In Part One of this series, I outlined some of the considerable tax benefits related to owning permanent life insurance. This part shall deal with how to reduce risk if you do proceed, while the third article shall talk about some of the newer investment options that may help achieve this goal. For today, however, I’ll focus on other ways outside of the new investment choices, to help reduce risk.
Despite the benefits, as someone trained to see the dark cloud inside every silver lining (i.e “law school”), I see the potential minefields and quicksand that can go along with every situation, including owning permanent life insurance. Moreover, I have seen first-hand from clients inherited from other advisors some of the cautionary tales that can send chills into the spine of every financial planner who is not a sociopath. Accordingly, I want to pass along some tips to hopefully prevent you from being another chapter in the sad canon of insurance sales gone wrong, while also helping you keep your existing or future policies operating on all 8 cylinders. As I said in my last offering, permanent life insurance is like an investment portfolio – it needs to be managed on an ongoing basis in order to optimize performance.
Square Pegs and Round Holes
This article isn’t going to rehash any of my previous musing on the merits of permanent or term life insurance, although I like to think I provided a rousing introduction to the issue in Part One of the series — space is limited and, as typically seems to be the case, I have a lot to say. Instead, I propose to jot down a quick checklist of things to consider before saying “yes” to permanent insurance. Although I am a big fan of permanent insurance when the right policy is combined with the right client, the wrong product with the wrong client is a recipe for disaster.
- Is it the right tool for the job? Although life insurance can do a lot of things well, the real question is whether it is the best tool for your main purpose? For example, although life insurance can be a great tax deferral vehicle, so can TFSAs and RRSPs, which also provide you with far more investment options and flexibility. Even if those are topped up, if investment for your own retirement is the key goal, I also suggest looking around at other options to diversify your existing investments when deciding whether or not to buy permanent insurance.
- Too much of a good thing? Even if permanent life insurance makes sense for you, particularly inside a corporation, make sure that you’ve not purchased too much of a good thing. Although a slice of cake may be delightful and a second helping a tasty treat, that third or fourth serving is seldom a good idea. Just like the rest of your investment portfolio is properly balanced, be careful about overconcentrating too much into permanent life insurance. Although permanent insurance can be used as a very tax-effective retirement tool, particularly if used as collateral for loans to finance your retirement, I do not want my clients’ entire retirement contingent upon bank or insurance company lending practices and current CRA tax policy. In a perfect world, I still prefer using insurance primarily for its traditional purposes such as estate maximization, providing cash to pay final taxes, preserving legacy assets or ensuring that your estate is large enough to take care of everyone left behind. Although potentially using permanent insurance to fund your own retirement is an enticing option, I don’t want it to be the cornerstone strategy for paying for your beach vacations. Even when used for traditional purposes, I also like to see a comfortable margin for safety should my clients need more money for retirement than expected or their investments underperform.
- When do you need the money? Most permanent insurance strategies can take a decade or decades to work the best after you buy the policy. They also often require many years of funding along the way as well. Accordingly, you will need to have other assets to fund your needs along the way and you also need to be relatively certain that you will be able to continue making your targeted premium payments over the long term, with some room to spare. Cashing in your policy can be very expensive from a tax perspective and many insurers have significant cancellation fees if you cut bait particularly over the first 10 years. Furthermore, like a car, you need to properly fuel your insurance policy in order for it to take you to your destination, with a little extra in the tank just in case. Accordingly, if you can’t make the planned contributions, you’re likely to run out of gas along the way and you may feel like you’ve been stranded at the side of a road without a cell phone.
What to do if Permanent Life Insurance Does Make Sense
Assuming that you’re read through the previous section and are satisfied that permanent insurance is the thing for you, the next step is ensuring that product you’ve selected fits like a bespoke suit rather than something you picked up off the rack. At the risk of wildly mixing metaphors, this part of the process is also sort of like the early stages of a relationship – it’s important to set realistic expectations in order for things to work out over the long term. Here are some ways to achieve these goals:
- Canvass the Market. There are a lot of different insurance products out there, with many different combinations of bells and whistles. I like working with an advisor who can shop around to find the insurance product that best suits my clients’ individual needs. While one company may sell a product that is ideal for some, it might be a little too tight around the chest or have the wrong sleeve length for someone else.
- Work with Someone You Trust. Although shopping the market is always a good idea, I also firmly believe it is vital to work with someone you think knows what they’re doing and has your best interests at heart. Accordingly, if you have someone you think is the bee’s knees, I don’t necessarily seeing it as a deal-breaker if they can’t sell you every policy under the sun so long as their product is competitive after you’ve looked around and you’re convinced that they will be in it with you for the long term. At the end of the day, you need someone who can continue to help you manage your policy in order to make it hum and sing on an ongoing basis. Although price and product both matter a lot, so does working with the right person.
