UNDERSTANDING THE INGREDIENTS OF LIFE INSURANCE (TERM AND PERM)

Michael James wrote a thoughtful post comparing temporary (term) life insurance and permanent life insurance. Like our canine friends above, both are similar, yet different. The best choice depends on different factors. A winner on one scale loses on another. As Michael’s analysis shows, comparisons can be misleading or omit important elements (like inflation).

Typical Plans

A temporary plan like Term 10 is often

• renewable to extend coverage for another 10 years for a higher-but-guaranteed premium
• convertible to permanent insurance without underwriting up to a maximum age

Since a permanent plan lasts for life, there’s no need for renewal or conversion options. Here are typical plans.

Temporary Life Plan	Permanent Life Plans
Term 10 (renewable, convertible)	Term 100
Term 20 (renewable, convertible)	Whole Life
Level term to age 65	Universal Life

We won’t be looking at which form of insurance is better. We’ll be looking at how they’re different.

First Principles

Mortality rates underlie all life insurance. The mortality rate is based on the true probability of someone like you (same gender, age, smoking status and health) dying during the year. Your mortality rate  increases annually because you’ll die eventually (based on current medical science and how we define life).

Your retail premium rate is based on your wholesale mortality rate with margins added for expenses and profits. Your premium is the premium rate multiplied by how much insurance you’re buying. There may be additional loads for premium tax and Investment Income Tax (IIT).

One Year At A Time

When you buy insurance, you are getting one year of protection at a time.

Comparing With Property Insurance

With your car and home insurance, the insurer will usually offer you coverage for another year under similar conditions. Your new premium depends on factors such as their claims (actual vs. projected), expenses (actual vs. projected), investment earnings (actual vs. projected), capital requirements and profit targets.

The insurer could refuse to insure you next year or change the contract provisions (e.g., weaken protection for water damage). You could decide to switch companies.

The Additional Guarantees With Life Insurance

Life insurance also protects you a year at a time but usually

• you have the right to renew your coverage until a maximum age (even if the insurer stops new sales)
• your premium rate scale is fully guaranteed (e.g., you keep your nonsmoker rates if you start smoking or stop exercising in the future)
• your insurer can’t modify the contract unless the change is an improvement

You get this extra protection because you may not be able to switch insurers if your health has deteriorated. You might even become uninsurable.

Yearly Renewable Term

The building block of all life insurance is Yearly Renewable Term (YRT), which is sometimes called Annually Renewable Term (ART).

Do you see the problem?

Your probability of dying during the year increases from 0.01% to 1% to 10% to 80% to 100%. This means your YRT rates will increase every year and become increasingly unaffordable as claims becomes more likely. That’s not good for you or your beneficiaries.

There is a solution: prefunding. Suppose you need insurance for 22 years. You could average the premiums and put that amount into a savings account every year and make withdrawals to pay the YRT premiums.

You could have the insurer invest for you instead. With Term 10 life insurance, you pay a level premium for 10 years at a time. The insurer does the averaging and bears the investment risk. At the extreme, Term 100 life insurance has a level premium for life (and is really permanent insurance and often continues beyond age 100 without further premiums).

Whole life insurance uses YRT rates (which might not be guaranteed). Universal life usually offers two guaranteed scales: YRT and LCOI (Level Cost of Insurance).

Start With The Need

Is your need for insurance temporary or permanent? If you’re addressing the risk of dying while you have financial obligations (e.g., children, a mortgage, a spouse or ex-spouse, other family members), life insurance is the ideal way to create or enhance your estate — if you’re insurable. How else can you get a specified tax-free lump sum at death?

For a temporary need, term life insurance is ideal. You get the most protection for the lowest price.

What If You’re Wrong?

A need which initially looks temporary may last longer than you expect. For instance, a child may have a lifelong disability due to an accident. If you guess wrong, term life insurance gets expensive. You can often renew coverage up to a maximum age without underwriting but the premiums shoot up each time.

Compared with renewing, you may be able to save money by buying a new term plan with new underwriting.

Conversion

Term life insurance often allows you to convert to permanent protection without underwriting up to a maximum age (e.g., 65). You pay the premiums for your age at the time of conversion (your “attained age”).

Example: Suppose you buy Term 10 at age 32. If you convert eight years later, you pay the permanent premium for a 40 year old. This will be more than the permanent insurance premium at 32 and may be more than what a newly underwritten 40 year old would pay for permanent insurance.

Why Permanent Insurance?

You might want permanent life insurance for estate planning. You may not see the need now because you’re not thinking of your legacy. Maybe you will in your 50s or 60s.

