YOU'VE DONE WELL, PAID OFF YOUR DEBTS AND PUT AS MUCH INTO YOUR PENSION PLAN AND YOUR RRSP AS YOU CAN- BUT YOU'VE STILL GOT SAVINGS YOU'D LIKE TO PROTECT
Al and Carol Dawes* had an estate planning problem. Al, 64, had just retired as an executive in a manufacturing company and Carol, 56, was looking ahead to retiring in four years from her teaching career. They wanted to take out a permanent insurance policy on their lives that would give a $500,000 benefit to their daughter, who has a disability and can't work full-time. In addition, they were searching for a way to shelter investments currently sitting outside their RRSPs, so their daughter would not be hit with hefty taxes when she inherited them.
They did what a number of other Canadians in similar situations have been doing recently and chose an insurance product called "universal life" to cover both their insurance and their investment needs. Universal life, introduced into the market about 20 years ago, has been enjoying an upsurge recently, accounting for 50 per cent of Canadian new sales (as measured by premium volume) in 1998, up from 28 per cent in 1994.
"No question, it is growing in popularity, especially in the 50-plus market," says Jim Rogers, chair of The Rogers Group Financial Advisers Ltd. in Vancouver and also the current chair of the Canadian Association of Insurance and Financial Advisers.
Given the right financial circumstances and careful selection of the product, universal life can be a very good choice. However, Rogers and other advisors stress that it is not for everyone, especially those who are carrying a heavy debt load or are in lower income tax
And it is definitely not the right route for the novice who wants to conduct a quick do-it-yourself research project comparing rates and returns and then sign up with the company that offers the best deal. There are features, variations and nuances to this product that even a sophisticated investor can't navigate without an experienced coach.
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WHAT IT IS
There is a core basis to every universal life offering. At its essence, it is a term insurance policy that is attached to a sheltered investment account. To dissect that mouthful, "term" refers to the kind of insurance taken out for a specified number of years. Under a provision in the Income Tax Act, the investment account that goes with the insurance is sheltered, so that beneficiaries don't have to pay taxes on the growth of funds inside the account.
After those basics, you're into particular companies' features and options. "The product is changing constantly," says Bruce Carbert, a financial adviser with John Nicola Financial Group Ltd. in Vancouver, who finds it a popular choice for his clientele of primarily professionals and small business owners. "Investment options available have grown dramatically over the last five years," adds Paul
Tompkins, owner of Tompkins Insurance Services Ltd. in Toronto, whose company deals primarily with high-net-worth individuals like Al and Carol. Tompkins estimates that universal life accounts for about 70 per cent of the permanent insurance his clients choose as part of their estate planning.
All major insurance companies offer universal life policies, with other institutions such as TD Insurance and CT Financial also in the field. The options available for the investment fund used to be limited but now range from pure interest-rate accounts offering GIC-like guaranteed returns to funds linked to such indexes as the TSE 300, S&P 500 and Morgan Stanley World
Index. Administration and management fees vary from company to company, as do bonus plans that kick in additional interest at various points in the life of the insurance contract. Some companies with bank affiliations have even added an automatic line of credit to their features, secured by the cash value of the policy.
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HOW IT WORKS
Policyholders pay an annual insurance premium and then top up the plan as their cash flow permits. The topped-up part, minus expenses and administrative fees, forms the investment portion. The maximum amount policyholders can add to the plan is defined by tax legislation and depends on an actuarial calculation related to the amount of insurance coverage and the policyholder's age.
Think of universal life like a bank account, suggests Tom MacKinnon, a director and insurance analyst at Scotia Capital. You make deposits each year, the bank takes charges out of the account to cover expenses and then it adds the interest that the funds deposited have earned.
A big attraction of these plans is their flexibility. Policyholders can put in their maximum or minimum (the insurance premium) or any amount in between every year.
They can also withdraw funds at any time paying the applicable taxes and usually a surrender charge, depending on how long the policy has been held -- as long as they leave enough in the account to cover the insurance premiums. They can eventually pay the insurance premiums out of the funds built up in the investment portion. The funds can also be used as collateral for a loan.
What expenses and management fees are involved and are they guaranteed against future increases?
How highly do agencies such as Moody's and Standard & Poors rate the underlying insurance company? (You want to be sure the company is going to be around for awhile).
How flexible is the plan in terms of investment options?
Above all, be sure you trust and respect the financial advisor you are dealing with. Universal life can be almost anything you want it to be. Do your homework in choosing an adviser well, and let him or her sort through the myriad details. This strategy will save your pocketbook and your sanity.
