June 22, 2008

The Two Drawbacks Of Investing In Life Insurance

Tax-sheltered growth in life insurance is great unless you're forced to compromise with
  1. limited investment choices
  2. relatively high Management Expense Ratios (MERs)
These two criticisms have been levied against life insurance. There's a feeling that it's better to Buy Term and Invest the Difference. Insurance investment choices have evolved to better suit the needs of active investors. Here's a history lesson.

Passive Investors
Whole life insurance gave no choice of investments. The insurer made the investment decisions and you got whatever returns resulted. Rather than blindly trusting the insurer, most Canadians wanted more control.

In response, Universal life (UL) insurance was developed and gave let you choose fixed interest investments. Since the highest tax rates are on interest, these investment are ideal for tax-sheltered growth. But this is a small subset of the investment universe. And unappealing to active investors.

Active Investors
Universal life insurance evolved to add indexes as choices for a "buy and hold" portfolio. A handful of mutual funds may also be available. However, you can't invest in vehicles like real estate, your own business or Exchange-Traded Funds (ETFs). Also, the MERs are generally higher inside UL because of Investment Income Tax (IIT), a hidden tax which adds about 0.5% (50 bps) to the Management Expense Ratio.

What good is investing in UL when the investment choices are limited and the MERs are relatively high? Buying term and investing the difference outside seems appealing. There is a solution.

Investing Outside
You can use a cash-rich UL policy as collateral for investment loans. Besides getting tax-sheltered growth inside the policy, you can get three advantages by leveraging:
  • unlimited investment choice: you invest the way you normally invest
  • tax deductible loan interest
  • tax savings on a portion of the premium when the lender requires insurance to secure the loan
Next time we'll look at "10-8" financial leveraging, a recent innovation which gives you the advantages of normal investing while using life insurance to reduce the risks of leveraging.


1 comment:

Anonymous said...

There are several different drawback to life insurance, though I'd like to believe they are all worth it: if you choose carefully, the positives should far offset the cost. Since I've begun dealing long term care insurance in Canada, I've kept on trying to find ways to give people the best benefit they can receive. Hopefully, receive it they won't need to :)
Keep writing,

P. S. Good insight. Like the diagram.