The tax-free insurance proceeds can be an inexpensive way to pay taxes at death, leave money for heirs or help a charity. Coverage is available in a cheaper form called Joint Last To Die (JLTD), which insures you and your spouse. The money gets paid when the longest living spouse dies. That’s when the bulk of taxes are due.

Some younger people buy a small amount of permanent insurance for their legacy and a large amount of term insurance for their temporary needs.

An Appreciating Asset

Why does permanent life insurance have a savings component? Further, why do the savings grow on a tax deferred basis? The government doesn’t give valuable advantages without reasons. There are ways you can benefit with planning.

Permanent life insurance grows in value every year because the payout becomes more likely — especially if your health has deteriorated. Your insurance contract could easily have a market value which is much higher than the cash surrender value. An investor may want to buy your contract, pay the future premiums and get the death benefit. That’s called a life settlement. They are legal in the US and several Canadian provinces (but not Ontario).

More

Permanent life insurance gives you the opportunity for tax-deferred savings. Universal life provides the most guarantees, flexibility and transparency. You could

• invest more (limited by the Maximum Tax Actuarial Reserve (MTAR))
• select the investments
• stop paying premiums (e.g., in 20 years or at age 65), though not always guaranteed

Having more options helps with tax planning, especially for incorporated businesses.

Affordability

You can offset the cost of your insurance by reducing your coverage as

• your financial responsibilities drop (e.g., children older, mortgage smaller, spouse’s income)
• your assets grow (e.g., savings, pension)

Before you do, consider inflation which decreases the value of money. Also, your financial obligations could grow (e.g., new children, divorce, health issues).

Conclusion

Temporary life insurance gets compared with permanent life insurance but both cover different needs and timeframes. Since advisors get paid much more for selling permanent insurance, they may have biases they don’t even realize. Explore different scenarios before deciding and re-evaluate your needs over time.

For general questions, ask below. I'll answer what I can here or on Question an Actuary (QanA). For personalized answers, reserve time to Learn About Life.

Links

• Life Insurance: Permanent vs Term (Michael James on Money)
• How Pink Floyd’s insights on mortality help you
• Does Warren Buffett “buy term and invest the difference”?
• The two drawbacks of investing in life insurance
• image courtesy of nafets

PS Remember insurance for disability, critical illnesses and long-term care too.

CHECK YOUR INSURANCE STATEMENTS FOR MISTAKES

My client’s annual statement for universal life insurance showed a tax-free death benefit of the face amount ($2,000,000) plus the investment returns ($317,079). Do the math and what’s the total? I get $2,317,079. The insurer showed $3,317,079 — an extra million dollars. I contacted them and got a quick response. They’re issuing a letter of apology and a corrected statement.

Luckily, my client didn’t have whole life insurance where the lack of transparency makes mistakes almost impossible to spot.

Big insurers have big resources but even leaders in corporate governance make mistakes. That’s because computers are programmed and the limited testing is generally done internally. The systems are expected to be 100% functional when launched. In contrast, Gmail was in beta for from April 2004 to July 2009.

Time bombs

When I developed products, we focused on launching new offerings. We maximized our resources by delaying work which could be completed later. For launch, we needed

• marketing tools: an announcement, PowerPoint presentations for the marketing directors to use with advisors, computer-based tools for advisors to prepare proposals for their clients
• administration support: printing the policy contract (basics like accepting premiums, paying compensation etc were already part of the administration systems and rarely required major modifications)

To speed up times, we minimized printed materials like marketing guides. They looked nice but added costs and created delays. We then had leeway to make “last-minute” changes.

Month-to-month, universal life insurance policies operate much like bank accounts with deposits (premiums, investment returns) and withdrawals (mortality charges, administration charges). The major calculations took place on policy anniversaries. That meant we had almost a year to get ready.

Other capabilities like inforce illustrations (projecting performance after purchase) could be delayed for years. Manual calculations could be done in the interim, if necessary. I once got approval to add two unbudgeted head count. During a hiring freeze. That’s because we could no longer defer some work.

The Human Element

Staff leave. Staff forget. Staff are under pressure to meet deadlines. Miscommunication occurs. Documentation may not be comprehensive enough or clear enough.

Administration systems change. Older products might be on legacy systems. Migrating them to the latest system is much more difficult than upgrading from a version of Windows (see challenges in trying to upgrade to Windows 8 or from 8 to 8.1).

Be Vigilant

Mistakes occur. You might not be sympathetic but you can be vigilant. You don’t need a PhD in mathematics or to be an actuary (though both help). Instead, be a detective. Question what looks odd or what you don’t understand. You’re entitled to ask.

Links

• Reinstatement: trying to get your insurance back
• The perils of whole life insurance
• Insights from Carl Richards and his napkin drawings
• Repairing your computer vs fixing your finances
• image courtesy of PublicDomainPictures

PS Your advisor should be looking for mistakes on your behalf.

