Two years ago, after a few months of research, thinking and hesitation, I surrendered a whole life insurance policy that I had purchased and replaced it with a term insurance policy. As it was still early in its premium payment term, it meant losing a large portion of my premiums paid.
I did it because I had reached the conviction that buying a term plan would be more cost effective and, aside from treating what I had already paid as a sunk cost, I figured out that if I invested the cash value of the policy and the premiums that I could save, I would be able to more than make up for the amount that I would lose. In short, my plan was to “buy term and invest the rest” (BTIR).
Since then, my perspective on BTIR has changed somewhat and, although I still believe that the term plan is superior to whole life policies as an insurance tool, I have come to appreciate that BTIR is just one of the options that choosing a term policy provides.
There is a lot of debate in the world of personal finance and wealth advisory around BTIR as an approach to insurance and investing, especially when it is compared to buying whole life insurance policies. And even though this has raged on for many years, the end is nowhere in sight.
Recently, Chee Kian, one of our client advisers, and I had an opportunity to speak with Reggie on an episode of the Financial Coconut Podcast about term insurance as it compares to whole life insurance. At Providend, we are strong proponents of using term plans for most of your insurance needs and, on the podcast, we said as much.
The stand that we take, however, is sometimes criticized as being one of BTIR, so I wanted to share some thoughts about why, despite our belief in the use of term insurance for most cases, the BTIR strategy is not the main reason we think term insurance makes sense.
What is “buy term and invest the rest”?
Here is a quick summary of the main BTIR argument:
- As compared to covering your insurance needs with a whole life policy which accumulates cash value, if you buy a term life policy, you pay less in premiums since you are paying exclusively for the cost of insurance. (Read this if you would like a refresher on how term plans and whole life plans work.)
- Properly investing the difference in premiums on your own costs less and can yield better investment results than the often-meagre returns on relatively more expensive, insurer-managed life funds where your cash value accumulates.
- At the end of a period, the value of the invested difference (with an assumed higher rate of return) exceeds that of the cash value of the whole life policy. Thus, you are better off.
Some pitfalls of “buy term and invest the rest”.
To be honest, the maximising economist in me loves the above argument.
Comparing BTIR to buying a whole life policy, we can plug in some numbers, do some calculations, and then conclude that one has a better financial outcome than the other.
The issue is that when trying to define it as a mathematical problem, we often fail to consider some of the human factors and specific situations. The critics are right when they say that:
- You may not end up “investing the rest” consistently.
The BTIR strategy only works if you invest the amount you save in premiums, but it can be extremely tempting for you to spend that money instead. If you are not the type to track your expenses closely, you may not even notice that the supposed savings have disappeared.
And even if you do not end up spending it, the savings may also just sit idle in a bank account. It can be easy to accumulate a pile of cash if you are unsure about how best to invest it.
- You may not be able to invest well enough.
For BTIR to give you a meaningfully better outcome, you need to achieve a rate of return that is sufficiently higher than the insurance life funds in question. And the success of that approach would be highly dependent on you being able to stay invested over a long time, across all sorts of market conditions.
The risk required to achieve the higher rate of return may also be higher than the risk you intend to take, or even be more than some investors can bear.
Why term insurance is still the way to go.
Having said all of that, and given the potential pitfalls of BTIR, why do we still hold the belief that term insurance is the best choice for the majority of our clients’ needs?
- The fundamental need for insurance is for protection over a specific period.
As it pertains to an overall, holistic wealth plan—the kind we advocate for and provide our clients with—the need for insurance is first and foremost for protection. Additional features above and beyond the basic life, total permanent disability, and critical illness coverage (including an investment portion, accumulating cash values, or reversionary bonuses) can be nice to have, but are far from essential.
The length of time that coverage is required for income replacement purposes is also almost always a fixed period ending at the point that you intend to retire or stop working. Therefore, the need for a policy to cover you for life does not often exist. (Watch this timeless, informative video on how to assess your own insurance needs.)
- The immediate financial costs and ongoing opportunity costs are lower.
Premiums for term life policies are generally lower than whole life policies by a significant amount since the premiums only go toward the cost of insurance and do not include a portion that is diverted to being invested in a life fund.
