Financial Jungle

I don’t know about you, but I’m frightened by universal life insurance. Once you sign the dotted line, it becomes a life-long commitment that comes with a hefty early termination fee. The existing term insurance policy which we currently hold is pretty flexible, since we are free to adjust the insurance premiums in accordance to our needs.

For instance, if we allocate $400 per month of spare cash, we can purchase a million dollar policy with $100, and invest the remaining $300 into any securities of our choice. Should we be lucky enough to self-insure later on, we can cut off the insurance premiums, and invest the full $400.

Insurance can be too complex of a topic to explain over the dinner table by an insurance agent. I recommend taking the materials home, and spending some time doing a little critical and independent thinking. Since insurance agents are generally commissions driven, it is in your best interest to consult an independent financial advisor to verify if this is the right product for you.

How does a universal life insurance policy work?

When you buy universal life policy, not only are you paying for your insurance premium, you’re also contributing to an investment portfolio. In effect, the insurance company is underwriting your insurance and managing your retirement nest egg simultaneously. For instance, the company takes your $400 spare cash, and split it between the insurance premium, administration fee, and investment contribution. The company then offers you a limited list of investment vehicles. Sounds like a rip off if they charge you the extra administration fee and reduce your investment options, but …

What are the benefits?

1. The portfolio grows tax-free. This is similar to RRSP and RESP, where you can switch between different mutual funds without triggering capital gain taxes. This is different from a taxable account where capital gain tax can cut into your capital. The smaller the capital you have, the less it will compound.
2. The portfolio and the face value of the insurance policy go to the beneficiaries tax-free when you pass away.
3. Unlike taxable accounts, there are no probate fees. This can save as much as 5% of your total assets.
4. The portfolio is creditor proofed. This is useful for anyone concerned about lawsuits. (Does anyone know if RRSPs are creditor proofed too?)
5. The portfolio can be used as a collateral for loans. The loans can be repaid by the policy, but that will reduce the death benefits.

What are the key drawbacks?

1. Again, the investment options are limited, and often expensive.
2. You are committed to buying insurance for life even when you have no more dependents.
3. Early termination fee is steep.

Am I better off with universal life insurance?

To find out if universal life is better, we need to explore the alternatives. Most Canadians don’t max out their RRSP. If you still have RRSP contribution room, then I think you’ll get better bang for your bucks by contributing your free cash flow into RRSP. Since the $300 is after-tax money, the pre-tax equivalent is $400 if you’re in the 25% tax-bracket. Most payroll departments let you deposit pre-tax income directly into your RRSP brokerage account. Next step is to pick an investment vehicle, and what’s a better way to show off your patriotism by investing in the Canadian TSX index. Since you’re investing on your own, you’re able to shop around for the cheapest index fund or ETF. The cheapest Canadian index fund that I am aware of is the TD Canadian Index e-series fund with an MER of 0.31%, while the cheapest ETF is iShares’ XIU with an MER of 0.17%. Since XIC trades like regular stocks, you’ll have to pay transaction fees to buy. Refer to my previous post on Interactive Brokers.

As a comparison, Sun Life universal life insurance policy offers their version of the Canadian index fund with MER of 1.50%.

Let the race begins

If you invest pre-tax $400 worth of TD Canadian Index fund (MER = 0.31%) inside RRSP and assuming the market compounds at 10% over the next 30 years, your portfolio balance will grow to $6,413 before tax. The highest marginal tax rate for British Columbia is 43.7%. If you liquidate the entire RRSP account at once, you’ll receive at least $3,636 after-tax. This is the worst-case scenario, since the RRSP can be transferred to the surviving spouse tax-free. The freedom you enjoy with a term life insurance is you can terminate the policy once your dependents leave the nest. By then, you won’t need supplemental insurance. This unleashes bonus cash flow to excel your RRSP portfolio further. I have not factored in the probate fee, since it depends on the lawyer and if your beneficiaries are willing to handle the paper work.

If you invest after-tax $300 worth of Sun Life Canadian index fund (MER = 1.5%) over the same 30 years, you portfolio will grow to $3,467 tax-free. Based on my understanding, this is on the optimistic side for two reasons. First, I’m ignoring the administration fees. Secondly, the insurance company withdraws portions of the portfolio to offset your rising insurance premiums. Please feel free to complete my math if we have an insurance expert here.

What if I have no more RRSP contribution room?

If you’re in a high tax bracket, pay down your mortgage. This strategy saves you in the neighbourhood of 5%, or 8.33% before-tax assuming your marginal tax-rate is 40%. Although this not as sexy as Sun Life Canadian Index fund’s 8.5%, it is a guaranteed return instead of a projected return.

Is universal life good for anything?

My opinion is that universal life is third in line after RRSP and mortgage. It cannot be emphasized enough. I’m not a certified financial planner nor an insurance expert. Materials are presented here for discussion only.