Why Eat (Pay) More Donuts (Money) for the Same Gym Membership (Investment)?

Consider an alternate universe. In this universe, gym memberships do not cost money. Instead, in exchange for patronizing a gym’s services, gym management insists that you eat several donuts each year. Weird, right? (While it is weird, it works well for explaining the pricing of investments products.)

If I exercise regularly – and the gym does not require that I eat too many donuts – I could probably lose weight for all my effort. However, if a particular gym requires eating lots and lots of donuts, I could likely end up fatter – or at least worse off than had I patronized a gym with a low donut eating requirement (ER). 

Now, consider two gyms that are literally identical: they have the same exercise machines, offer the same classes, are open for business during the exact same hours, are in the exact same location, and are even staffed by the exact same people – or maybe each person’s twin brother or sister. There is absolutely no difference between these two gyms – except the donut eating requirement (ER) of each gym.

The first gym, the Vanguard Group gym, requires that I eat five (5) donuts a year. In the end, the eating requirement (ER) of just five donuts a year would be negligible next to the benefits of regular exercise. Despite eating those five donuts each year, I would get in shape. In fact, I would be in better shape eating five donuts a year and exercising every day, than if I just sat at home and did nothing - eating zero donuts and not working out. Regular exercise would more than completely cancel out the small donut eating requirement (ER) of the Vanguard Group gym - leaving me fit and trim.

The other identical gym, the Haufenbrau Investments gym, requires that I eat 150 donuts a year. (While there is not a mutual fund company called Haufenbrau, there is a mutual fund company that will charge you 150 basis points annually for an S&P 500 index fund.) That is a substantially higher annual eating requirement (ER) than the Vanguard Group gym - especially considering that the gyms are identical. However, even if I do choose the Haufenbrau Investments gym, eating 150 donuts a year could probably be nullified by regular exercise. Naturally, I would end up in better shape over at the Vanguard Group gym - given Vanguard Group's low annual donut eating requirement. But in the end, the Haufenbrau Investments gym would also help me drop some pounds.

However, the Haufenbrau Investments gym also imposes an additional donut cost over its existing annual eating requirement (ER). Every time I work out, I am required to eat an additional 4.75% of my bodyweight in donuts! So, any effort to work more frequently - to cancel out the 150 donuts (ER) I have to eat annually - is itself nullified out when I am loaded up on donuts (4.75% load) each time I workout.

While it was entirely possible that I could get relatively fit by exercising regularly and having to eat just five donuts annually – I am unsure if I would even get in shape given the vast amount of donut consumption required by the Haufenbrau Investments gym. In fact, I am concerned that all my donut eating at the Haufenbrau Investments gym would cancel out my fitness goals – leaving me exactly where I started - or maybe even fatter!

Naturally, the Vanguard Group gym is the best solution. Since the gym is absolutely identical to the Haufenbrau Investments gym, the smaller donut eating requirement brings me much closer to realizing my fitness (investment) goals.

Now, to Haufenbrau Investments's credit – at least they are getting people to exercise. However, next to Vanguard, Haufenbrau's high annual donut eating requirement (ER) and the 4.75% donut load will not net much weight loss (investment gain).

That being said – why would anyone ever consider paying more (having to eat more donuts) for the exact same product? The simple answer is that without shopping around, a gym goer (read: investor) may not know that the Vanguard Group gym even exists. Further, an investor may not know about the mutual company structure of the Vanguard Group - a company structure that skirts normal business conflicts of interest.

Another reason for the success of companies like Haufenbrau Investments may be due to aggressive marketing efforts. Consider you’re solicited for a gym membership (mutual fund investment). You know that you should be exercising (saving for retirement), so the donut eating requirement (fee) sounds reasonable - in part because you have no idea what the other gyms are charging. Also, those gym contracts and accompanying fees are sometimes made purposefully confusing.

Most people are not dieticians (investment advisors), so the high donut eating requirements (fee) may come across as particularly extreme (expensive). However, with a little knowledge, the exercise junkee knows that the exact same product can be had for less. This way, you're saving for retirement and not eating so many donuts so as to cancel out your investment gains.

It Goes Both Ways

In a previous post, we saw an example of the negative correlation of Long-Term United States Treasuries to the broad market. (For a primer on negative correlation, read this and this.) In that example, the broad market  saw negative returns for the moment. At the same time, United States long-term Treasuries were up.

In another instance of the negative (or inverse) correlation of United States long-term Treasuries to the broad market, see the snapshot below of yesterday's market performance. Every asset class listed below shows a positive return. The one exception is United States Treasuries - both nominal and inflation-adjusted (TIPS).

