Tax Planning: The Top Five Insured Strategies

Last time we looked at life insurance sales in Canada. This time we'll dive deeper to see what permanent insured wealth management strategies affluent Canadians use. As you'll see, the main reason is tax planning.

The Top Five

Here are the perennial top five strategies based on research from the Newlink Group, which surveys major national firms selling insurance across Canada, including members of the Investment Dealers Association (IDA) and Mutual Funds Dealers Association (MFDA).

The ranking is by cases sold (highest to lowest):

1. Legacy Bond (31%)
   
2. Insured Retirement Strategy (19%)
   
3. Estate Protection (12%)
   
4. Income Shelter (10%)
   
5. Insured Annuity (10%)
   

Only Estate Protection has a traditional insurance focus --- and that's only 10% of cases. The rest target investment growth, after-tax income and tax reduction. Do these strategies address the six financial fears of Canadians? Not exactly. Those fears were for the general population. The wealthy have different concerns.

Fans of the 80/20 rule may notice that we're close with 82/18. Naturally, the suitability of a strategy depends on various factors such as age, health, investment style, time horizon and tax rates.

#1: Legacy Bond
Situation: You have set aside money to create a financial legacy for your heirs. As a prudent custodian, you require that the capital is preserved. So you invest in conservative, highly taxed investments like GICs. You'd like to maximize your gift by minimizing tax.

Strategy: You use the money to buy the largest possible tax-free death benefit and pay the least for it (e.g., the monthly minimum premium) to minimize the cash flow.

#2: Insured Retirement Strategy
Situation: You are investing to supplement future income (e.g., during retirement). You want to minimize tax on your investment growth and would welcome creditor protection.

Strategy: You transfer liquid invested assets or income into universal life insurance for tax-free growth. You get tax-free income later by assigning the cash rich policy to a bank as collateral for tax-free loans. The loans are repaid with the tax-free death benefit.

#3: Estate Protection
Situation: You want to maximize your estate for your heirs by eliminating or offsetting the effect of taxes on your investments, RRSPs, RRIFs, etc.

Strategy: You buy life insurance for the projected tax liabilities and other expenses due at life expectancy (if you have a spouse, this would be at the time of the second death).

#4: Income Shelter
Situation: You understand the effect of tax on investment growth (see $1 million after taxes) and want your investments to grow tax-free using the original Tax-Free Savings Account.

Strategy: You transfer a portion of your nonregistered assets or income to a universal life contract. Should you want tax-free income later on, you can transform your solution to an Insured Retirement Strategy.

#5: Insured Annuity
Situation: You want the assurance of income guaranteed for the rest of your life but you don't want to erode your capital. So you invest in GICs and spend the after-tax income.

Strategy: You buy a life annuity for guaranteed lifetime income --- only a portion is taxable. You use a portion of the annuity income to buy permanent life insurance to replace the investment in your annuity. This gives you more after-tax income and restores your capital upon death.

Links

• Canadian life insurance sales in 2007
• $1,000,000 After Taxes On Investment Growth
• The Six Financial Fears of Canadians
• The Original And Overlooked Tax-Free Savings Account
• "10-8" Leveraging: Turbocharging the Top 5 Insured Strategies (new)
  

Canadian Life Insurance Sales in 2007

Canadians bought staggering amounts of individual life insurance in 2007

• $1.1 billion of premium (up 5% over 2006)
  
• $180.0 billion of face amount (up 5%)
  
• 652,617 policies (down 3%)
  

These figures from research organization LIMRA exclude group life insurance, generally provided by employers.

The Four Products
There are four main life insurance products, each with different characteristics. Here's a ranking by level of flexibility.

1. Term life for temporary needs (no tax-free investment growth)
   
2. Term to 100 for permanent needs (no tax-free investment growth)
3. Whole life for permanent needs and tax-free investment growth
   
• insurer overcharges but provides a refund (called a dividend) if
• mortality is lower than expected
• expenses are lower than expected, or
  
• investment returns higher than expected (the insurer makes the investment decisions)
  
4. Universal life for permanent needs and tax-free investment growth
   
• the insurer guarantees the mortality rates and expense charges for life
• you select the investments, how much you deposit, how often you invest
  

The Distributors
Life insurance is distributed primarily by

• career agents: restricted to products from one company
  
• independent advisors: select products from multiple companies

Let's dig deeper into independent advisors by looking at

1. what Canadians are buying
   
2. the average policy
   
3. growth trends

What Canadians Are Buying
Here is the market share for 2007 by new premium

1. Universal life: 67% (grew 12% in 2007)
   
2. Term life: 22% (grew 13%)
   
3. Whole life: 8% (dropped 4%)
   
4. Term to 100: 3% (dropped 18%)
   

If you look at the spectrum of choices, you see that 89% of premium goes to low-cost simple solutions (term life) and customized high-end solutions (universal life). There's very little in between.