- Use Conservative Projections. I love the fact that most insurers now run policy illustrations (projected results compared to alternative investment strategies) showing results at 3 or more different rates of return inside your policies. For Universal Life (“UL”) policies, I generally prefer to see illustrations showing a 5% rate of return, with alternative illustrations at perhaps 3% and 7%. Although you may hope and expect bigger and better things from your policy, I am not comfortable with my clients proceeding unless the results look good with less-than-stellar returns in the policy and the alternative investment is assumed to outperform the policy by at least 1% before taking income tax into account. For Participating Whole Life (“Par”) policies, I want to see how things look if the current dividend scale (essentially the yield on the cash value of the policy to oversimplify things) is at least 1 to 2% less than its current rate, as I think there is a good chance rates could drop unless interest rates eventually pick up significantly. Ultimately, not only does the future performance of the policy dictate how big a payout and cash value there will be down the road; it may also influence how much money you need to put into the policy along the way. I never want my clients to be in the position of having to pay into a policy for 15 years rather than 10 because of unrealistically lofty expectations or, even worse, have to cancel or reduce their insurance at that point because it has become unaffordable. While this can’t be guaranteed, setting the investment return bar low at the beginning dramatically reduces the chance of unfortunate outcomes later.
- At Least Consider Level Term Policies, Have a Conversion Plan or Invest More Conservatively. One of the reasons for the subprime mortgage debacle south of the border last decade were the “teaser” rates for the initial period of the mortgages. Although it saved money in the short term and allowed clients who couldn’t afford a home to purchase a place to call their own, it meant disaster when the other shoe dropped and clients had to start paying based on higher rates or even come up with lump sum cash “balloon” payments. In the permanent insurance world, UL have something that is slightly similar. Many policies allow client to base their annual required premium payments on either the cost of what it would take to buy a one year term policy each year so that each year’s premium costs more than the one before or having a set annual premium cost etched in stone for the life of the policy.
The former (“Yearly Renewable Term” or “YRT”) means very cheap rates initially that start to increase dramatically as clients age and their chances of dying that particular year go up, while fixed amount or “Level Term” policies mean essentially prepaying some of the future costs now which means bigger cheques initially, but having cost certainty for life. YRTs let more of the money you put into the policy in the early years grow in that policy’s investment fund and, if the markets are kind, this extra compounded growth is more than enough to help pay the higher insurance costs later as you age. The problems come if clients do not fund their policies as planned, investment returns are lower than expected, you have a couple bad years in a row, or the clients live to a very ripe old age. In these scenarios, the client may have to come up with extra money to pay into the policy at a time in life when it is no longer affordable, which can mean letting the policy lapse, borrowing to fund it or reducing the amount of coverage.
Thus, although YRT policies can do well if the markets cooperate, they can mean more risk later. To combat this risk, at least get quotes on how a Level Term policy performs as a comparison, plan to convert from a YRT to a Level Term a set age, knowing the pricing in advance, or reduce investment risk inside the policy. In particular, since the need to put extra money into the policy will depend on the cash value of the investment fund, shooting for lower, less volatile and less risky returns inside your policy vastly reduces the chances of having to put more money into your policy during retirement if the markets have several bad years in a row. Since most insurance funding strategies involve only paying into the policies for a limited number of years and then using the extra money contributed during this time, plus investment growth, to pay for the years ahead, this means having to sell some of your UL policy investments every year based on current stock market conditions. Thus, a few years of having to sell some of these investments at the worst possible time can crater a policy. As a result, unless you have ample additional funds to top up your policy, a large margin of safety or are invested in a specially designed policy that has or will reduce insurance fees to a pittance, I suggest looking at lower risk investments, particularly those that pay at least some income that can be used to cover premiums. Furthermore, be sure to regularly review and rebalance your investments inside your policy, just like you would for the rest of your investment portfolio.
- Be Clear on When Contributions Stop. Some permanent policies stop asking for premiums at age 100 while others make you keep paying for life. Why take the risk of having to continue paying until you are 115 if medical advances continue to mount if you can get a comparable policy where you’re done at age 100 come hell or highwater? It can be very stressful to clients in their 90’s and their families if funds are tight to realize that a policy could lapse if the client lives to a century. Knowing that the policy will be “paid up” at that time lets everyone breath a bit easier, allows people to plan so that can ensure the policy survives those few more years and, even better, lets them know that the fund may start to grow again from age 100 onward. If insurance premiums become a thing of the past at that time, the size of the investment fund now may be able to take off again since you now have the money you would otherwise need to pay in premiums each year staying in the fund and compounding.
