Fabien Major is a financial planner and host of the popular personal finance podcast The plan. He has been a wealth management advisor since 1998.
A little shiver of horror runs through my column when I hear about young people under 40 who shell out hundreds of dollars a month for permanent life insurance…despite unused contributions to RRSPs, RESPs and TFSAs.
Why bet so much on his death while neglecting savings during his lifetime? Inevitably, I am told that it is an investment. Certain life insurance products are indeed an interesting diversification option for the wealthy. When RRSPs, TFSAs and RESPs are full to the brim and budget surpluses remain, using wealth planning strategies with an insurance policy can be worthwhile. Some permanent life insurance products include a savings component, in addition to the payment of a sum to the beneficiaries upon death. I’m talking about two of these products here: whole life insurance and participating life insurance. They each have their particularities, but both allow you to accumulate capital.
It is this savings component, called surrender value, that your advisor cousin may have been bragging to you: the money deposited there grows tax-free, and the heirs do not have to pay any nor when the death benefit is paid. Your cousin may have been mostly arguing about cashing out the savings portion while you’re alive. You can indeed use this part of the insurance policy to obtain an annuity on retirement or take out a large sum all at once.
It’s all lovely on paper, but nothing can match the immediate tax deductions of RRSPs, the tax-free accumulation of TFSAs and the grants and incentives of RESPs (governments pay into these amounts equal to 30% of our contributions). Obviously, the cousin’s calculator is missing buttons. If he claims that life insurance replaces savings products and plans, be suspicious. And ask questions.
First and foremost, ask yourself why you want life insurance. Most of the time, it is to pay debts or future expenses, so as not to leave your loved ones in need. It could be the mortgage, the credit card balances, even the slate from the revenue agencies or the higher education of your children and grandchildren. Generally, term life insurance does the job just fine. It provides protection for a limited period, such as 10 or 20 years, while children grow up, while whole or participating life insurance provides protection for life. The financial security advisor has the obligation to properly assess these needs and especially to align them with the budget of the living. The premium for a permanent insurance product is indeed more expensive than that for term insurance.
Recently, I met Théo, a 35-year-old man whose true identity I’m going to conceal. He has a $373,000 whole life insurance policy that costs him $500 a month, or $6,000 a year. It is an insurance product that he can keep all his life and which will provide his heirs, upon his death, with a tidy sum.
The savings component can inflate the capital at death or provide him with an annuity at retirement. Or even be used to create a reserve account which will make the payment of the premiums in its place; after having accumulated capital for 15 years, for example, Theo could thus stop dipping into his pockets to pay his policy. Obviously, for this, the hoard, the famous “redemption value”, must be very large.
Insure or invest?
On paper, at age 60, Theo should have at least $132,753 in cash value built into his $373,000 protection if he dies. This surrender value is guaranteed: he could then terminate the policy and recover this sum. Is this a good deal?
To find out, we calculate the total paid in premiums for term insurance for 25 years, as well as the values generated by a more traditional investment such as an exchange-traded fund (ETF) or a mutual fund. This comparison can be made easily. By requesting a quote on a brokerage platform that brings together hundreds of Canadian insurers, I found death protection of $373,000, “term 25 years”, for a non-smoking man, at a monthly cost of $37. .
Theo is currently paying $500 a month for his insurance contract; suppose he invests the difference, or $463, in an investment product consisting of international equities. For comparison purposes, I take the TFSA. As with the insurance policy, there will be an increase in tax-free savings.
To make my product choice, I used Morningstar’s database. I was able to find hundreds of mutual funds there that were at least 25 years old. It was also easy to spot dozens of funds with an annual historical average return of more than 8% (similar to major stock indices). This performance is not a guarantee of the future, but it can serve as an indication.
After 25 years of monthly deposits of $463, the growth in principal and compound interest equals a total value of $423,570. Quite a difference compared to his 132,753 dollars in cash value guaranteed at age 60 by his insurance contract. Even a 4% return yields a higher sum of $236,368.
It must be said that permanent insurance is very expensive, since it protects for life, without an increase in the premium. Of the 500 dollars disbursed monthly by Theo, more than 37 dollars are used to pay for the insurance. The insurer therefore pays less than 463 dollars in savings vehicles, which limits the increase.
In addition, during these years when cash value is accumulated, cash outflows are penalized in many contracts. Money placed in a TFSA can be withdrawn at any time.
So in Theo’s case, the option of taking out term insurance and investing the difference would be much more advantageous. For whole life insurance to be more interesting, Theo would have to die prematurely, before the age of 50.
Several uses of whole life insurance and participating life insurance strike me as questionable, including these:
- Use this vehicle to replace RRSPs, TFSAs and RESPs;
- devote more than 25% of available savings to it;
- Take out insurance while you are young to “protect your insurability” and the rate;
- Make it your primary retirement planning strategy.
On the other hand, getting a whole life or participating insurance can be wise if you know that you will need insurance for your whole life and that you can afford it. If, for example, you hold significant real estate assets, it may be interesting to have insurance that will allow the heirs to have cash at the time of death, without having to sell buildings in a hurry.
But to be sure, always ask for a comparative valuation that presents the final value if you had taken out a term insurance policy (much less expensive) and had invested the difference in the premium in traditional investments free of constraints at the redemption.
Life being what it is, that is to say changing and accompanied by hardships, many policyholders are forced to dip into the surrender value of their policy during a reversal of fortune… canceling at the same time all the beautiful promises. It is therefore wise to limit your “investments” in insurance policies. Paying 5% to 10% of its assets seems reasonable to me.