By Robert P. Murphy
Hands down, the biggest stumbling block to spreading the “good news” of Nelson Nash’s Infinite Banking Concept (IBC) is that it relies on acquiring whole life insurance policies. As “everybody knows,” only a fool would take out such a policy—just ask Dave Ramsey! The financial gurus tell us with confidence that an individual does much better to “buy term and invest the difference.” In the present article I’ll point out some of the flaws with this standard objection to whole life (and by implication, IBC).
WHAT THE CRITICS MEAN
Before diving into the analysis, we need to be clear on what the critics mean by the phrase, “Buy term and invest the difference.”
Nobody disputes the fact that the premium for a whole life policy for a particular individual and carrying a specified death benefit is significantly higher than the premium on a term life policy for the same individual with the same death benefit.
Rather than paying for the more expensive whole life policy, critics such as Dave Ramsey suggest that it’s a no brainer to buy the cheaper term policy for whatever one’s pure insurance needs are, and then investing the savings (because of the lower premium) in a mutual fund. Since the historical returns on mutual funds are higher than the growth rate of cash values inside a typical whole life policy, the critics argue that the individual can take care of his insurance needs while growing his financial wealth more quickly, using this latter strategy.
APPLES AND ORANGES
The problem with this standard objection is that it does not compare apples to apples. The critics think they are getting their clients the “same insurance policy” but they’re not. They also think they are getting “the same investments but with a higher rate of return,” but again they’re not.
OPTION VALUE EMBEDDED IN WHOLE LIFE POLICY
One obvious difference between a whole life policy and a term policy with the same death benefit, is that the former gives the policyholder the option to maintain coverage for life. (This after all is the reason we call it “permanent life insurance” and the plain vanilla “whole life” policy.)
For example, the critic of whole life has in mind something like this comparison: Imagine Harry and Tom are identical twins who are 20 years old and have the same income. They each have a stay-at-home wife who is raising young children. The men are responsible and seek to protect their families by buying life insurance.
Harry takes out a whole life policy with a $1 million death benefit. Tom takes out a 20-year term policy with a $1 million benefit. Tom makes all of the same investment decisions that Harry does, except that he contributes a few hundred dollars more each month into his mutual fund since he is quoted a lower premium from the insurance company for his term policy.
The standard treatment (by critics such as Dave Ramsey) then concludes the scenario in this fashion: Consider Harry and Tom at, say, age 35, after they’ve been working and saving for 15 years. They both have the same insurance protection in case they die, but Tom has more net wealth to his name. That is, his 401(k) or other retirement vehicles possess more shares than his brother Harry’s. Harry for his part has accumulated some cash value in his whole life policy, but it has not grown at the same rate as the stock market. This explains why Tom has a higher net worth at age 35.
What Dave Ramsey and others are neglecting to mention is that when Tom’s term policy expires (at age 40), he may be uninsurable. For example, he may have been diagnosed with cancer or some other serious disease during the 20 years of the term policy.
Even if Tom is in perfect health, nonetheless his premium will be higher at age 40, if he wants to renew his term policy, for the obvious reason that the insurance company is more likely to make a death benefit payment to a 40-year-old than to a 20-year-old who both sign up for new policies.
In contrast, Harry can keep his whole life policy in force for as long as he wishes, so long as he continues to pay the same level premium that he paid when he was a 20-year-old whippersnapper. Even if he’s diagnosed with cancer and takes up skydiving at age 62, the insurance company can’t raise the premium because a level premium was part of the original contract.
Although Ramsey tells his listeners that at some point, they will be rich enough (following his advice) to self-insure, the crucial point is that this might not be true at age 41. If Tom drops his insurance coverage because he is either uninsurable or because it’s simply too expensive, then his family is at a serious disadvantage to Harry’s during the decade of their 40s. If something should happen to Tom, his widow will now not get a large, tax-free check from the insurance company. It’s true that he can more aggressively contribute to his mutual fund holdings if he doesn’t even have a term premium to pay, but that won’t make up the difference if he has a heart attack at age 43.
So we see that part (not all) of the reason for the higher premium on a whole life policy, is that—in addition to the accumulating cash values—the insurer is effectively providing a pure insurance term policy with the option of indefinite renewal at the same premium. Since the insurer is clearly offering a better product to Harry than to Tom when we isolate the pure insurance component, the insurer naturally charges Harry a higher price for it.
If they really wanted to compare apples to apples regarding the pure insurance aspect, critics like Ramsey should run the numbers for Harry and Tom starting at age 101. In that case, the level premium quoted to Tom for a 20-year term policy would truly be “the same” insurance package as a whole life policy offered to Harry. If the insurance company would even underwrite such a policy, the numbers would look far different from the scenario when both men are 20 years old. The simple fact is that insurance companies don’t pay out a dime on the vast majority of their term policies, because typically people only buy them when they are starting their careers. There isn’t a booming market in term life policies for 75-year-olds because the actuarially fair premium on such policies would seem far too expensive to be worth it.
MUTUAL FUNDS RISKIER THAN CASH VALUES
Another major difference between our hypothetical brothers is that Harry’s wealth, though it might not be expected to grow as quickly on average and over a long period, is nonetheless much less volatile than Tom’s.
