Thursday, October 10, 2013

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.


1 comment:

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