By Brian Hartstein MSFS, CLU, ChFC | 10/29/2012
"Over the long term, stocks have historically outperformed all other investments." (CNNMoney Money 101:Lesson #4). This generic statement has led many people to believe that the absolute best and possibly only way to purchase coverage is to buy term coverage and invest the difference in the stock market. Is this statement a fact or just an opinion? Furthermore, is buying term insurance and investing the difference of what would have been spent on a permanent option really the best course of action? Are permanent policies really poor tools for wealth accumulation?
We will explore that below by examining the variances of the rate of return of stocks using the S & P 500 as an example. We will at no time use actual dollar figures as this is not a dollar for dollar comparison of one specific plan choice to another. This is an effort to explore whether permanent options can provide insurance protection and has a place in an individual's portfolio.
The S & P 500 index represents approximately 75% of the U.S. market cap can be a reasonable substitute for the overall stock market in general. If the assumption that dividends are invested into the index then the average rate of return from 1992-2011 is 9.58% percent (source - Ohio National - Form 2832). Very strong - right? This 20 year time frame is universally considered to my "long-term." However if a 15 year time frame is used then the average return would be 7.47% and, for a 25 year time frame, the average return would be 10.90%. The important point here is not the actual numbers themselves but that different time periods will yield much different results.
Like many things in life - timing is everything. When you actually enter and exit the stock market is much more crucial than the actual overall returns of the stock market over an extended time period in computing the actual rate of return that was earned. Historical returns and actual experienced returns can be and are quite different. Thus, the stock market may provide a better rate of return that a permanent plan however it may not as well depending on the time period examined.
Also - how do dramatic downturns in the stock markets over a short period of time affect rates of return? Here is a quick example:
|Option 1||Option 2|
|3 year average rate of return||5%||5%|
|3 year real rate of return||5%||4.84%|
While both scenarios have an average 5% rate of return Option 2 requires a greater than 20% return in year 2 to get back to the same point as Option 1. Therefore the real rate of return for Option 2 is lower than that for Option 1. Had this been reversed Option 2 would have the higher 3 year real rate of return. Again - timing is everything. The rates of return for Option 1 are similar to those earned in a permanent plan such as Whole Life which those in Option 2 mimic the stock market.
So - is "buy term insurance and invest the difference" the right course of action? The answer is - it really depends on the situation and the person. If the coverage need is temporary then perhaps yes. If the need is for a very long time period or perhaps for life then the answer is no. Is cash accumulation unimportant then no. If it is an important factor then yes. If the diversification of a person's or family's investments is important then a permanent policy is the right answer. If not then term coverage is the right way to go.
Many states have bankruptcy and creditor protection for the cash value of permanent life insurance policies while most investments held by an individual outside of a qualified plan have no protection. In addition, there can be emotional factors and biases which must be addressed, and in some cases dispelled, before a proper decision can be reached.
Truly, there is no "cookie-cutter" answer. Each person's fact pattern, needs, risk tolerance, and financial picture both in terms of investments and cash flow must be considered to arrive at the most beneficial course of action.