Whole life insurance as investment – a disappearing excellent investment opportunity for retirement planning

Summary:
A unique, high cash value providing, permanent life insurance policy will be withdrawn in a few weeks. For some people, especially financially stable young ones (provided it’s not an oxymoron in itself!), women, and business owners, it can be an excellent investment vehicle for retirement planning. Some numeric examples are shown below, demonstrating situations where the ‘Buy term and invest the difference’ rule certainly wouldn’t apply.

 

Often, people rely on rules of thumb like these: ‘Buy term and invest the difference’ [meaning: it’s better to buy lower-immediate-cost term policies than more-expensive-today permanent life insurance plans because all in all one can benefit from investing the premium difference independently from the insurance policy even though eventually there will be a cross-over point after which the price of the term policy will be increasingly higher than that of the permanent policy] and, more generally, ‘You get what you pay for’. My rule of thumb with rules of thumb is that sometimes they are misleading.

Here is an example, a unique life insurance policy that was clearly mis-priced in a way that makes it an excellent choice, even from a purely investment return point of view, for many 18-45 years old, … and which will be therefore withdrawn from the market in mid July. It’s a permanent protection plan, with premiums payable only until age 65, and with exceptionally high guaranteed cash values starting at age 65. There are a few policies of this type available on the market; what makes this one outstanding is that this guaranteed cash value is so much higher than (in most cases more than double of) what the other policies offer. Arbitrarily, I picked Maria (27 years old), Tom (38), Greg (45), and Julia (45), each healthy non-smokers, and examined from an investing/retirement planning perspective how they would fare with this policy. As you will see below, the annualized guaranteed investment returns are very attractive for them.

If Maria invests $1,000 in this policy in each of the next 38 years, at age 65 she is guaranteed to get (if she terminates the policy then) $112,962. For all the others, see the relevant amounts in the table below. One can look at this Cash Surrender Value (CSV) amount in various ways:

    (i) to achieve the same final amount, she should have an 5% annualized return in an investment account with the same one thousand annual contribution, … the main difference being that while with the insurance alternative she would have a $281,000 coverage but no liquid cash before age 65, and a paid-up permanent plan then, with the pure investment option she could have liquidity all the way, but no life insurance protection at all;

      (ii) if we consider that with this particular plan she would get a Best Doctors service availability package, and acknowledge a modest $200 value per year for that, then the annualized guaranteed return for the 38 year period would be 5.91% (because she would be assumed to invest $800 only, … the rest being paid for Best Doctors);

        (iii) if we acknowledge the value for her of the insurance protection at $375 (annual cost of a 38 year term policy for her) then the annualized return is 6.9%;

          (iv) finally, one can argue for considering both of these benefits – life insurance and Best Doctors for 38 years – which would lead to a purely investment outlay of $425 per year, and a consequent 8.43% guaranteed annualized return that she is supposed to achieve in an outside investment to get the same cash value at age 65.

          Guaranteed annualized returns
          Maria (27, non-smoker) Tom (38, n-s) Greg (45, n-s) Julia (45, n-s)
          Insurance face amount (life coverage), in $ 281,000 123,300 313,000 346,000
          Annual premium flow until age 65, in $ 38 times 999.78 27 times 999.41 20 times 4,995.40 20 times 4,997.80
          Guaranteed CSV at age 65, in $ 112,962 49,567 125,826 139,092
          Value of term insurance for period up to age 65 (annual premium, in $) 375 315 770 583
          Annualized return needed to lead to same accumulation as this investment, at age 65, in % [i] 5.0 4.1 2.1 3.05
          Annualized return needed … considering Best Doctors, in % [ii] 5.91 5.44 2.50 3.40
          Annualized return needed … considering term life coverage, in % [iii] 6.9 6.4 3.65 4.15
          Annualized return needed … considering both term life protection and Best Doctors, in % [iv] 8.43 8.46 4.08 4.55

          While the percentages in the above table, at least at younger ages, are not too bad even when the life protection and Best Doctors benefits are disregarded, they are definitely good when they aren’t. In fact, looking at it historically, those above-8% numbers are extremely good, … better than most investors immediately grasp it, I believe. To understand why, have a look at this chart:

          As you can see, the 8.43% annual growth rate (the result of which is represented here by the blue dotted line) is extremely good historically. Let’s have a look at the lowest rate calculated here for Maria:

          While there is no more premium to pay after age 65, the CSV continues growing if the policy is not surrendered; in fact, in some of the policies of this type that remain on the market, it grows even faster than it does in this soon disappearing ‘focussed-on-age-65-CSV’ policy, … although even in situations when the CSV will catch-up eventually with this one, it will happen only decades later. That’s what makes this particular policy so outstanding for some people.

          So far, we disregarded taxation completely. With the insurance alternative, she would not pay any tax during the 38 year accumulation period, but would pay tax when cashing out. To diminish the tax burden, a good aspect is that the policy doesn’t have to be surrendered all at once, … it can be done partially or in chunks as well, thereby potentially leading to taxation in lower tax brackets.

          Counter-arguments

          The main disadvantage of this particular policy is that there is no CSV at all before age 65. With the other policies of this kind, it’s different: there is some cash value offered with them after usually 5 or 10 years. Also, in some cases, if the client stops paying the premium, there might be a switch to a paid-up permanent protection plan of lower benefit amount; with this policy, however, if the premium payment stops permanently before age 65, then all the protection is lost forever. (There is a more generous than usual rule for reinstating the policy in case of temporary interruptions in premium payment, but going into such details would be unnecessary here. Similarly, there are some other side benefits coming with this policy, apart from the Best Doctors service, that I don’t want to detail here because of less significance.)

