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How to ‘buy term and invest the rest’

Seth Wee

Buy term, invest the rest is a strategy that provides an alternative to whole life insurance policies. The rationale for such a strategy is that one can invest the savings in premiums one receives by purchasing an inexpensive term policy rather than a pricier whole life policy. The accumulated savings and investment returns will then make up a sum of money for one's insurance needs in future when the term policy ceases.

An example to show the difference

Here's the math for such a strategy:

Jack, a 24-year-old non-smoking man, wishes to insure himself for $200,000 against death, total and permanent disability and critical illnesses. A 35-year term policy will cost him $642 a year. A whole life policy costs $3,018.00 per year, and the premium term is 35 years (he pays 35 years of premiums to be covered for his whole life) for the sake of easier comparison.

The difference in premiums works out to $2,376 a year which can be invested.

Whole Life Policy

At Year 20 at 5.25% projected investment return

Coverage Payout: $277,066

Surrender Value: $68,925

Buy Term Invest the Rest

At Year 20 at 7.5% projected investment returns

Coverage Payout: $200,000

Accumulated Value of Savings: $110,609

After 20 years, the whole life policy will be providing for $277,066 amount of insurance coverage. If a claim is made, only this amount is paid out to Jack (or his family if he dies), and the policy is terminated. For the term policy, a claim amount of $200,000 would be paid out. On top that, Jack is able to liquidate his $110,609 of accumulated savings if he wishes.

Whole Life Policy

At Year 35 at 5.25% projected investment return

Coverage Payout: $345,810

Surrender Value: $174,615

Buy Term Invest the Rest

At Year 35 at 7.5% projected investment returns

Coverage Payout: $0 (Term policy expires)

Accumulated Value of Savings: $393,989

As you can see, the difference in the premiums can be invested to give an accumulated sum of money in the future after the term policy expires. This sum of $393,989 belongs entirely to Jack and he can self-insure. No claims need to be made nor is there any definition for critical illness to be met — Jack is able to use this sum of money for contingencies should he have a use for the money, or simply leave it to his beneficiaries when he passes away as if the sum of money was an insurance payout. This is perhaps one of the strongest advantages of buying term and investing the rest as the money is not like a claim that is subject to approval.

One thing to note is that there is a disparity in the projected investment returns compared. Let's consider a similar return of 5.25% pa with an expense ratio of 1.0% pa.

Buy Term Invest the Rest

At Year 35 at 4.25% projected investment returns

Coverage Payout: $0 (Term policy expires)

Accumulated Value of Savings: $191,865

The accumulated amount of $191,865 is now lower than what the coverage of $345,810 the whole life policy is providing, though there is an advantage that there is no need for a claim for Jack to use the sum of money.

In the first place, one of the reasons for 'Buy Term Invest the Rest' is that many people, including Jack, who is a young person, are able to take higher risk for potentially higher investment returns than what the insurance company is able to offer for such whole life policies, especially in the long duration of more than 20 or even 30 years of coverage a term policy provides. It is arguable that the conservative portfolio a whole life policy is invested in is too conservative for people who are young and/or have a long time horizon for investment.

There are many more considerations when it comes to how one should go about insuring oneself. Personally, I feel that most people lie somewhere in the middle between the continuum of being suitable for "100% Buy Term Invest the Rest" and "100% whole life coverage", with many closer to the side of buying term (ie, a mixture of both term and whole life policies with a greater emphasis on term).

Only with a proper and unbiased description of the two can consumers have an informed choice. The reality is that most consumers believe premiums for term to be a waste of money, not knowing that there is a cost of insurance to be paid regardless if it's a term or a whole life policy. Agents are more than happy to perpetuate such a misunderstanding as the commissions for whole life policies are more attractive.

By Seth Wee, an Independent Financial Adviser who blogs on personal finance at Seth's Blog on Finance. Posted via www.MoneyMatters.sg, your guide on how to make more money, save smarter, invest intelligently, and enjoy your money like a pro. Visit our site to get our free report on financial freedom.