Buy term and invest the difference — not anymore!
By Nick Paleveda MBA J.D. LL.M
National Pension Partners
This article presents a series of demonstrations that challenges certain stereotypes in the financial services industry.
In Demo 1, the myth that an investor will always do better in the long run by investing in the S&P 500 is dispelled. Since the beginning of this century, that has not been the case. In fact, a simple pension annuity has outperformed the S&P 500 since the year 2000.
In Demo 2, the myth you should buy term and invest the difference is dispelled. This myth began in the 1970s, when interest rates were in double digits, and a teacher named A.L. Williams created an entire company based on this slogan. The 15 percent certificate of deposits are gone, yet the myth remains.
In Demo 3, the myth that tax deferral will not work if the tax rates are the same at retirement is dispelled. A greater amount being reinvested will actually create a larger amount for the investor at retirement. If the investor factors in a change of marginal rates at retirement, the dispersion is even greater.
Finally, the article concludes with the advantages of having assets such as life insurance inside of a defined benefit plan. The purchase of life insurance inside of a qualified plan can allow the taxpayer an additional deduction for the mortality cost, provided the death benefits come out to the surviving spouse in the form of a lifetime income or QPSA. The extra cost of the death benefit is not taken into account in determining the 415 limit in a defined benefit plan. If the plan combines life insurance with a fixed annuity that qualifies under section 412(e)(3), the plan may escape the 4971(a) penalty that takes place when a plan becomes underfunded. There are numerous tax and asset protection advantages for the purchase of insurance inside of a qualified plan, as opposed to outside of a plan.
Demo 1 myth: The S&P 500 is a better long-term investment for retirement then a pension annuity.
Here's a comparison of pension annuity versus S&P 500:
|Contribution||Running Total Pension Annuity||Rate||Contribution||Running Total S&P 500||Rate|
This model shows that this particular myth is not true for certain time frames. It clearly demonstrates that a pension annuity earning a guaranteed rate of 3 percent or the crediting rate of the insurance company beat the S&P 500 in 10 to 12 years and beat the S&P in the long run. What is the bias? The year the model was started. If you use different years, you will get different results (for example, the last three years). However, if you go back four years or even five years, you will have another result. Timing is an issue in all models; however, in this example, I use the last decade as the basis of the model. Demo 2 myth: It is better to buy term and invest the difference.
Here we compare whole life insurance with "term and invest the difference." This model dispels the myth that it is better to buy term and invest the difference. In fact, it is better to buy whole life if you can afford it.
On February 18, 2013, the top CD rate published nationwide was a 2 percent, 10 year CD. The 10-year treasury has a rate today of 1.97 percent. During that same time frame, a super select life premium for $3,009 10-year term would fund a death benefit of $1,666,666.
The CD and U.S. 10-year treasury were selected as an asset class comparison, as it represents a low risk investment. The life insurance was a high cash value whole life policy based on current assumptions (BOCA). The policy is designed to be used inside the qualified plan.
The life insurance contribution and benefit schedule is published below. The CD will follow the same contribution schedule. The life insurance is for a 55-year-old male, retiring at age 65. The policy is designed to be used in a qualified plan so the mortality is unisex (minus rounding errors).
Whole life insurance:
|End Year||Contribution||(i)||Cash Value||Death Benefit|
CD or U.S. 10-year treasury:
Whole Life insurance BOCA = $898,234
Death Benefit = $1,666,666
10 year U.S. Treasury or CD = $869,295
Death Benefit = 0
Whole Life + $28,939
Buy term and invest the difference
But if you factor in the term cost, the myth of buying term and investing the difference is radically dispelled. To help the reader, the first number is the first year contribution. Next, the term cost is taken out. This equals the amount left over to invest.
The next number is the return at 2 percent. Finally, the second year contribution is added to the amount and the process is repeated (minus rounding errors).
|Contribution||Cash Value||Term Cost||Net||Interest|
Whole life insurance BOCA = $898,234
Death Benefit = $1,666,666
10 year U.S. Treasury or CD = $835,690
Death Benefit = $1,666,666
Whole Life + $62,544 Results
Term cost over 10 years: $(30,090)
U.S. Treasury or CD investment 10 years: $835,690
Whole life contribution over 10 years: $775,034
Cash surrender value after 10 years: $898,324
The model clearly demonstrates that the high cash value product, BOCA, performed better over a 10-year period then a top 10 year CD rate or a 10 year U.S. Treasury. This takes place even if you do not factor in the cost of the term insurance. If you do factor the insurance, the person who purchased the term and invested the difference is even worse off. In both cases, the tax benefits are not even considered. The tax benefits are discussed in Demo 3.
Why does this happen?