What this means is that it is the more affordable option. With term insurance, you will be able to cover yourself sufficiently, up to the amount you need, for a lower cost. Sometimes, the premiums of a whole life policy, which can be as much as ten times the amount for the same level of coverage, can even make getting adequate cover impossible or very difficult.
Then, there are still other costs to consider, such as what you could do with the money that would otherwise be “locked up” in a life fund if you choose to buy a whole life plan—also known as the opportunity costs. (Hint: this does not only refer to the potential investment return from investing yourself.)
The key is an intentional choice.
The truth is that trying to settle the BTIR vs whole life policy debate by looking at the potential financial outcomes at the end point alone can be an oversimplification and too narrow. Although it is a reasonable way to compare the two approaches for someone with a fixed budget to spend on insurance and investments, it does not consider some other important elements.
When using term insurance, the absence of a part of your total premium contributions that is “locked up”, especially in the early years of your desired coverage period can be a big advantage. As your life changes (which it inevitably will), your goals and priorities will also shift. Paying less upfront for insurance expenses means better cashflow and the freedom to choose what to spend the money on at each point in time, depending on the situation, and in the face of unforeseen circumstances.
Term life insurance works such that you only pay for what you use or need. If, for some reason, you no longer have the need for the insurance because you have reached your goals, or your goals have changed, you can cancel your coverage without fear of being penalised upon performing an early surrender of your policy.
- Investments are not always of the sort that concern the financial markets.
Comparing only the outcomes of investing in the markets on your own and putting them into a life fund with your insurer is a false dichotomy. It is important to consider that not all investments come in the form of financial products. Although saving for retirement and building wealth is important, there are other good ways to invest your money.
Spending to take advantage of potential business opportunities (if you are lucky to come across them and are so inclined), investing in your own personal development, or purchasing invaluable experiences that you can share with your loved ones are just some of the other ways that the savings can be used to enhance your life now, as well as in the future.
Being aware of the full range of options that you are forgoing when you place your money in an insurer-managed life fund (and for what is often a multi-decade period) is the key to making the decision that is right for you.
Some cases where whole life insurance may still be useful.
Of course, this does not mean that whole life policies are an inherently bad proposition, and there are some cases where whole life insurance may be appropriate. There is not enough space to discuss these here in detail, but here is a brief, non-exhaustive list:
- Whole life policies with critical illness coverage can be used to ensure a small amount of critical illness coverage for life. Your hospitalisation insurance should already cover the cost of your medical expenses, but the critical illness coverage can be used to cover the non-claimable costs of alternative treatments (TCM, homeopathy etc.) and optional care arrangements, if so desired.
- Whole life policies may be used to ensure an estate has sufficient liquidity for distribution purposes, or to allow for current spending without depleting too much of the eventual estate. This can be useful when the estate is made up of illiquid assets that are difficult to divide, or where the owner of the estate wishes to draw on some of her assets for spending, without affecting her eventual intended gifts.
- Whole life policies with a coverage multiplier also exist. They are hybrid products (which are basically whole life policies with additional term life coverage bundled together) that can provide you a small portion of lifetime coverage and a larger amount for a limited period. This may be desired for some of the reasons stated in (1).
We would be happy to change our minds.
At the end of the day, when it comes to buying insurance, it is most important to ask yourself what type of insurance you need, how much coverage you need and how long you need it for. And then, to look for the cheapest way to get yourself fully covered.
What you do with the rest of your budget afterward is a separate question that should be answered by taking into consideration your personal situation and your values.
As things currently stand, BTIR or not, the fact remains that term insurance is the most affordable option on the market when it comes to being able to meet your protection needs (what insurance is for!), and I would be surprised if that were to change soon.
At Providend, we are constantly searching for the best tools that we can use to the benefit of our clients. And if someday down the road something better came along, we certainly would not hesitate to take a different stand.
But until then, buy term—and just maybe, invest the rest.
This is an original article written by Bryan Chan, Associate Adviser at Providend, Singapore’s First Fee-Only Wealth Advisory Firm.
For more related resources, check out:
1. Ten Seconds of Wisdom on Our Insurance Philosophy
2. Ten Seconds of Wisdom on Our Investment Philosophy
3. Complex vs Simple Wealth Solutions
We do not charge a fee at the first consultation meeting. If you would like an honest second opinion on your current estate plan, investment portfolio, financial and/or retirement plan, make an appointment with us today.