Fabien Major is a financial planner and host of the popular personal finance podcast The plan. He has been an asset management consultant since 1998.
A small shudder of horror runs through my column when I hear of young people under 40 who are paying 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 to save during his lifetime? Inevitably, I’m told it’s an investment. Certain life insurance products are actually an interesting diversification option for the wealthy. When RRSPs, TFSAs, and RESPs are full to the brim and there is still budget surplus, using wealth planning strategies with insurance can be worthwhile. Some permanent life insurance products include a savings component in addition to the payment of an amount to the beneficiaries on death. I’m talking about two of those products here: whole life insurance and participating life insurance. They each have their own quirks, but both allow you to accumulate capital.
It’s this savings component, called surrender value, that your advisor cousin may have bragged to you: The money deposited there grows tax-free, and heirs don’t have to pay anything, even when the death benefit is paid. Your cousin may have argued the most about paying out the savings portion while you’re alive. You can use this part of the insurance to obtain an annuity upon retirement or take out a large sum at once.
It’s all great on paper, but nothing can match the immediate tax credits of RRSPs, the tax-free accumulation of TFSAs, and grants and incentives from RESPs (governments match these amounts equal to 30% of our contributions). Obviously, the cousin’s calculator is missing buttons. If he claims that life insurance is replacing savings products and plans, be suspicious. And ask questions.
First of all, 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 IRS or your children’s and grandchildren’s higher education. In general, life insurance does the job just fine. It provides protection for a limited period of time, such as 10 or 20 years, while children grow up, while whole or participating life insurance provides protection for life. The financial security adviser is obliged to assess these needs correctly and especially to adapt them to the budget of the living. The premium for a permanent insurance product is actually more expensive than for a term insurance.
Recently I met Théo, a 35-year-old man whose true identity I will hide. He has a $373,000 life insurance policy that costs him $500 a month or $6,000 a year. It is an insurance product that he can keep throughout his life and which will give his heirs a handsome sum upon his death.
The savings component can inflate the capital on death or give him an annuity on retirement. Or even be used to create a reserve account which will make the payment of the premiums instead; after having accumulated capital in e.g. 15 years, Theo could thus stop dipping into his pocket to pay his policy. It is clear that the store, the famous “redemption value”, must be very large.
Insure or invest?
On paper, by 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 cancel the policy and get this amount back. Is it a good deal?
To find out, we calculate the total premium paid for term insurance over 25 years, as well as the values generated by a more traditional investment such as an exchange-traded fund (ETF) or mutual fund. This comparison can easily be made. Requesting a quote on a brokerage platform that aggregates hundreds of Canadian insurance companies, I found death protection of $373,000, “term 25 years,” for a non-smoking male, at a monthly cost of $37. .
Theo currently pays $500 a month for his insurance contract; suppose he invests the difference, or $463, in an investment product consisting of international stocks. For comparison, I take the TFSA. As with the insurance, there will be an increase in the tax-free savings.
To make my product selection, 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 annual historical average returns of more than 8% (similar to major stock indexes). 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 amounts to a total value of $423,570. Quite a difference compared to his $132,753 in cash value guaranteed at age 60 by his insurance policy. Even a 4% return yields a higher sum of $236,368.
It must be said that permanent insurance is very expensive as it protects for life without the premium increasing. Of the $500 that Theo pays out monthly, more than $37 is used to pay for the insurance. The insurance company therefore pays less than $463 in economy cars, which limits the increase.
In these years when the cash value accumulates, cash flows are additionally 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 turning 50.
Several uses of whole life insurance and participating life insurance seem questionable to me, including these:
- Use this vehicle to replace RRSPs, TFSAs and RESPs;
- allocate more than 25% of available savings to it;
- Take out insurance while young to “protect your insurability” and the rate;
- Make it your primary retirement planning strategy.
On the other hand, it may be wise to get whole life or participate in insurance if you know that you will need insurance for your entire life and that you can afford it. For example, if you own significant real estate assets, it may be interesting to have insurance that enables the heirs to have cash upon 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 term insurance (much cheaper) and invested the difference in premium in traditional investments with no restrictions on redemption.
Life being what it is, i.e. changing and accompanied by hardships, many policyholders are forced to dip into the surrender value of their policy during a reversal of fortunes…and at the same time cancel all the nice promises. It is therefore wise to limit your “investments” in insurance. Paying 5% to 10% of one’s assets seems reasonable to me.