Buy term and invest the difference!
That slogan, long the mantra of multi-level marketing giant Primerica and like-minded distributors of term insurance, is founded on a simple premise: that consumers should purchase only term life insurance to cover income replacement needs; and that savings used to fund a retirement nest egg should be ploughed into vehicles — stocks, mutual funds, ETFs and the like — that are more cost effective or better performing than permanent life insurance. Term policy buyers thereby secure greater retirement income for themselves and legacy wealth to pass onto to heirs.
If only it were so simple. Increasingly, critics are calling into question the argument for this ever popular protection and investment strategy. And the naysayers include not just carriers, agents and advisors with a vested interest in sales of cash value policies.
Also favoring permanent life insurance as part of retirement income planning strategy are independent academics and market researchers who study the topic in-depth.
The latest assault on the “buy term” strategy took place at the Retirement Income Industry Association’s 2015 fall in Indianapolis on September 16. Wade Pfau, co-presenter of that morning’s session on retirement income optimization and a professor of retirement in the Ph.D. program for Financial Retirement Planning at the American College, outlined the financial benefit of permanent life insurance-funded retirement income plan.
The benefit is indeed big. Outlining six scenarios for “Steve” and “Susie” — three when they purchase insurance at age 35 and three at age 50 — the hypothetical couple enjoys a superior distribution of income (at age 65) and legacy wealth (at age 100) when (1) whole life insurance is integrated into their portfolio; and (2) they experience typical (“median”) investment returns.
For the three scenarios at age 35, Pfau pegs the median distribution of income at age 65 at $82,034 when whole life insurance is part of the investment portfolio. This compares with $58,556 with term insurance.
The difference in legacy wealth distribution at age 100 is substantially greater: $2,132,234 (whole life scenario) vs. $649,780 (term life scenario), a whopping 228 percent more for the first. For the 50-year-old scenarios, the chasm is even greater: $1,460,439 (whole life) versus $265,164 (term), a 451 percent difference.
To be sure, the varying scenarios rested on a host of assumptions. A number of these — 401(k) totals, the amount set aside for savings and insurance, term life and whole life premiums, taxes paid, among others — are detailed in the slides beginning on page 3.
Also not to be ignored: The varying outcomes don’t rest solely on differences in performance by policy type. While both the term and whole life scenarios include taxable investments, the whole life illustration also features a single-life, single premium immediate annuity.
The reason: to produce a more efficient retirement outcome than is possible using a term-and-investment-only strategy. By pairing a whole life policy with a SPIA, said Pfau, the client can create in effect “actuarial bonds” that yield better hedging of retirement income needs.
“By combining them, the overall planning horizon can essentially be fixed at something close to life expectancy, as whole life insurance provides a higher implied return when the realized lifetime is short,” said Pfau. “And income annuities provide a higher return when the realized lifetime income is long.”
If you’re thinking that term policy buyers can achieve a comparable retirement outcome by adding a SPIA to their portfolio, think again. Wade’s six scenarios, as the following tables show, also include two that bundle investments with term insurance and a SPIA (albeit a joint-life annuity contract to provide a death benefit to the surviving spouse).
The distribution of legacy wealth at age 100 in the term life plus investment plus SPIA-funded scenarios are even worse than those under the term-and-investment-only illustrations ($649,780 vs. $217,897, respectively, for the 35-year-old couple). The difference in performance for the same 35-year-old couple is likewise substantial when income is distributed at age 66 ($1,668,778 for term plus investments vs. $940,551 for term plus investments plus SPIA).
“The integrated [investments plus SPIA plus whole life policy] approach is actually able to provide more legacy wealth in these cases, while also supporting more retirement income,” said Pfau. “This is the meaning of greater efficiency.”
The three scenarios outlined in the subsequent slides each show three potential outcomes resulting from different sequence of investments returns on a portfolio. Assuming their post-retirement portfolio performance is in the 10th percentile (the “bad luck” outcome), they suffer negative investment turns in the early years, a result they’re not able to adequately compensate for, even when enjoying higher returns in later years.
The median percentile in Pfau’s illustration is the norm, where the couple enjoys (on balance) good investment returns in retirement. Because it’s the most likely outcome, the median percentile is the primary focus of Pfau’s presentation. The 90th percentile, which yields excellent returns throughout retirement, is also an unlikely outcome.
For a full explanation of the assumptions detailed in the following slides, see Pfau’s white paper, “Optimizing Retirement Income by Combining Actuarial Science and Investments.”