If you’ve looked into buying life insurance before, there’s a good chance you’ve heard the adage, “Buy term and invest the difference”. We do not sell insurance at Mullooly Asset Management or hold ourselves out to be insurance experts. However, we do help our clients out with basic financial planning, and in doing so insurance frequently comes up. In this post and podcast, we break down the main differences between term life insurance and whole life insurance. Where these products differ is where the old adage comes from.
Before even delving into term and whole life insurance, we think it’s important to bring up the reason why people buy life insurance: to provide income to their family in the event that they pass away. Expenses that most people look to cover through insurance include their mortgage, other loans, college expenses for kids, final expenses and a few years of general expenses to allow their family to adjust to life without them.
Term life insurance is exactly what it sounds like. For a specified period of time, if you pass away, your family will receive a death benefit from the insurance company. Pretty much any other type of life insurance is whole life insurance or some variation thereof. The difference between whole life insurance and term life insurance is that the coverage is not limited to a specified period of time and it includes a savings component. Today the savings component has morphed into all sorts of indexed and variable policies, but we’re sticking to the basics here. In a whole life insurance policy you accumulate a cash value over time. Sometimes this feature is pitched to people as an investment vehicle. Since term life insurance is more basic, it costs much less to purchase than whole life insurance. You pay extra for the permanent insurance coverage and savings component.
So why do people say to, “Buy term and invest the difference”? In short, life insurance is really good at doing what it was invented to do: provide income to your loved ones in the event of your death. Life insurance is not so great at doubling as an investment vehicle. Whole life insurance is an expensive way to invest your money. There are simply far more cost efficient ways to do things. Before anybody thinks about funding the cash value of a whole life insurance policy, they should absolutely be maxing out other tax-deferred savings vehicles like 401k’s, 403b’s, 457’s, SEPs, IRAs, Roth IRAs, etc.
It’s important to understand that if you choose to invest through the savings component of a whole life policy, you shouldn’t expect to see any value accrue over the first year or two. This is because much of the fees and commissions associated with these products are front-loaded. You’re essentially paying the broker who sold you the policy for the first two years. Additionally, the investment options within many variable and indexed policies can really be dragged down by their internal expenses. The cash value of a whole life insurance policy will have a hard time keeping up with a regular, diversified portfolio created using no-load mutual funds and ETFs. This is where the adage comes from.
Many will say that if you buy term life insurance and invest the money you saved from not buying whole life insurance, you’ll be better off in the long run. Is this definitely true for everybody? Nobody can answer that question with any certainty. We’re all different people with unique situations. For most people, term life insurance and a sound investment strategy will be a more cost efficient way to gain coverage and save for the future. You should consult with an investment advisor and insurance expert before making any decisions though. You also have to commit to the adage’s second half of, “investing the difference”. If the adage ends up becoming, “Buy term and spend the difference”, you may not be better off after all. This is where working with a good fee-only investment advisor or financial planner can really help. Insurance policies are complicated products. Make sure that you understand the terms of any contract before you sign it, and ask any questions that come to mind.