strategy is a Myth?
The key argument in favor of ‘buying term and investing the difference’ is: because the money a policyholder is investing is not being used in part to pay life insurance premiums, they will be able to generate a more efficient return. However, investing wisely is a key factor in determining the success of this strategy.
According to a study conducted by “Dalbar's 2015 Quantitative Analysis of Investor Behavior,” over 20-year period, ending Dec. 31, 2013, the average investor (in all varieties of mutual funds) only managed an average total return of about 2.5%. *
As mentioned before, IUL policies mimic a specific stock index, such as the S&P 500, and provide returns based on market performance. According to an article published on Investopedia, the historical average annual return is in the S&P 500 is around 7 percent.**
Depending on the type of investments, investors may then have to pay taxes on their return while policyholders of an IUL can access tax-free loans from their policy. Investors do have the option to put their money into a tax-deferred investment such as an IRA. However, the IRS strictly limits the amount that a person can contribute each year. As a result, accumulating a substantial amount in an IRA can be difficult based on the relatively low level of annual contributions that can be made, when compared to an IUL.
There is no limit as to how much money a policyholder can put into an IUL. And because the money paid toward this product has already been taxed, withdrawals, and or loans, can be made tax-free once the cash value has built up to a substantial level.***
How Should Your Clients Invest Their Money?
Ultimately, a person who wants to purchase either of these products should consider all their options and seek the advise of an independent financial or insurance professional to decide which method is right for their personal situation. However, “buy term and invest the difference” provides an arguably inferior insurance product, in addition to possibly a riskier investment portfolio.
Bottom Line: It is all about the taxes! The tax deferred nature of cash value life insurance allows the values inside of an IUL to accumulate better than "investing the difference". This is because (assuming you are in a high enough tax bracket) the internal costs of the IUL are actually LESS than the taxes you would pay on the gains in your investment account.
*Retrieved from: Dalbar's 2015 Quantitative Analysis of Investor Behavior
**Retrieved from: What is the average annual return for the S&P 500?(http://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp)
***This is assuming the policy remains a non-MEC