          Who are the candidates for buying this policy then?

          I think it’s mainly young and healthy people, who need life protection (at least before age 65), but who may want to switch the accumulated assets in the policy into retirement income at age 65 (or later). The Best Doctors benefit is more important to those who buy smaller policies, since it’s a fixed size benefit. For someone who has got a critical illness policy, the Best Doctors benefit is most likely not valuable since it is typically part of those policies. While the tax-deferral aspect of this policy is a good feature, most people can probably benefit more tax advantages from investing first in TFSAs and RRSPs, … limiting the range of potential candidates who can afford even this one. It’s very important that a potential buyer be reasonably sure that /s/he will be able to pay the premium all the way, because of the basic inflexibility mentioned in the previous paragraph. On the other hand, the decision opportunity at age 65 represents more flexibility than having a term policy would: if the client thinks then that /s/he doesn’t need the cash value, the policy remains in force, without paying any more premium, to benefit next generation even if s/he lives long. Smokers shouldn’t bother with even dreaming about investing this way, … their insurance costs are simply too high for that.

          [Correction, on July 03: In fact, I was probably too categorical here, and would like to show why on the example of Maria, 27, above. If she is a smoker, she’d pay $1,368 for the same $281,000 coverage, … making the annualized return a paltry 3.65%, … so this far the strong disapproval of this choice is warranted. Even after considering the $200 value of the Best Doctors service, the return is only 4.33%, … not good enough on a purely investment assessment basis, … even if it is guaranteed, because of its locked-in nature for so long. However, if she really needs insurance for perhaps whole life, but certainly until age 65, then the return becomes more interesting again, simply because the price of her protection – the amount we deduct for the calculation from the $1,368 premium – is also higher, … $684 for a T38 plan. The rates calculated this way are 6.55% (if Best Doctors is disregarded) or 7.92% (if Best Doctors is also considered). While these percentages are somewhat smaller than the previous 6.9% and 8.43%, calculated for the non-smoker Maria, they are still very attractive, mainly because they’re guaranteed. Similar pattern with Tom: If he is a smoker, then the previous 6.4% becomes 5.32%, and the 8.46% changes to 7.01%, … still respectable.]

          Business situations

          One of the weak features of this policy, no cash value before age 65, can be seen as a strength if a corporation buys a policy on the life of key persons/owners/partners. In such situation, it can deduct premiums as an expense. If after some years, but before age 65, the corporation transfers ownership to the insured individual, then there is probably no deemed taxable benefit received by him/her, because there is no cash value in the policy yet, … even though the CSV will be available at age 65. This arrangement can be very advantageous from both a taxation point of view, and as a way to give incentives to key persons to stay with the company.

          There is still time to act

          Since there is practically only two weeks left to act if someone wants to get this policy, it’s worth mentioning that an insurance application evaluation and approval takes generally a few weeks, and the client has 10 days even after policy delivery to change his/her mind without consequences. In other words, there is maybe two weeks only for submitting an application, but several more weeks to completely understand all the details and get accountants involved if needed, in a business situation, e.g.

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          2 Comments »

          1. Comment by Ian McEwen

            Hey, just noticed that you didn’t mention that the paid up 65 eats away the cash value of the policy.

            Regards,
            Ian Mcewen

            ———
            Hi Ian,

            Could you please explain what you mean?
            Yes, the policy was withdrawn, so in a sense there is not much usefulness in talking about it anymore, but I’d like to clarify if you did misunderstand something, … which appears to be the case here.

            I can repeat what I wrote: this policy was payable until age 65. It provided permanent death benefit. There was no cash value until age 65, but there was an outstanding cash value from that point onward.

            What kind of ‘eating away’ are you talking about???

            Regards,

            Laszlo, the curious

          2. Comment by Julio

            Do you really mean to say that once the ownership is revoked from corporate to personal there is no disposition only becuase the csv”s are at 65.What happens if the transfer happens at age 65 .Then what?
            Thanks.

            —–

            Thanks for the opportunity to clarify, Julio. Yes, I’ve heard about corporations having done this move. I believe the stories are true but I have no direct knowledge of the participants. As I understand, they did the transfer not at the time when the CSV appeared, or immediately before it, but a bit, let’s say 3 or 4 years, before.

            It indicates that they certainly wanted to avoid the attention of Revenue Canada, but I still don’t think it’s necessarily purely a case of exploiting a loophole. I’m not a tax specialist, an accountant or lawyer specializing in taxation, and I’m not aware of any Revenue Canada position on this issue; if you want to get a more definite answer to this detail that you can rely on, I’m not the appropriate person to ask. However, I can imagine that it could be challenged if Revenue Canada assessed a taxable benefit when the transfer of ownership happens years before the CSV appears. It’s not only that there is nothing of actual monetary value changing hands then, but even that future value is very much potential only at that point. What if the insured dies or cancels the policy before the CSV is available?

            The speculation is rather theoretic now, with the disappearance of this particular policy the post was about, … there are probably no more very similar policies on the market any more; the cash value appears immediately or after just a few years in the remaining ones. Even if the CSV is deemed as taxable income at transfer of ownership, as it does with these policies, the arrangement may make sense in many situations, although not as spectacularly good as this perhaps debatable and risky earlier strategy was.

            Laszlo

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