- Make Sure the Right Person or Entity Owns the Policy. Chess and financial planning are both about how you move and organize your pieces. Permanent insurance is the same. To get the best results, you need to make sure that the policy is owned where it can do the most good. Furthermore, it can often be quite expensive if you need to switch it up later, so it’s vital to get it right the first time. Although I love owning insurance corporately for the tax advantages, this can be a disaster if you are planning to sell the company later or perhaps close it down during retirement. In both instances, there can be a very large tax bill that could have been completely avoided when trying to remove an insurance policy from a company, particularly if there is a large cash value. In other cases, if creditor protection, privacy or will challenge avoidance are the key issues, it makes sense to own the policy personally. Finally, some people may be better off owning life insurance inside a trust, particularly since the investment fund in the policy is exempt from the 21-year rule that otherwise taxes unrealized capital gains inside the trust at that time. Ultimately, professional advice is essential in this area specific to your own situation and goals.
Regular Repair and Maintenance
For perhaps about the 51st time, I shall repeat that owning life insurance is like owning an investment portfolio – both require regular repair and maintenance. In fact, I see life insurance as one of those fiddly foreign cars that aren’t properly understood by all mechanics with a host of issues not associated with domestic models. Here are the things to keep on top up if you want to keep your permanent insurance policy in peak condition:
- Pay as Promised. As stated earlier, just like you need to keep gas in the tank if your car is going to take you to your destination, you need to make the targeted contributions or adjust your route along the way in order to achieve a less ambitious goal. If you have not properly funded the policy, it is unrealistic to expect that you won’t have problems later. Accordingly, if life changes and you can’t make your expected contributions, you need to work with your advisor to recrunch the numbers to decide on next steps. It could mean cancelling the policy, reducing the amount of insurance coverage so the money already committed won’t run out or switching to a less expensive type of coverage. In some cases, you may also consider donating it to charity, as this can often produce a surprisingly large tax credit for older policies.
- Rebalance and service. It may be the case that you have several types of different investments inside the policy, which can often be a really good idea for larger policies in order to diversify risk. Just like you do for the rest of your portfolio, if you have a UL policy, you will need to look at the underlying investments at least once a year to ensure that you have the right investments for your current time horizon and that they remain in the right proportion, as well as reviewing performance. As a word of caution, however, for some policies, particularly in the early years, there is a minimum amount that has to be on hand to go into each fund at a time. If there isn’t enough money to make the minimum contribution, the money sits in a low interest account until you have reached critical mass. Thus, rather than initially contributing to 5 different funds inside your UL policy, you may need to narrow down your choices so your money actually gets invested promptly or plan to regularly switch how each fresh contribution is allocated so you still get diversity but not at the expense of having too much money sitting on the sidelines. If nothing else, it’s good to be clear how things work for your policy.
- Do the 100-point inspection. Most people know that retirement projections are just educated guesses based on a host of variables and assumptions rather than fact. Insurance illustrations are the same way. Your investments may underperform in your UL or exceed expectations. Your Par policy may decrease its dividend payments, stay the course or, hopefully, one day, increase them again. Accordingly, it is important to recrunch the numbers at least every few years in order to see if you are on target and, if not, to discuss changes. For cars, it is a lot easier to take action when there is just a rattle under the hood than when the engine seizes. For insurance, it is a lot easier and less expensive to fix your policy by putting in some extra money or reducing coverage many years before the policy actually runs out of money rather than trying to come up with a solution when that time is already nigh at hand. At the same time, review who you have selected as beneficiaries, as well as your investment mix and related issues as outlined in the previous bullet. This is also a time to review the total amount of coverage you require and to see if it needs to be topped up or if you can either reduce some of your permanent policy or perhaps cancel term coverage that you have carried until now. Finally, if you have YRT premiums, keep up-to-date on how your premiums are scheduled to increase and discuss whether it makes sense to switch to Level Term coverage at that time instead.
Despite my natural focus as a finder of dark clouds and my many words of warning in this article, I still see permanent insurance as a wonderful solution for financial problems, but just not for every problem. As most people selling insurance spend more time talking about what can go right, however, I just wanted to provide a counterbalance so you can get the right policy in the right amount for your situation and, just importantly, know what steps to take after policy issuance to keep things on track once you are the proud owner of a policy to call your own.
Although I fervently desired to have enough space to also discuss some of the newer investment issues inside UL policies today that can reduce risk, that will have to wait for another day.