Think of it this way: Suppose Dave Ramsey told his listeners, “You are crazy if you stick with whole life ‘return of premium’ type policies. Instead of doing that, buy term and then invest the difference in junk bonds. These historically have a much higher rate of return than cash values sleepily growing in a whole life policy, so you clearly do better using this strategy.”
Everybody would quickly see the fallacy in this (hypothetical) recommendation: Even if an index fund of high-yield (“junk”) bonds delivered a much higher rate of return over a certain historical period than the cash value of a whole life policy, this wouldn’t be the only criterion for judging the two strategies. Obviously the high-yield bonds would be much riskier than parking one’s wealth in a whole life policy. A particular investor seeking aggressive returns for a portion of his portfolio might decide the risk was worth it. Yet it would be silly to focus solely on the rate of return, and conclude that “only a fool” would pass over the junk bonds in favor of whole life.
Although the difference is not as severe, qualitatively we have the same situation regarding the allegedly “safe” mutual funds touted by Ramsey and most other financial gurus today. Even if a household plays it “safe” by holding a diversified collection of the entire S&P 500, it turns out this isn’t so diversified after all:
Disregarding dividend payments, we see that someone who bought into the US stock market in 1999 still hasn’t even broken even. When the gurus tell us “buy and hold” is the optimal strategy, they should be clear that sometimes holding for 12 years isn’t long enough to start seeing the magic of their approach.
Ironically, when doing research for our book How Privatized Banking Really Works, I had an insurance executive explain to me that a whole life policy was really an application of “buy term and invest the difference.”
From the insurance company’s accounting perspective, the incoming premium payment on a whole life policy has to do two things: First, it must fund the pure insurance component of the policy; this part of the premium is allocated to what a term policy would cost, given the policyholder’s race, sex, age, medical history, lifestyle, etc.
Then, the rest of the premium (over and above the amount needed to cover the pure term insurance component) is allocated to buy assets so that the insurance company will be able to meet its contractual obligations when the policyholder either dies down the road or attains the age at which the policy completes (such as 121).
Now if insurance companies typically kept their portfolios in the stock market, they could offer higher projected rates of return on the cash values of a whole life policy. Dave Ramsey would no longer find such a huge (apparent) difference between the fortunes of Harry and Tom.
Yet if the insurance companies did plow their premium payments into the S&P 500 month after month, they couldn’t possibly offer guaranteed increases in cash value. If they engaged in a mixture of stock and bond holdings, they could offer a guaranteed minimum rate of return plus a portion of “the market” when it did well, but they couldn’t match the overall market during a boom. (If they could, then nobody would hold stocks—they would hold the clearly superior product that had a floor and equal upside performance.)
I hope my observations are shedding light on the fact that Ramsey et al. are botching the investment component of the analysis, in addition to their apples-to-oranges treatment of the pure insurance component.
Yes, at age 35, Harry may have a lower net worth than Tom, because Tom’s mutual fund may have grown faster on average over the prior 15 years than Harry’s cash values. Yet Harry’s wealth was much safer; it was in the form of what the layperson means by “savings” as opposed to “investments.” In particular, if a sudden financial burden strikes our brothers at age 36, it is entirely possible that Harry will have more in his cash value than Tom will have in his mutual fund. This is because the stock market might happen to crash that year—which it’s done twice now in the past decade, keep in mind. Even if it’s true that “it will eventually come back,” that’s little consolation to Tom if he suddenly loses his job or needs money to pay for a relative’s medical treatment.
A financial professional must look at each client’s individual situation and goals before offering recommendations. It would be foolish to say “nobody should ever buy a term policy” or “nobody should ever buy into the S&P 500.”
Yet by the same token, it is foolish when Dave Ramsey and other alleged gurus confidently tell their listeners that nobody should ever buy a whole life policy. Their recommended one-size-fits-all strategy of “buy term and invest the difference in a mutual fund” does not provide the individual with the same benefits at lower cost, as Ramsey et al. would have us believe.
On the contrary, “buy term and invest the difference” gives the individual a clearly inferior insurance product, in addition to a clearly riskier investment portfolio. Depending on the assumptions we make, the expected rate of return on this strategy might be significantly higher than buying a whole life policy with the same initial death benefit (especially if we let the whole life policy sit in the corner, rather than using it in the Nelson Nash way).
But so what? One could get a very high expected rate of return by becoming highly leveraged, investing in bio-tech stocks, and purchasing no insurance at all. (Remember that the insurance company, even on a term policy, is actually charging more than the actuarially “fair” premium, in order to cover overhead, profit margin, etc.) Yet nobody in his right mind would suggest that this leveraged, no-insurance strategy was preferable to buying term and investing the difference in a mutual fund.
The difference between my absurd recommendation and Dave Ramsey’s more traditional strategy is one of degree, not kind. Even though Ramsey thinks he is advising his listeners to act with prudence, in reality he is setting them up to have no insurance coverage in their later years, and to have their wealth in a much more volatile asset. (We’re not even looking at the tax issues and the government’s likely move against 401(k) and other accounts down the road, as the fiscal crisis deepens.)
Every household’s situation is unique and deserves customized recommendations. That is precisely why the blanket advice of “buy term and invest the difference” is so misleading.