Is the idea of buying term life insurance and investing the difference a quaint notion? Or has the death of term been greatly exaggerated?

Earlier this year, widely followed CFP and researcher Wade Pfau wrote a piece in Forbes discussing his research on the superiority of purchasing whole life insurance versus buying a term policy and investing the rest. His findings, in a nutshell: “The old mantra of buy term and invest the difference doesn’t hold when also considering retirement income planning.”

Pfau is a professor of retirement income at the American College in Bryn Mawr, Pa., and a principal at McLean Asset Management, based in McClean, Va. Because his findings contradict every analysis I’ve done, I decided to dig deeply into the results.

THE CLAIM

Pfau’s findings in his paper, “Optimizing Retirement Income by Combining Actuarial Science and Investments,” conclude that merging whole life insurance into a retirement income plan can yield more-efficient outcomes in income and legacy, or what is left to heirs.

The reasoning is that insurance companies are better able to pool financial market risks (sequence of returns risk) and longevity risk. Though individuals don’t know when they will die (or if they’ll outlive their money), insurance companies maintain decent statistical data as to what proportion of their customers will pass away by certain dates.

In his article, Pfau bases his conclusions on Monte Carlo simulations for both a 35-year-old and 50-year-old couple. He concentrates on the younger pair, but concludes that his findings apply to both.

In this hypothetical example, the younger couple puts $15,000 in their 401(k), less an amount needed for either term or whole life insurance. The term insurance for 30 years costs $539 annually, while the whole life policy runs $4,500 annually. The couple’s income puts them in the 25% marginal tax bracket. That means the two must reduce the amount stowed in the 401(k) by the cost of insurance and associated taxes that result from the reduced investment going into the retirement account. The death benefit for both the term and whole life policies starts at just under $400,000.

According to the article, at age 65, the couple that chooses not to buy the whole life policy has $58,556 annually to spend from the 401(k) assets, using a 3.5% spend rule. The couple buying the whole life policy has 13% less assets in their 401(k), and purchases a single premium immediate annuity. The annuity is for the husband only, since the wife will have the proceeds from the death benefit should he die before she does, which is statistically more likely. The move would support an annual spend rate of $82,034.

Voila! The whole life strategy creates 40% more income in retirement, as well as more money to pass on to heirs. “Buy term and invest the rest” is dead. Long live whole life.

THE CRITIQUE

Pfau states in the article, “Because this research is sponsored by an insurance company [OneAmerica], I take special care in the white paper to explain my methods and assumptions as clearly as possible, so that readers can potentially challenge my conclusions.” I found him true to those words as he welcomed those challenges.

I went through the assumptions, discussing them with Pfau. I noted first a scenario in the study in which the couple buying term and investing the rest purchased a SPIA at age 65. As the term insurance had lapsed, they had to buy a joint life SPIA because the wife would no longer have proceeds from the death benefit.

This scenario alone produced an income of $81,434, or just under 1% less than the whole life policy strategy. Nearly all of the 40% higher income came from the SPIA purchase, not that of the whole life policy.

However, this still gives a slight advantage to whole life. So let’s say “buy term” isn’t quite dead yet, although, based on the research, it might be on life support.

As I reviewed further, I found there were many reasons I disagreed with Pfau, but the top five issues I found with his study were the following:

  • The study assumed the 401(k) assets were invested in a target-date retirement fund with a total annual expense ratio of 1.59%, including a financial advisory fee of 0.75% annually. Using a target-date fund in the study is reasonable, but funds with expense ratios as low as 0.17% can be obtained from providers such as Vanguard. Other choices outside of target-date funds have fees of 0.05% or less.
  • The calculations from the insurance policy were taken from the illustration model numbers and not guaranteed. I’ve reviewed more than 100 policies versus the illustration to predict performance, and I can’t remember a single case when the policy value lived up to the illustration.
  • The SPIA purchased had no inflation adjustment, while the 3.5% spend-rate rule was based on increasing inflation rates. 
  • A SPIA is not the most efficient way to buy longevity insurance. Delaying Social Security is by far the best, followed by purchasing a deferred-income annuity, which provides far more longevity insurance for one’s money.
  • No one knows the death benefit’s future worth in today’s dollars, although it’s safe to assume that $400,000 will buy less in 30 years than it does today. If inflation matches the 3.2% historic average, then the benefit will be worth only about $155,478 in 30 years, and $113,468 in 40 years. Higher inflation would buy far less, so buying only the single life annuity may be invalid.

It is, of course, easy to pick apart assumptions. But what would happen if we tested the study’s results? It was simple to test the first two hypotheses by lowering the expenses and studying the guaranteed value of the insurance policy.

While I did not review the model itself, Pfau was kind enough to run his model using both a 0.18% expense ratio in the 401(k) and the guaranteed results of the policy. Running a test using the SPIA as income at age 65, in which couples bought whole life and single-life annuity, yielded the following income results in their retirement:

  • Buy term and invest the rest with joint annuity: $100,874
  • Whole life and buy single life annuity – illustration: $98,283
  • Whole life and buy single life annuity – guaranteed: $95,371

If we averaged the whole life at the midpoint of the illustration and guarantee, we got income of only $96,827 per year. Buying term and investing the rest actually provided more than 4% additional income over the whole life option. And that was before making any of the adjustments from the other assumptions.

If I ran a model with assumptions that I feel are more appropriate, I’d likely find far larger differences in favor of term.

When I discussed these assumptions and results with Pfau, he stated:

“Rational investors paying low fees who can overcome behavioral hurdles to annuitize can generate slightly higher income at retirement from buying term and investing the rest. Buying term, however, may sacrifice legacy versus buying whole life insurance.”

BEHIND THE CURTAIN

Pfau shared the insurance illustration with me, and I calculated some numbers. The cash value return over the 30-year period was a meager 1.29% annually for the guaranteed return and 3.89% for the illustration.

Again, taking the simple average, we might expect a 2.59% annualized return.

This was not terribly surprising because, as of Dec. 31 of last year, roughly 99% of OneAmerica’s investments were in fixed income, loans, and cash and short-term investments. One would expect a very low return, as that portfolio would also pay out sales commissions and cover overhead and profits.

The actual return to the policy holder would be determined unilaterally by the insurance company, which can pay out as little as the guaranteed illustration (1.29% annually over 30 years.)

This isn’t to say that, by doing so, the company is sinister. But if interest rates climbed by 200 basis points, the fair value of the company’s bond portfolio would likely plummet, putting a great deal of stress on the required reserves.

There is also the risk that our theoretical couple who bought the whole life policy would let it lapse. If one or both members lost their jobs, paying a $4,500 premium might be too hard.

Finally, with a greater amount stowed in the couple’s 401(k) from buying term and investing the rest, the two would be more likely to have the savings to delay taking Social Security, a far more efficient way to buy longevity insurance.

FINAL JUDGEMENT

Pfau wrote an interesting and thought-provoking paper. He agreed with many of my points, including my stipulation that delaying Social Security is a superior strategy. He conceded that the deferred annuity was superior to the SPIA.

I agree with him that insurance companies can add value in both longevity protection and sequence-of-returns protection. But the demonstrated costs to the policy holders over the decades far exceed these two benefits.

After completing this analysis, I found that the death of the “buy term and invest the difference” mantra was greatly exaggerated.  

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for The Wall Street Journal and AARP the Magazine and has taught investing at three universities. Follow him on Twitter at @Dull_Investing.

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