More Universal Life Thoughts

By | February 28, 2009

I’ve previously commented on Universal Life Insurance but wanted to expand on that a bit.

Universal life insurance in Canada belongs to the permanent insurance category. Typically you would consider universal life if you’re looking at life insurance needs for the rest of your life – forever. i.e. you know today you want the insurance when you’re 60,70,90 or 300 years old.

A universal life insurance policy consists of two aspects or features. The first one is the insurance cost. The second part is the investment component. Within these two components we have a myriad of options.

Lets look at the insurance portion to start. Note that we can treat the policy as just the insurance portion and completely ignore the investment part. And it’s a good idea to do that as the basis for your investigation. Let’s say you purchase $100,000 of Universal Life (UL). We’re going to be keeping the insurance in force for a good long time, so we need to know what the insurance premiums will look like over the duration of the policy.

There are two basic premium structures available; level and YRT. Level insurance costs means the premiums are set to never change – they’re level for life. No surprises now, or later in life when it comes to the underlying insurance costs. As an aside, we only ever recommend UL with level insurance costs.

YRT premiums, or Yearly Renewable Term, has premiums that go up every year. The premiums are based on your age, so they start out cheap when you’re younger but increase over time.

There are other options available with some companies where they mix these two (YRT for 20 years, then going to straight level) but that’s they all tend to be mixes of YRT and level.

Now lets look at the investment part. The way this works is any money put into the policy above and beyond the basic insurance and administration costs go into the investment part (or you can just pay the base insurance and admin costs and leave the investment part at $0). Let’s say your basic insurance premiums are $50 per month. If you pay $50, you have your life insurance and your investment sits at $0. If you pay $100 a month, the first $50 pays your insurance and the remaining $50 is put into the investment ‘bank account’ where it hopefully grows and earns interest.

What type of investment options are available? Well, these investment options look a lot like mutual funds. They’re not mutual funds but viewing them as such does give us a pretty good snapshot of what they do. And just like mutual funds, the world’s your oyster when it comes to investment options. All the insurance companies have their own myriad of investment options and some of them actually track well known mutual funds. Manulife for example has something in the range of 25 to 50 different investment options. Wawanesa conversely has a handful, most of them the standard index funds (if you’re an index fund kind of investor…and if you’re not you probably should be).

But! just lke mutual funds, these investments are typically not guaranteed. This ability for investments inside a UL policy to crash and burn just like the stock market or your mutual funds is the biggest risk I see. Be aware when reviewing a universal life insurance presentation that if it depends on some investment option, that quite likely that investment option is not guaranteed. If your investments track mutual fund A, and mutual fund A just crashed by 40%……then the investments inside your UL policy just dumped by 40% as well.

Another thing to consider is that some UL policies will offer some guaranteed investment. Something like a GIC type of rate would be common, maybe at 2 or 3%. But you only get those guaranteed rates of return if you actually invest in those GIC types of vehicles. If you invest in the equity based investments, you’ll not have those guarantees so if your illustration shows equity based investments with GIC type of rates, be careful.

The next thing to carefully consider when looking at investments inside a UL policy would be surrender charges. Some investment options require that your money stay inside the policy for a minimum amount of time. Withdrawing money back out from the policy prior to that time results in very heavy charges. I see no need to invest in a product like this when there are plenty of products available that don’t have these fees.

So what’s the benefit of the investment inside a UL policy? Very simply, money invested inside the policy grows on a tax sheltered basis. Just like an RRSP, if you earn $100 inside the policy you don’t have to pay taxes on it as long as the money stays in the policy. Unlike an RRSP, you don’t get a tax break on deposits (which means that RRSP’s are your first line of investment strategy whenever possible).

I’m going to write about some advantages in my next article, but for now, lets look at some pitfalls with universal life. (Note that I believe Universal Life is a great product. But you need to know what you’re getting and what the risks are). Lets say you want to build up a bunch of cash inside the policy for some reason later.

How to do that? Well, we want to shovel as much money into the investment portion as we can, as early as we can. Since we always have to pay at least the base insurance premiums we may decide to minimize those insurance premiums by going with YRT insurance costs. This gives us more money (since YRT premiums are initially lower than the level insurance premiums) to start putting into the investment portion. That early start we assume allows that investment to grow higher, faster. And if things go well, that’s exactly what will happen.

But things can go not so well. Let’s say you go with this strategy, but your investments later crash and burn (remember, the investment portion isn’t normally guaranteed). Now you’ve got poor investments and worse, you’ve got those high YRT premiums to pay since they get expensive later.

Consumers can and have ended up in similiar situations. Because we’re dealing with long durations, sometimes spanning decades, we may not realize the problems until many many years in the future. So it’s vital that you address all of this upfront when you purchase the policy. If you didn’t, now’s the time to pull out your UL policy and have another look at what you’ve got.

2 thoughts on “More Universal Life Thoughts

  1. Mike

    Why bother with the investment “side” of a UL policy now that we have TFSA’s ? ( Especially since TFSA’s have lower admin costs and broader investment options )

  2. Glenn Post author

    I disagree that TFSA’s have lower admin costs and broader investment options. Some do, some don’t. There’s just too many choices available to suggest something that broad.

    However – you are correct that RRSP’s are a better investment choice, and TFSA’s are probably reasonably similiar to investing in a UL. Where you’d see the biggest difference between UL and TFSA’s is if you went to take money out. TFSA’s, the money comes out untaxed. If you went to take money out of a UL there are potential tax implications. And by tax implications, I mean you may get dinged with a tax bill :). It’s that potential taxation when you remove money that in my mind would cause UL to be secondary to a TFSA as an investment.

    RRSP’s first, until they’re maxed. Then TFSA’s until they’re maxed. Then perhaps a UL for investment. But how many folks have maxed out both RRSP’s and TFSA’s? Few. So I rarely suggest investing in a UL policy. I like the idea of having it available, but unless you’re maxed out everywhere else already UL as an investment, well, you can beat it.

    In fact, the generally accepted use of the investment part of a UL is to generate pretax dollars to pay your premiums (you can use the earnings inside your UL to pay your premium, pretax). But with the TFSA now in play you’re probably going to have more flexibility in using that to fund UL premiums using tax free earnings rather than the investments inside a UL.

    I should note that the explanation of UL in the post above wasn’t an endorsment, it’s an explanation. Even when I recommend UL as a policy, I rarely recommend using the investment part. Quite simply, most people when asked if they have maxed out their RRSP’s, haven’t. That doesn’t mean don’t by a UL for life insurance coverage, it means don’t use it as an investment until you’ve got the RRSP’s topped up.

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