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WHO BENEFITS MOST
Financial advisors point to two classic cases where universal life offers the most benefits. The first is higher-income, older individuals who want insurance that will last the rest of their lives, who also have investments outside RRSPs on which they are paying taxes and whose beneficiaries will inherit this tax liability when they die. "Many people feel they are taxed to the max and chafe at sending any more money to the federal government than they have to," explains Jim Rogers.
Take Al and Carol Dawes. They pay about $22,000 a year for the first four years for their
$500,000 universal life coverage under a joint second-to-die policy, which means that the insurance is paid out when both of the spouses are dead. A little over $4,000 is used to pay the insurance premiums, with the rest going to investment options. The premiums for years five and up will then come directly out of this investment pool. The universal life investments they chose for the policy are forecast to increase at a rate of six percent per year and, given a 30-year life expectancy, the benefit at death of the combined insurance and investments is projected to be
The second classic scenario is a business owner or incorporated professional who is accumulating investment income within his or her company. "Universal life is very popular with lawyers, doctors and dentists who are capped in terms of putting money in RRSPs," says Tompkins. "Where else can they solve their current insurance needs, plus have funds grow in a tax-sheltered environment?"
About 80 per cent of Carbert's clients fall in this category. He advises them to fund their universal life insurance through their corporation, allowing the attached investments to grow within the company. "Our clients would typically put in $1,000 to $5,000 a month into a plan, with the object at retirement to withdraw any surplus that is not needed to support the insurance," he says. "This surplus is paid out as dividends to the individual after they retire, when they are in a lower tax bracket."
They can also take advantage of the
flexibility of the product. In years when the company is thriving, they can put surplus cash in the plan.
In years when cash flow is down or they have to purchase equipment or renovate facilities, they can withdraw the necessary funds leaving only enough in they the insurance premiums.
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RULE NUMBER ONE
Universal life is first and foremost an insurance policy, and the primary reason for purchasing it should be the reason that you purchase any insurance policy: to cover the needs of your beneficiaries. Rogers compares buying universal life for the investment part of the package to purchasing really nice tires and wheel caps but then asking the rest of the car because it happens to be attached.
Financial advisors first want to make sure an insurance policy covers the current needs of the beneficiaries -- the main part of the car, in Rogers' analogy. Term insurance in universal life policies is typically more expensive than buying term insurance on its own. If cash flow is a problem, then the cash available should be used for insurance alone. "If you can't do the job in a Cadillac, do it in a Volkswagen, but get the job done," as Rogers puts it.
This is typically true for younger individuals, Carbert adds. "My first priority is to make sure that people have
coverage at a cost they can afford." He would not usually advise universal life for a professional client who is 30 years old, because typically such clients have high debt, may have just bought a practice and probably have a mortgage and young children.
If they can afford sufficient coverage in basic term insurance but not the same amount in universal life, he would recommend taking the term. Later, once some debts are paid off and the children are older, the client could replace the basic term with universal life or some combination of the two.
UNIVERSAL LIFE IS, FIRST AND FOREMOST AN INSURANCE POLICY; YOU BUY IT TO
COVERTHE NEEDS OF YOUR BENEFICIARIES
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The hottest universal life product right now is the type linked to equity indexes, according to MacKinnon. The reason: Returns lately have been well into the double digits. However, advisors warn that these numbers are volatile over the long haul, and potential policyholders need to guard against unreasonable expectations.
Insuring companies provide agents/brokers with software illustrating how their universal life products will probably grow, based on historical performance. "These illustrations are by no means a guarantee of future investments," cautions MacKinnon, as account values may not necessarily grow at the same rates. The illustrations typically include a low, medium and high rate of return and may use some fairly aggressive assumptions.
"Ask to see the worst-case scenario first and base your decision on whether you can live with that," Rogers advises. "We all would like to believe the market is going to do well, but we should prepare for the worst."
Managing a universal life plan is the same as managing an RRSP, Carbert adds. "If you buy a 20-year term deposit, you know you are not going to have a lot of variability. If you are 100 per cent in equities, then you will have to accept the fact they are going to go up and down. Design your policy to your risk tolerance."
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IS UNIVERSAL LIFE FOR YOU?
Don't try to do this on your own; ask a professional well-versed in the product to guide you. If you don't know one, ask friends and colleagues for referrals. However, here are some general guidelines from the pros to start out.
Max out RRSP and pension contributions first before thinking about universal life. Also, pay down non-deductible interest debt, such as credit cards, and take advantage any of pre-payment options in your mortgage.
If you are in the 25 to 30 per cent tax bracket, the expense and costs of the tax-sheltering capability for investments, and the increased cost of the term insurance, will probably outweigh any benefits of universal life.
Only take out universal life if you need the insurance for at least a decade. The underlying investment may not perform well over a shorter period of time.
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