Rent Term, Let it Lapse and Squander the Rest.

 For decades, the rallying cry of the financial advice industry has been for clients to buy inexpensive term life insurance rather than more expensive whole life insurance and invest the premium savings on their own. The only problem is most clients never execute the second part of the equation, leaving many of them uninsured in later life and unprepared for retirement.

Just how unprepared are they? A recent study by the Government Accountability Office looked into the question and the answer is sobering. The study found that in households with members 55 and older, nearly 29% have no retirement savings nor a traditional pension plan. Twenty three percent of those households have a form or defined pension plan, but NO retirement savings plan. What about the other 48%? The GAO determined that they have “some retirement savings.”

In case you are a generation X member or even a millennial, your generation is not fairing much better, in fact many are worse off.

Why are things so bleak for seniors and others when considering retirement? According to a recent study1 by David F. Babbel, professor at the Wharton School of the University of Pennsylvania the answer is: “People don’t buy term and invest the difference.” Professor Babel co-authored and published the report in the May 2015 issue of Journal of Financial Service Professionals. (“Buy Term and Invest the Difference Revisited“)

“Our study sheds light on Wall Street guidance that has been taken as an article of faith, but that clearly underperforms for many who follow it,” said Mr. Babbel.

“People most likely rent the term, lapse it and spend the difference,” he said. “And even the minority of those who do invest the difference are prone to the real-world emotional investing when individual investors tend to buy high and sell low, perennially underperforming market indices,” he added.   

“Typical economic analyses that compare the cost of buying term and whole life policies fail to properly assess the guaranteed cash value growth component of permanent life insurance,” Mr. Babbel said. He noted that cash value guarantees always grow, while a more volatile portfolio of stocks and bonds can rise and fall with the market.

Mr. Babbel pointed to whole life insurance policies that he and his wife bought decades ago as examples (neither of which are New York Life policies). The cash value of his wife’s $25,000 policy, purchased in 1988, is now worth $61,138 and his $178,000 policy, bought in 1997, has increased to $307,520. The growth, which has significantly outpaced inflation during those respective holding periods, represents both the annual guaranteed increase plus the policy dividends from their “participating” policies that are reinvested to purchase additional coverage.

Finally, traditional buy-term-and-invest-the-difference models, referred to as BTID models, ignore the valuable options of whole life insurance such as the flexibility to borrow against the cash value or to take tax-free distributions, he said.

Although it is common to think about term vs. whole life insurance as an either/or decision, it may be more appropriate to think of both. For example, a young client with a family will not be able to afford all the death benefit he needs via whole life insurance. So this client should purchase a small, $50,000 or $100,000 whole life policy AND then also purchase the rest of the needed death benefit using convertible term insurance. As the client’s income increases, he can shift more of the term to whole life.

“But I will not need life insurance when I get to age 65,” you regurgitate what you have heard on the radio and elsewhere. The fact is, that statement is coming from the same source that has put so many Americans in the retirement saving perdicament they are in with the Buy Term and Invest the Rest mantra. Real life happens and other factors need to be taken into consideration.

What are some of those factors? Have you heard of kids moving back in with parents? What about aging people having health issues? Ever heard of a 65 year old who still has a mortgage on their home? (According to the same GAO study discussed above, 65% either do not own a home or still have a mortgage.) If you are able to escape these three factors and have gone against human nature and actually saved, then possibly your life insurance can go away when you turn 65. But then again, think for just a moment; wouldn’t it be a bummer if on your 65th birthday your insurance ends and you die the day after? Tell me seriously when would you not want a tax free benefit for your family?

There are other tax advantaged features of whole life, such as converting the cash value to guaranteed income or borrowing against it. Such tax-free distributions can also be used in retirement to pay for Medicare premiums. Life insurance distributions are not counted in the Modified Adjusted Gross Income calculation that determines monthly Medicare Parts B and D premiums that increase with income.

Generations of Wall Street professionals have been trained by their firms to trash cash value life insurance so the investment firms could maintain those dollars under management.

To sum it up, this new academic study, using rigorous economic modeling, has debunked Walls Street’s heavily marketed, but largely erroneous path to financial security.

1. This study received partial funding from New York Life, but Mr. Babbel noted that all of his previous research and that of other researchers cited in the paper were not subsidized and all have undergone rigorous peer review.