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. This is the case of permanent life insurance products, also called whole life insurance, which, in addition to the payment of a sum to the beneficiaries upon death, include a savings component.
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.
This all sounds 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 them 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 life or permanent 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.
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 pay 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 amount. 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.