Economic Models Show Wall Street Rallying Cry is Flawed
NEW YORK, Aug 4, 2015 – A new academic study authored by scholars from the University of Pennsylvania’s Wharton School and Carnegie Mellon University’s Tepper School of Business identifies failings with a strategy many financial advisers suggest: buy term life insurance rather than whole life, and invest the premium savings on your own.
According to the study this strategy, often abbreviated to “BTID” within the industry, is shortchanging Americans grappling with the challenge of creating a sound financial plan.
“Our study sheds light on Wall Street guidance that has been taken as an article of faith, but that clearly under-performs for many who follow it. Without question, the American people deserve better than BTID. With a national retirement savings deficit of about $4.13 trillion for all U.S. households,* Americans need sound and realistic financial guidance that they can rely on, which this study aims to provide,” said David F. Babbel, professor at The Wharton School and co-author of “Buy Term and Invest the Difference Revisited.”
Oliver D. Hahl, assistant professor at Carnegie Mellon University, also co-authored the study. A thorough, systematic review of existing economic research, the study details BTID’s limitations. It concludes that BTID, studied in rigorous economic models, is “rarely chosen by rational, well-informed consumers” in reasonable scenarios. Dr. Babbel identifies the main takeaways from their work to be:
- BTID assumptions are not validated by real-world behavior
BTID assumes that people will value the term life insurance when in fact, term life insurance lapse rates are more than twice as high as whole life policies.** Those individuals may not be keeping the insurance in place long enough to provide the protection they need. BTID also assumes that people will invest the difference between the term life they bought and the permanent life they didn’t. Not only do national savings rates disprove this point, but statistics show that individual investors buy high and sell low.*** So people don’t buy term and invest the difference, they most likely rent the term, lapse it, spend the difference and if they invest, they are prone to real-world emotional investing.
- BTID model fails to properly value the guaranteed cash value growth of permanent life insurance
The study states that models used to promote BTID don’t appreciate that “the cash values in whole life always grow by positive amounts in relatively stable ways…they manifest stability in growth patterns that exceed that available in the ever-popular stable value funds,” or in a Guaranteed Investment Contract (GIC).**** In contrast, the BTID model dictates that you invest the difference in a portfolio of stocks and bonds that can rise and fall with the market.
- BTID ignores the valuable options of permanent life insurance
Whether you’re supporting adult children longer than expected or still paying a mortgage into retirement, the need for life insurance can last longer than expected. Permanent life insurance gives consumers flexibility that is unlike any other financial instrument. The study references a “breakthrough seminal paper” by Michael Smith, professor at Ohio State University. That study, ignored by BTID advocates, demonstrates that whole life insurance is “a package of options that is not precisely duplicated by any other combination of commonly available financial contracts.”
Trash The Cash
“Generations of Wall Street professionals have been trained by their firms to trash cash value life insurance so the investment firms could maintain those dollars under management,” said Chris Blunt, president of New York Life’s Investments Group. “The idea was to tell clients to buy less costly term insurance instead. Buy term and invest the difference became part of the lexicon of Wall Street, and a lot of folks on Main Street were sold on that notion.
There was just one problem. People bought term and did other things with the difference – they bought a new car or a flat screen TV– and fell short of their financial goals. In addition, they lapsed their term insurance only to be found uninsurable later in life.
Finally a new academic study, using rigorous economic modeling, has debunked Wall Street’s heavily marketed but largely erroneous path to plan for financial security.” The study concludes with an analysis of scenarios and assumptions during a 15-year period offering a combination of term and whole life insurance as the optimal solution.
“It is undeniable that more Americans need to commit to a solid savings plan. Financial professionals across the country have long encountered problems that BTID has caused as they work with families and businesses toward this goal,” added Mr. Blunt. “The study proves that the short-sighted advice Americans have gotten to buy term and invest the difference is unrealistic, providing a false sense of security or even worse, leaving families and businesses unprotected and at risk.
The study does more than debunk BTID. We hope it also provides both financial representatives and the families and business they work with the sound and proven financial guidance they need to improve their outlook for lifetime financial security.”
The study, which received partial funding from New York Life, was published in the May issue of the Journal of Financial Service Professionals, a peer-reviewed academic and professional journal. The paper is available here.