Olga is thinking about retirement

Olga (42, nonsmoker) is a self-employed professional, with $50,000 annual income. She has saved $60,000 for retirement in various registered investments. She has also bought a term life insurance policy to protect her children, and also she has disability insurance. However, she feels that critical illness insurance would complement and enhance her insurance portfolio significantly. Her parents have retired, and she has bought long term care insurance for them. Now, she is more concerned about financing her own retirement. She has heard about the tax-effective nature of investments that are connected to life insurance within an increasingly popular kind of policy, called universal life insurance.

She has calculated the amount she needs at age 65 to live comfortably on after her retirement then. She learned that if she wants to have an annual (taxable) income of $35,000 (in today's money) last until age 90, then she will need $633,362 at age 65 (in current money terms, that is $1,249,995 in nominal terms, if we boldly assume 3% inflation and a 6% annual average rate of return on her investments while retired). To reach her aim, she has to save $8,484.79 every year (again, in today's money terms) in the next 23 years, provided she can achieve an annual 9% rate of return on her investments in that period. (To see the details of how these numbers were crunched, click here.

Olga, from various sources, has learnt that universal life policies has several strong points relevant to her situation. She has heard of people who borrow money form banks and use the policy as a collateral, resulting in a very tax-effective way of living off their savings during many years of retirement. Olga is also aware of some points that can be raised against universal life policies. Click here to see the strengths and weaknesses she collected before going to see the relevant numbers.

Olga now pays $550 a year for her $400,000 10 year renewable term policy. She knows that it could have been bought for less than $400 as well, but she did not shop around. At least she is satisfied that she did not end up with a similar policy for around $800. Fortunately, she is healthy and can find a better policy to switch to. She was advised that the new one should be either a universal life, or a 10 year term policy, if she does not want to keep the insurance after 10 years. She wants to see the costs and benefits of various options that seem viable to her, before making a decision. Let's say she thinks she could spend $9,000 for the insurance and retirement savings combined. She wants to see the following two basic options compared:

Option 1: Keeping the cheapest pure life insurance for 10 more years only, until her kids become independent; then giving up life insurance totally, and putting all she can into registered investments until age 65. (detailed calculations here)

Option 2: Starting a universal life policy right now, saving for retirement in it, and then deploying the accumulated capital tax-effectively, i.e., by living on bank loan against the cash value in the policy. (detailed calculations here)

The comparison of the two options can be summed up like this:


Option 1

Option 2

Insurance protection (tax-free for beneficiaries)

for 10 years, $400,000 death benefit

for whole life, starting with $600,000 death benefit that increases dramatically (almost 0.9 million in 10 years, and 1.2 million, net, if she lives until age 80)

Cost of insurance

low, paid with after-tax money

comparable to T100 policies, but paid with before-tax money

How long the planned income can be gained from it

until age 90

until age 100, but even than the money is not used up

Tax status of retirement income

to be taxed

tax-free, since it is a loan that is not considered as income

Briefly, Option 2 is clearly more advantageous for either Olga or her family.

Didn't we cheat with our assumptions somewhere on the way? Not at all. (Or if we did, we did it so that the comparative advantages of Option 1 be enhanced; we disregarded for example that Olga is not as free in dealing with her money in an RRSP as she is with it within the UL policy.) Obviously, the returns in the investment attached to the UL policy are not guaranteed; just like they are not guaranteed for any other kind of investment where we can assume decent returns. For the comparison, the important thing is to use the same growth assumptions for investments both within and outside of the insurance. In this case, we used worse assumptions for the universal life scenario than for the other. If one is risk averse and wants to use lower returns, it can be done, since the choice within UL policy-linked investment options is wide, and includes lower-risk-but-probably-lower-return options as well.

Actually, we have not emphasized one more advantage of Option 2. Since Olga has a disability plan, and wants to keep it irrespective of whether her kids are around or not, it would be a very good idea to switch to a UL plan where the disability insurance protection is bought as a rider to the basic policy. This way the disability protection also could be paid with tax-free money.

What made Option 2 such a clear winner? Apart from the enhanced protection (that in this case is not the main issue for Olga, but still probably not meaningless) it is the tax-advantages this option offers:
(i) wealth can accumulate with tax-deferment, just like in some registered saving plan, even if the policy itself is not registered
(ii) paying for protection is with tax-free money,
(iii) living on tax-free loan in retirement and using the cash value of the policy as collateral is possible,
(iv) the unused part of the accumulated wealth is paid out tax-free as a death benefit, unlike it would be the case with moneys kept even within an RRSP.

The advantage of UL would be even greater for someone who is in the lookout for a tax-shelter, because /s/he would have more money to save than the size of the available RRSP room.

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