Due to the low interest rate environment today, it is actually better to purchase a whole life policy than purchase term and invest the difference. The model is based on a 55-year-old funding for 10 years to normal retirement age (NRA) of 65. Just like any model, there is bias built in. Will the client receive a super select rate? Will the client be comfortable with a CD rate of 2 percent over 10 years from a bank somewhere in the U.S.? Will the insurance company be able to sustain the rates of return illustrated along with the mortality cost?
Can’t I do better in the stock market? (discussed in Demo 1) What are the tax benefits and issues? (Discussed in Demo 3)
Demo 3 myth: If I am in the same tax bracket when I retire, it will not make a difference.
Most financial matters are boring. The math on tax deferrals with later-on inclusion is quite simple. If you assume the tax rate will remain the same, it does not matter whether you defer or pay the tax upfront. Or does it?
Example 1: The tax rate is 10 percent and interest earned is 10 percent. You may pay the tax up front or elect to defer the tax.
Pay the tax up front
- I -T= N + i - t = NN
T — tax
N — net
i — interest
t — tax
NN — net/net
- $100,000 - 10,000 = 90,000 + 9,000 - 900 = 98,100
- $100,000 - 10,000 = 90,000 + 9,000 - 900 = $98,100
Add years 1 and 2: $98,100 + 106,929 = 205,029
$205,029 is available for retirement. (R) Tax is deferred
- I + i = N I + i = N (N + N + i = NN - t = R)
$210,000 + $21,000 = $231,000 - 23,100 (10 percent tax) = $207,900
Pay the tax: $205,029
Defer the tax: $207,900
Why does this work? The upfront tax gave less of a lump sum to accumulate interest outside of a plan than inside a plan.
Example 2: When you add other factors, such as lower marginal tax rates when the assets are withdrawn, the model is more dramatic. Today, the 39.6 percent rate plus the 3.8 percent rate on income over $400,000 or (39.6 + 3.8 percent = 43.4) places a heavy burden on extra earned income. What happens if this income can be deferred and later withdrawn at a lower rate when brackets go down due to retirement?
Pay the tax and invest
$100,000 - 43,400 = 56,600
$100,000 - 43,400 = 56,600 + (56,600 + 5,660 - 2,456) = 59,804 + 56,600 = $116,404 for retirement
Defer the tax
$100,000 = $100,000
$100,000 = $100,000 + $10,000 interest = $210,000 - 17 percent tax (at retirement the rate on the first $100,000 is effectively 17 percent) = $174,300 for retirement
$174,300 - 116,404 = 57,896 more available for retirement
Why did the tax rate change from 43.4 percent to 17 percent? A high-income person may be taxed on the next $100,000 of income at 43.4 percent. When he or she retires, the first $100,000 is taxed at an effective rate of 17 percent. Hence, deferral makes marginal sense for some people (see example 1) and major sense for other people (see example 2).
Why you should use life insurance in a defined benefit plan
First, as Demo 2 suggests, a high cash value policy produces a return to the plan equivalent to a CD or treasury with an additional death benefit, which a CD or treasury does not produce.
Second, guaranteed high cash value whole life lessens the impact of a 4791(a) penalty and the need to generate a form 5330. When the market declined 37 percent in 2008, TPA firms spent a lot of time and client funds solving the 4791(a) issue.
Third, the table 2001 rate does not need to be paid. However, the death benefits will come out taxable to the spouse in the form of a QPSA or spousal lifetime income.
Fourth, an additional deduction takes place due to the mortality cost being deducted in the plan, provided the benefit is a QPSA or spousal lifetime income.
Finally, the table 2001 rates are generally less than the term rates if the client elects to include them in income to provide tax-free benefits.
Why you should use other investments in a 401(k) profit sharing plan
Markowitz, who invented modern portfolio theory in 1957, demonstrates that a combination of fixed asset class plus a variable asset class will lower risk and increase return. Assuming this theory works, a client may place his low risk assets into the pension plan, thus negating AFTAP failures and 4971(a) penalties (life insurance and fixed annuities). Then in his 401(k) profit sharing plan, place low risk high return assets. Today, a taxpayer may adopt both plans and fully deduct both (provided the pension plan is covered by the PBGC) as section 404(a) (7) (the combined plan limitation) was modified in PPA 2006 and technical corrections were made in WRERA in 2008.
Finally, assets in a qualified plan are exempt from creditors under the Bankruptcy Restructuring Act of 2005. In some states, life insurance and annuities are not exempt.
This is the last of the demonstrations. In fact, modeling and demonstrations can go on forever. Based on various predilections, bias, timing etc., different conclusions may be reached. Each individual situation is different, and they should consult their financial, legal and tax advisor for the plan that best suits their situation.