Archive for August, 2012

Buy term invest the difference? Not if you look at the numbers

August 14, 2012

49 comments

Today’s guest post is by Glenn Cooke, a life insurance broker and president of LifeInsuranceCanada.com who believes in an educational approach to life insurance rather than a product sales approach. In the post he urges readers to take a closer look at the numbers behind the conventional wisdom of buy term and invest the difference.

Proponents of buy term invest the difference advocate strongly against purchasing whole life insurance. For those unfamiliar with the idea, it suggests that buying cheaper term life insurance and investing the difference in a mutual fund is a better financial option than purchasing a whole life policy and cancelling it at age 65 for the cash values. The strategy itself is rooted back in the 1980’s when the life insurance industry was promoting whole life insurance to consumers as some type of savings vehicle. The strategy often provokes a strong emotional reaction against life insurance companies. What many people may not realize that the biggest promoters of this concept even today are actually life insurance companies who use it to sell term life insurance and mutual funds.

Nevertheless, back in the 1980’s with interest rates where they were and with the products we had available back then, a pretty strong ‘numbers’ case could be made. But that was like 25-30 years ago. Things change. Is this emotional argument that got foisted onto consumers by the insurance industry still valid? Let’s have a look at the numbers today.

Before I do so, let me just state clearly – I have no preference either way. I do however believe in looking at the actual numbers once in a while, rather than just blithely continuing to parrot what everyone else has been repeating for 20 odd years without ever checking their facts.

It’s also important to appreciate that the buy term invest the difference argument is NOT a numbers game. It depends on your assumptions. What do you think is the correct long term interest rate over the next 15-20 years? 8%? or 3%? Or somewhere in between?

OK, lets get to the numbers. I’m using the Compulife® database for my premium information, the database used commonly by insurance brokers as well as what powers the quotes on my website. And we’re going to look at a male, nonsmoker age 45 purchasing $100,000 of life insurance. For the term policy I’m going to use Equitable Life’s 20 year term at $286 per year. For the whole life I’m going to use a whole life policy from BMO Life with premiums of $1276 per year.

Case 1: (Assume 8% rate of return, no taxes on earnings.)

  • Term Case: If they buy the term and invest the difference at 8%, at age 65 they cancel the insurance and have $48,928 saved.
  • Whole Life Case: If they buy the whole life and cancel at age 65, they will have a cash value of $27,160 (less a minimal amount of tax).

The term is $20 G’s better than the whole life. Case closed – it’s a win for buy term invest the difference.

But wait. All is not as it appears. Back in the 80’s one could convince consumers that 8% was a nice conservative rate of return and lead into both a term insurance and a mutual fund sale. Today? Clearly not all consumers are going to buy into the idea of an 8% rate of return over the long term.

So lets try the same numbers at 3% rate of return.

Case 2:(Assume 3% rate of return, no taxes on earnings.)

  • Term Case: Buy term and invest the different at 3% and cancel their policy at age 65, they’ll have $27,399.72 saved.
  • Whole Life Case: If they buy whole life and cancel at age 65, they’ll have a cash value of $27,160 (less a minimal amount of tax).

Really? At 3% rate of return the two products are almost identical! Actually, it turns out that they’re not identical. At this crossover point, the whole life actually has substantial benefits over the term policy.

  1. First, the 3% we just assumed you’d earn with your term and invest strategy? Not guaranteed. The cash value on that whole life policy? Guaranteed. We’re comparing a non-guaranteed rate of return with a guaranteed cash value. Win for the whole life policy. Clearly in today’s environment some Canadian consumers are going to be interested in the equivalent of a guaranteed 3% rate of return – even when compared a higher non-guaranteed rate of return.
  2. Secondly, what if we change our mind and don’t cancel the policy? If you bought the whole life, your premiums remain at $1276 for the rest of your life. If you bough the term life insurance, you now have to take a medical exam and buy a new whole life at age 65, for premiums of about $3500. Win for the whole life policy of over $2000 a year for the rest of your life.
  3. But there’s a third option. The whole life policy allows you to stop paying premiums and take a smaller policy of $46,500 for the rest of your life, no further premiums due. By comparison with the term policy, if you took your $27,000 in savings from your term policy, you could buy a 10 pay whole life policy of $25,000 for about $2500 per year for 10 years – which roughly burns down the money you just saved. Stop paying premiums and keep the coverage, the whole life policy will provide you $46,000 of lifetime coverage, the term option, about $25,000. Win for the whole life policy of $20,000 when you pass.

