You don’t think about insurance until you need it. When you decide it’s time to protect loved ones you face another problem: what to choose from among the gluttony of options? So you get a call amidst your decision from someone hawking universal life insurance. Should you buy in? All prudent financial advisers unanimously say no. Here’s why.
Let’s begin by looking at why someone would need life insurance: it is income replacement for someone who has financial responsibilities. What are financial responsibilities? They are debts and dependents. Debts include mortgages, credit cards, car payments; dependents are anyone who would need your income to pay bills and maintain quality of life.
Life insurance is an altruistic move on the buyer’s part thinking of those who would be left behind.
Of course you only need to be old before getting life insurance right? Would a single 20 something person need life insurance?
The answer is ‘depends‘. If someone has no assets, no bills, and no family then maybe no. However, if you had assets or debts, a family medical history, future included plans for marriage, house and or family (or other dependents), then the answer is YES.
Would a 50, 60, or 70 year old need life insurance? Hopefully not because their period of financial responsibility would be gone, and if they had planned their finances prudently they would have built up their estate to the point of financial independence or self insurance.
Avoid Universal Life Insurance At All Costs
Universal life insurance (universal life) consists of life insurance and an investment account which can also be called the side or linked account.
(At this point it must be mentioned that many independent financial experts recommend that insurance and investments be kept separate.)
Universal life allows for flexible premium payments as long as the minimum premium is paid to keep the policy in force. Whereas premiums in a typical term policy are about a third of a percent (1/3 of 1% = .33%) of the death benefit, in universal life they are 1% or more. Over many decades that can be costly.
Universal Life Forces Higher Premiums
Why so high? The premium is used for the expenses incurred by the insurance company. These expenses are: premium tax, administration fees (including commissions), and the mortality expense (cost of insurance). There are also management expenses on the investment account. The policy owner has no control over these expenses. Some but never all of the cost of these expenses are guaranteed by the company. Some but usually not all are outlined in the policy where they can be easily identified by the potential buyer.
The universal life investment account could range from aggressive to conservative investments, such as segregated funds or index funds. Remember, unlike mutual funds you DO NOT own a segregated fund. The investment account is subject to market fluctuations. Policy owners have discovered in the past that a negative return means they have to increase their payments to keep the policy in force. How many universal life owners had to put out extra money in 2008′s bear market?
In Universal Life you DO NOT own the funds.
In Universal Life increase payments based on negative returns on the investment side.
The management expenses are always higher that a non-registered identical investment outside a universal life policy. This is odd because there are no extra management requirements, or active management in either index segregated funds. They are all clones of other investments. As one observer put it they charge custom prices for an off the shelf product. Would you pay prime rib prices for a single patty fast food hamburger?
In Universal Life management expenses are higher despite no management requirements.
Access to Universal Life Insurance Investment Account Extremely Limited
Policy owners will build up their investment accounts over a period of time. However, did you know that in the first 10-15 years of a universal life policy if they wish to access their own money in that account they must pay a fee called the surrender charge. These fees can be up to or exceed the value of the account. For example: After 5 years an investment account is $8409. The surrender charge is $9450. Another example: After one year the investment account is worth $5244. The surrender charge is $12, 500. We all know life has speed bumps and hurdles along the way. These could include relationship breakdown, layoff, or sickness. How many of you know anyone who over a period of a decade and a half has not had an adverse financial event? How would it feel lose your money and on top of that pay up to double?
Withdrawing money early means paying a surrender charge up to the value of the investment.
But don’t you get a great return in the end? Most universal life illustrations base their future projections over many years, perhaps decades. They try to reel in the potential buyer by showing how a fully funded policy would look in 20-40 years. But as mentioned already life does not unfold that neatly. Maximum monthly premiums are in the thousands of dollars. How many owners can maintain that payment over decades? The majority of universal life owners pay only the minimum premium. Even the insurance company will admit as much:
Interest rates are for illustration purposes only, they do nor represent a guarantee of future performance. Actual results will likely differ from those illustrated. Current practice assumes that premiums are paid in full on the due date, that the allocation of premium among the accounts remains the same, that interest rates remain the same, that term investments are reinvested for the same term, and that cost of insurance rates for any increase in sum insured are the same rates as those used at issue. However, in reality all of these elements may vary.
UL must maintain a certain insurance investment ratio to keep the side account tax exempt. According to the Income Tax Act the Maximum Tax Actuarial Reserve line states that above a certain rate of return those gains will become taxable. In reality most times that rate of return will not be achieved because of the high management fees, and the client is usually advised to pick a conservative investment. The companies have invented a way around that rule but in reality few owners could afford to fund that. But the crucial question is: why buy an inferior investment that is very costly and that you cannot control? Why pay ocean front prices for a one room shack on a busy highway?
UL policies combine high fees and conservative investments leaving investor with nothing.
The only way that no taxes will be paid on the policy gains is if the policy pays out at death. Anytime before there will be a policy gains tax. And remember the death benefit from term life insurance is tax free as well.
Another selling feature is the policy loan. Again there are many restrictions on that, the main one being that the bank only considers the investment account value. Thinking back to the bear market of 2008 one must wonder how many loans are being issued these days, It seems strange to pay fees and interest to borrow your own money and to be made to feel that is a privilege.
Policy loans are only based on investment side
Alternatives to Universal Life Insurance & Investments?
The high-school drop outs who sell universal life insurance will cry foul over RRSPs and the recent TFSA instruments. Fact is, educated financial advisers and market executives would never recommend UL for fear of being ridiculed by their peers.
To put into perspective, the advent of the Tax Free Savings Account (TFSA) should render universal life obsolete because its supposed tax benefits have been replaced by an investment vehicle with less restrictions and cost.
TFSAs Should Render UL Obsolete
Universal life may be good for someone that meets ALL off the following criteria:
- The potential buyer, and spouse if applicable, have maximized their RRSPs.(even universal life marketing literature states that)
- The potential buyer has cash that is not needed for any other purpose for the LONG term.
- He or she understands the risks of leveraging.
- He and or she will have a need for higher income in retirement that can be provided through regular means.
- A genuine need for life insurance has been established.
- At least one insurance council has noted that in reality universal life insurance is being sold to many
- Canadians who meet NONE of those criteria and can only make the minimum premium payments.
Nevertheless if a person is insistent on buying universal life insurance despite the above caveats here are some questions you should ask first. Understand it is a game that the agent would rather you didn’t play and you might want to get the answers checked by a third party.
Another way life insurance sale people (they push hard because of high commission; products easily sold by high school dropouts) try to sell life insurance is to point out all the taxes upon death. Probate fees and taxes on the estate of a deceased person? Probate fees apply only to the part of the estate that has no named beneficiary. If the estate is being passed on to a surviving spouse there will be no tax owed. In any event, life insurance premiums on the type of products that claim to offset these costs cost many times more than either probate fees or taxes in most instances.
In part two we post some important questions to ask if you insist on choosing UL, and also some practical examples of UL vs. TFSA investments.