Apples to Apples

By Zalman Polott, PhD

Nothing heats up a discussion among agents, as well as between agents and their clients faster than the 'buy term and invest vs. buy permanent life' debate. It's the old fight between 'don't pay more than you have to in order to secure your benefits' and 'are you getting your money's worth?'

If the numbers are only compared on the surface, it doesn't look like there's a real debate. Take, for example, a 45-year-old non smoking healthy male who buys a $100,000.00 20-year-level term policy for a $204.00 yearly premium. After 20 years, assuming he's still alive at the end of the term, he will have paid $4,080.00 for the policy. But if he purchases a $100,000.00 whole life contract for $1,933.00 per year and lives to age 65 without lapsing the policy, he will have shelled out $38,660.00.

A simple comparison of the cash laid out for funding the coverage - $4,080.00 versus $38,660.00 - yields a difference of $34,580.00. If this kind of comparison of the cost of funding insurance needs were actually apples to apples, cash value policies would not exist. Clients and agents must consider additional elements, such as cash flows, accumulated cash values and indirect benefits such as tax treatment when comparing equivalent amounts of whole life and term coverage (when the premium difference is invested).

Before we can do a proper comparison of the two insurance-buying strategies, let's agree on certain basics of how the comparison will work. We'll call each kind of strategy a 'system' and the money inputs will be as equal, meaning that whatever sums go into one strategy must go into the other. We'll then compare the financial results the two systems generate. All monies going into the system have already been taxed.

In comparing the two strategies, we will also account for opportunity cost, which is the cost associated either with the investment of savings or the potential loss of any expenditure. Building on the example mentioned earlier, if the purchaser of whole life saved $204.00 per year under his mattress, in 20 years he's have $4,080.00. But if the yearly $204.00 were invested at 6% after tax, we'd have $7,992.00, a gain of $3,912.00. The $3,912.00 would be considered opportunity cost.

Let's expand on our earlier example, and look at the systems for 45-year old twin brothers John and Bob. Both want to buy life insurance to protect their families, and both want to put the assets they've earmarked for coverage to the best possible use. Each man makes about the same income and has similar savings needs as well as household, business and child-raising expenses. After each brother's advisor does a fact-find with him, the best choice for each turns out to be a life insurance policy with a $100,000.00 death benefit.

Each brother can comfortably set aside $1,933.00 per year for premium needs. Figure that each brother's total investment for the insurance will go into two 'black boxes' - one for John, and one for Bob, for each takes a different path. Each buys $100,000.00 of insurance, but Bob buys whole life, with a $1,933.00 yearly premium, and John buys $100,000.00 of 20-year term and invest $1,933.00. Assume that at the end of 20 years, John has let his policy expire, and Bob will cash his in. Here's the contents of each man's 'black box.'

John (Fig.1) plunks down $204.00 a year to buy a $100,000.00 face value 20-year term policy. He then invests $1,933-the money that would be equal to the premium for the same face amount of permanent insurance coverage- in a mutual fund earning 10% before taxes each year for 20 years. We'll assume all fund earnings are taxable in the year earned. Over the next 20 years, assuming no money taken out and that the growth remains at 10% pretax per year, John will accumulate $121,784.00 in the investment. However, he will have to pay taxes each year on its earnings.























As he's in a 39.6% tax bracket, the taxes come to $32,917.00 over 20 years. He pays those taxes from the tax refund he gets on his salary (which is the same as Bob's), so that the mutual fund assets can continue to compound. He must understand the opportunity cost associated with those taxes and term premiums. The $4,080.00 he spent on his term premium and the $32,917.00 in taxes are considered expenses, and are not subtracted from the $121,784.00.

Bob (Fig.2) pays $1,933.00 a year to buy a participating $100,000.00 whole life insurance policy from a mutual company, which includes a waiver of premium rider. He won't pay income tax on the investment income generated by the premium, because the cash value portion grows tax-deferred. Bob gets a tax refund from his withholding, and he invests it into a mutual fund that earns 10% pre-tax. He also takes an additional $204.00 per year and puts it into a non-qualified investment vehicle paying 10% a year pre-tax. The projected cash value in his policy after 20 years, using the current dividend scale, is $63,766.00 - a 60.6% increase from the $38,660.00 he paid into the policy. As his cash value accumulated tax-deferred, Bob does not pay taxes on his gain. Separately, he invested his tax refunds each year - totaling $32,917.00 - into an investment vehicle earning 10% pretax. So the total value of Bob's input at the end of the period-cash value plus his savings and investments - will be $120,189.00. Bob will recover opportunity cost.

With the inputs for the two systems equalized, we can compare costs and benefits. By buying whole life, Bob did not have the same term costs or tax payments as did John, and by investing this money, he will recover the opportunity cost advantage. However, the difference is still $1,595.00 in John's favor. But if we assume John's policy, then the discount for taxes on the gain in Bob's cash value yields $11,541.00 - an even larger difference. This calculation shows that if the client cannot establish an insurance need for the future, he may go along with the concept to buy term and invest the difference.

Permanent insurance, however, has advantages difficult to quantify in dollar amounts. One is flexibility. Bob can continue to pay his premiums and increase the death benefit, or he may be able to stop paying premiums - if the premium offset option applies - and keep the policy at the same face value. He can also borrow from the cash value at 8%, or even 5%, which is a good bit cheaper than a loan from a bank, or use the policy for estate or business planning, for collateral at a bank or other institution, or for other purposes. The money will not be taxed as long as the policy stays in force until the insured dies.

A second advantage is creditor protection. Assets in a life insurance policy are usually protected from general creditors, but mutual fund shares are not. And choosing the waiver of premium option will le the permanent life insurance program complete - keep the policy in force and up to date-in case of disability. In addition, part of the money in the permanent policy's cash value is guaranteed value, and the client's beneficiaries are assured of receiving the face value or more of the insurance (if paid up additions were purchased) free of income tax, when the insured dies.

The only barrier to a whole life sale is a prospect's belief that term insurance is a better buy. But that's not necessarily so. If the client lives a long life, he can outlive the term policy, or the term premiums become so high that it may not be viable, and he may decide not to pay. Also, he may be uninsurable or rated at renewal time. In either case, the insured dies without coverage. Clients who can afford to buy permanent insurance and be disciplined about paying premiums, will keep the policy their whole lives.

Bottom line, a client who buys term and invests the difference is in control of the money he invests. Term premiums and income taxes are his mandatory payments. For the client who buys permanents insurance, on the other hand, the premium is the mandatory payment and the client can invest and save term premiums and taxes. Still, when buying permanent insurance, clients frequently disregard the saved term cost, saved taxes and the opportunity cost.

Even if he saves this money, he is not associating those savings with his life insurance plan. So an incorrect comparison takes place, which leads to wrong conclusions.