So now the ‘numbers’ seem like the whole policy is actually a better buy. But there’s some downside to this as well. With the term policy, despite the drawbacks mentioned above, the cash is liquid whereas it’s not easily accessible inside the whole life policy. Does that matter? Maybe it does, then again, for some folks maybe it doesn’t. And for many consumers, paying the higher premiums of whole life simply may not be feasible.

As you can see, it’s not as clear cut as it’s often made out to be. What product is ‘best’ often lies in the underlying assumptions. High interest rate or low? Guarantees vs. non guarantees? Higher premiums or lower premiums? As different people have different preferences and tolerances, so to do we have different solutions for different people. It’s not nearly as simple as buy term invest the difference and believe you’ll be better off financially in the future.

Saving & Investing Book Giveaway

August 14, 2012

92 comments

Last Fall, Glenn Cooke of LifeInsuranceCanada.com approached a few bloggers to contribute a chapter each to a book that will help Canadians learn to successfully save and invest on their own. Five of us signed on to the project. Krystal Yee, who writes the Give Me Back My Five Bucks blog, contributed the first chapter on creating a budget and living within one’s means. Jim Yih of the Retire Happy Blog, explained the basics of various savings vehicles such as RRSPs, TFSAs and RESPs that are available to Canadians and how each can vehicle can help in achieving different financial goals. As you might expect, your’s truly provided a crash course on how passive investing with Exchange-Traded Funds or mutual funds can help with investing one’s savings wisely. Million Dollar Journey provided a primer on using dividend stocks for those investors who want to be a little more hands-on with their portfolio. Last, but not least, Glenn Cooke provided some valuable background on an area that many neglect: life and disability insurance.

Since it takes a special talent to gather contributions from five different people and make it all work together, Glenn roped in Mr. Couch Potato, Dan Bortolotti, as the editor. The result is a neat little book titled The Beginner’s Guide to Saving & Investing for Canadians. The book is currently available in electronic or dead tree format through the book’s website. It will soon be made available through Amazon.ca.

Giveaway

I’m giving away five copies of The Beginner’s Guide to Saving & Investing. To enter, just leave a comment in this post (please do not send an entry via email) and please remember to include your email address. If you are reading this through your favourite RSS Reader, you have to click through to the website and scroll to the bottom of the page and type in your comment. Some quick rules: (1) Deadline for entries is 8 p.m. EDT on Friday, August 17, 2012. (2) One entry per person. (3) Canadian residents only. (4) I treat your privacy very seriously. Your email will be used for the sole purpose of contacting you if you happen to win. (5) I’ll pick five entries at random and announce the winners after the deadline.

This and That: Bill Gross, Jeremy Siegel, John Bogle, Burton Malkiel and more…

August 3, 2012

5 comments

In his Investment Outlook newsletter Bond King Bill Gross says that the cult of stocks is dying and that expected returns from financial assets are going to be very modest: 2% nominal returns for bonds and 4% nominal return for stocks. Mr. Gross also questions how stocks could have returned an inflation-adjusted 6 percent when economic growth has averaged just 3.5 percent.

In an interview with CNBC, Jeremy Siegel shot back saying that there is nothing un-economic about total stock market returns over the long run being greater than GDP growth. He also says that stocks are relatively undervalued today.

The matter did not end there. Prof. Siegel and Mr. Gross battled it out on Bloomberg TV. Prof. Siegel said Mr. Gross has “the economics wrong”. Mr. Gross responded by saying the good professor’s theory “lacks common sense”.

Wanting to milk this storm in a teacup for all it is worth, Bloomberg TV brought in John Bogle to weigh in on the debate. Mr. Bogle thought that stock returns can be expected to be lower than historical levels but thought that Mr. Gross’s estimate is a bit on the low side. As you may expect from someone who founded Vanguard, Bogle says buying and holding a portfolio of stocks and bonds is not dead at all.

In an interview with the IndexUniverse website, Burton Malkiel says that Treasury bonds are likely to be very bad investments because the debt problems in the developed economies are going to be solved on the backs of the bondholders.

Jason Zweig reports in The Wall Street Journal that retail investors are getting “disgusted” with the stock market in the wake of yet another “flash crash” in many blue chip stocks on Wednesday.

In his column in The Globe and Mail, John Heinzl listed the seven common investor mistakes and offered tips to avoid them.

Preet Banerjee argues that providing updates on how the financial markets performed every day is pointless both for long-term investors and those who make frequent trades.

Canadian Money Forum members weighed in on news that the parent of ING Direct Canada is looking to sell the online bank.

Now for something completely different. The Globe and Mail put together a very nice graphic showing the history of Canadian in the summer Olympic games since 1900. You can sort the medals by year, colour, sport and gender.