Remember to interpret the above not as a danger of holding Long Term Treasuries. It is quite the opposite. Consider the diversification value of holding assets with low or negative correlation. In the event that one asset class is down, another asset class will be up. This "hedge" functions to buffer your portfolio from  downward movements.

Case Study: Buy Term & Invest the Difference (BTID)

As mentioned, recent blog posts were inspired by a conversation with a future family member about permanent life insurance. As argued, a downside of a term life policy is that there is no cash value at the expiration of the policy. While that is accurate, the trade-off is that a permanent life policy costs so much more than a term life policy. This significant difference in premiums (monthly payments) presents the opportunity to invest that difference. In today’s post, we take a very close look at the numbers by performing an actual case study for the term versus permanent life debate.

San Diego Life Permanent Life Policy Case Study

There are two strategies being compared. The first strategy is to purchase a permanent life policy. For this case study, I have the fortune of using real data from a San Diego Life permanent life policy quoting benefits for a female non-tobacco user age 43, for $500,000 of coverage. (San Diego Life is not the real name of the company.)

Our second strategy is to “buy term and invest the difference (BTID).” For this comparison, I am using quotes for a term life policy from intelliquote.com. Why this site? It’s the number one result when Googling for a term life quote. (This is not an endorsement for the site.)

Running The Numbers

The data from this specific San Diego Life policy shows an annual premium of $12,000. Alternatively, quotes for a 20 year term life policy providing $500,000 of coverage for a female non-tobacco user age 43 vary from as little as $549 per year, to as much as $4,005 per year.

For the initial comparison, consider the more expensive $4,005 term life premium. The San Diego Life uses an assumed nominal (not counting for inflation) growth rate of 10% annually. For equity, we’ll apply that same rate to the “invest the difference” strategy – but tax dividends annually at the highest marginal rate: 53.7%.

Taxes - Dividends
Federal, Unqualified Dividends	39.6%
Medicare Surtax	3.8%
California Highest Marginal Tax Rate	10.3%
Total Dividend Taxes - Applied Annually	53.7%

 

Further, capital gains will be taxed at 34.1% after 20 years.

Taxes - Capital Gains
Federal	20.0%
Medicare Surtax	3.8%
California Marginal Tax Rate	10.3%
Total Capital Gain Taxes - Applied at Distribution	34.1%

This gives the BTID strategy a return of 6.91% annually, net of taxes. Below is the performance of the two strategies over 20 years.

When it comes to San Diego Life's permanent life policy, reading the fine print matters. San Diego Life’s permanent life insurance policy has a 20% + $25 surrender fee. Over 20 years, that’s the difference between a capped maximum of $250,000 for the permanent life policy against the after-tax value of over $324,000 with a buy-term-and-invest-the-difference (BTID) strategy. That’s a difference of over $74,000.

"... the BTID strategy comes out on top by... $74,478"

Even with taxes eating away at over a quarter of gains, the BTID strategy comes out on top by a large margin - a margin of $74,478. Even ignoring the cap of $250,000 in benefits for the San Diego Life permanent life policy, a quick look at the graph above reveals the rate at which the BTID strategy outpaces the cash value offered by the permanent life policy.

 

Running Better Numbers

Recall that these computations were performed assuming a term life policy with an annual premium of over $4,000. That’s an unusually high premium. A more likely scenario is a policy premium of around $500, with (qualified) dividends and capital gains being taxed at just 15%. Given this more realistic scenario, the 20 year difference in a permanent vs. BTID strategy is over $380,000.

Why the startling difference in returns? Consider that in the first year of this permanent life policy, there is no cash (surrender) value. Why? Because that money goes to pay for agent commissions. Further, each year (after the first), the permanent life policy adds around $6,000 in principal. This is roughly half of the annual premium. In contrast, the BTID strategy contributes over $11,000 each year. That's the savings available (for investment) when purchasing a term life policy over a permanent life policy.

Simple math dictates higher returns in the absence of a middleman.

Conclusion

For certain high net worth individuals, a permanent life policy provides particular  tax advantages for estate purposes. However, if your net worth is less than $10.5 million, the case study above of an actual San Diego Life permanent life policy proves BTID as the more lucrative investment strategy. Proponents of permanent life argue the value of the forced savings aspect. However, savings/investing can be easily automated - requiring no additional effort on the part of the individual beyond the initial set up. See below.

Given the data provided by this actual case study of a San Diego Life permanent life policy, it is not surprising that many financial planners advocate for clients to buy a term life policy, and then invest that difference themselves (BTID). If you’re unsure of how to do just that, you can speak with a fee-only financial planner (and not a commission-based  financial salesman) about setting up automatic withdrawals from your checking account to invest in a low-cost target date fund.