If we rank by number of cases instead, the distribution is term (49%), universal life (32%), whole life (14%) and Term to 100 (5%). This pattern is probably what you expected.

The Average Policy
The average policy in the growing segment has the following characteristics

• term life: face amount of $388,035 and premium of $869
  
• universal life: face amount of $272,025 and premium of $3,947
  

The declining categories are remarkably similar

• term to 100: face amount of $85,806 and premium of $1,085
• whole life: face amount of $84,496 and premium of $1,033

In real life, you'll see wide swings that the averages mask. If available, I would have used medians (the midpoint when items are ranked from smallest to largest).

Growth Trends
If we look at the last quarter of 2007, we can see the momentum in premium growth:

• term life: +5%
• universal life: +20%

That's enough numbers for now. Let's see how 2008 turns out.

Links and Sources

• Canadian Individual Life Insurance Sales - Technical Supplement (LIMRA, 4th Quarter 2007)
  
• Does Warren Buffett Buy Term and Invest The Difference?
  

The Original and Overlooked Tax-Free Savings Account

The Tax-Free Savings Account will provide Canadians with a powerful incentive to save. This flexible, registered, general purpose account will allow Canadians to watch their savings grow tax-free. It is the first account of its kind in Canadian history. --- Jim Flaherty, Finance Minister

The government is once again using tax incentives to encourage Canadians to save. This time with after-tax dollars in the new Tax-Free Savings Account (TFSA). That's terrific.

What if you want to go beyond the restrictions of another registered plan? Let's dive in and see what the wealthy already do.

The Good News

This [the Tax-Free Savings Account] is the single most important personal savings vehicle since the introduction of Registered Retirement Saving Plans in the 1950s." --- Jim Flaherty, Finance Minister

As you probably know, the TFSA provides

• tax-free growth
  
• tax-free withdrawals
• withdrawals at anytime
• permanent contribution room (can use unused capacity in the future and amounts withdrawn can be re-contributed later)

The Drawbacks
There are drawbacks

• maximum annual contribution of $5,000 (when growth is tax-free you want to invest as much as possible as soon as possible)
  
• no relief for small business owners or incorporated professionals for the onerous tax on passive investment income (reduced on Jan 1, 2008 from 49.8% to 48.7% in Ontario. Lowest in Alberta but still 44.7%.)
• not available until 2009
  

These drawbacks hurt Canadians who have wealth or are on the road to wealth. Fortunately, they can continue to use the original --- often overlooked --- Tax-Free Savings Account, cash value life insurance.

Going Beyond The TFSA
With universal life insurance, you get

• unlimited contribution room (based on the death benefit you choose)
  
• tax-free growth (until withdrawn, but there's an alternative to withdrawals)
• tax-free income (by assigning the cash value to a bank for tax-free loans which the tax-free death benefit repays)
  
• consistent treatment for individuals, small businesses and incorporated professionals
• nonregistered
  

The accountant-approved tax planning I see often has annual investments for 3-5 years of $50,000 to $500,000 --- well beyond the scope of the TFSA.

Links

• source of quotes (Ottawa Citizen)
• Federal Budget 2008: Tax-Free Savings Account (Million Dollar Journey)
• The Ideal Investments for Tax-Free Growth
• The Overlooked Advantages of Universal Life

The Six Financial Fears of Canadians

Sister says, "we're next in line"
The man he says, "that's okay."
And the Government says you're gonna pay, pay, pay
And you pay, still you pay.
--- Simple Minds, Soul Crying Out

What are your financial fears? Here are findings from a 2004 study of Canadians by LIMRA, a research organization established in 1916.

1. Government's ability to fund health care (88% worried)
   
2. Government's ability to continue pension plans (82%)
   
3. Cost and availability of Long-Term Care (77%)
   
4. Having enough income if critically ill (72%)
   
5. Having enough money if disabled (69%)
   
6. Having enough money for retirement (69%)
   

Sadly, there's plenty of overlap with the six basic fears that Napoleon Hill identified before most of us were born:

• poverty (was #1): all 6 but mainly from long-term care (#3), critical illness (#4), disability (#5) and retirement (#6)
  
• ill health (was #3): public health care (#1), long-term care (#3), critical illness (#4), disability (#5)
  
• old age (was #5): government pension plans (#2), long-term care (#3), retirement income (#6)
  

Even more sad are the downward trends. Concern about long-term care worsened by 9% (from 68% to 77%) in just three years. And our population continues to age.

There are tools to help. Insufficient government funding (#1-#2) can be addressed with your vote and personal savings. Insurance is available for long-term care, critical illness and disability. For many, affordability remains a problem due to stagnant family incomes.

Links and Sources

• 2004 TOPIC Tracking Opinions of the Public in Canada (LIMRA, 2005)
• The Six Basic Fears From 70 Years Ago (Napoleon Hill)
• The Four Financial Risks