CAN AN ADVOCATE SERVE TWO MASTERS?

In a game of strategy, you can’t play on both sides at the same time. If you switch allegiances, who can trust you?

Near the end of 2011, I had an epiphany. I realized that I wasn't putting your interests first as well as I could.

Product Design

When I designed health and life insurance products for a decade, I knew there were compromises that boosted profits.

Example (skip if you don’t like statistics): universal life might have a contingent bonus that rewards you if your investment returns are high. For instance, you might get a 2% bonus if you earn 5% in a year. That looks appealing but research showed the bonus would only pay 60% of the time. That reduced the projected payout to 1.2% (= 2% rate x 60% probability). To cover costs, the investment loads were increased by 1.2% (say from 1.8% to 3.0%).

I was okay with this because other insurers had similar designs and sales were made through independent advisors. Buyer beware looks fair when you have an impartial advisor with the will and skill to help you make sound choices. I didn’t realize that advisors also suffered from the plague of innumeracy (low financial literacy).

One For All

When I spent 5 years helping top advisors sell insurance, I saw a more troublesome issue. Since I was working for an insurance company, I could only promote their offerings. No company in any business can have the best product for every situation. That's because companies make different compromises. For instance, clients at younger ages or buying smaller policies may be charged more to subsidize older clients buying larger policies. Why? There's more competition for the wealthy, which means better prices for them.

Representing a single company creates a conflict between what you’ve got and what's best for the client. I rationalized. I was supporting independent advisors who could deal with different companies. They decided what to offer their clients and I was there to help them. Never mind that compensation or other incentives might influence the recommendations. Since the advisors were really salespeople, they were not required to put your interests ahead of their own (see the insurance loophole).

All For One

Since 2009, I've been saying that I've been serving you directly, bypassing the salespeople. At least that’s what I said. That wasn't 100% correct. In some cases, I was still collaborating with advisors to serve their clients. This is often called “splitting cases” since the revenue gets shared. That looked like a win/win:

• advisors had clients but needed more credibility or expertise
• I had both but, as a startup, needed more clients

This time, I had access to products from different companies, which allowed the better solutions to be presented.

There was a bigger problem.

Oh No

Since the advisors "owned" the clients, I had to meet their interests first. This lead to conflicts since I would not concede. Too often, these advisors wanted to sell products with

• more coverage than necessary
• higher compensation than conscionable, or
• strategies with more sizzle than substance

There was reluctance to provide after-sales service, since revenue came primarily from new sales.

Example: You know mutual funds have high investment expenses. You may not know — but probably guessed — that investments inside life insurance have high investment expenses too. This is normally hidden, but I told you in 2008 (see two drawbacks of investing in life insurance). A salesperson might not feel compelled to inform you but an advocate for you must ...

What if an advisor doesn't provide full disclosure? There's the sin of omission. It's not the same as telling a lie but now the onus is on you to pose questions you might not think to ask. Even if you do, what answer can you expect?

What's worse than fooling a client? Fooling their tax advisor into recommending a strategy. When clients find out what happened — which may take years — the tax advisors get blamed since they were more trusted.

Conundrum

Do you see my conundrum? Serving you with life and health insurance is my calling. It's the only thing I've done in my entire career. This is not my Plan B or Plan C.

How could I serve two masters, the salespeople and you?

I couldn't find a way to overcome the troubling conflict of interest. There's a time to take sides. That's why I've stopped sharing cases with advisors who make their living by selling health or life insurance.

I've terminated every single arrangement by the end of 2011. I can't serve them and you.
I choose you.

Links

• Who can you trust?
• The foolproof measure of trust
• The word advisors imply but dare not say
• The ABCs of 1-2-3: The key to financial literacy
• The Globe and Mail on Canada’s insurance loophole: what else is wrong?
• What are you doing about your high investment expenses?
• How to fight cynicism
• image courtesy of nacu (Spain)

Podcast 152 (6:51)

direct download | Internet Archive page | iTunes

PS I still collaborate with hand-picked specialists like accountants, lawyers, fee-only financial planners, investment-only advisors and employee benefit specialists.

RATE HIKES: IS YOUR ADVISOR SLEEPING ON THE JOB?

Is this the start of a bad trend? September is the official Life Insurance Awareness Month with ambassador Lamar Odom. October is the unofficial jack-up-the-rates month. This also happened last year.

Scope

Premium rates for guaranteed life insurance products, which already have increased by 8%-10% this year [2011], recently have been boosted by up to 12% by some insurers. Another wave of premium hikes is expected to hit next spring [2012].
— Investment Executive, Sep 23, 2011

Life insurance premiums are going up again for permanent plans with level insurance rates which are typically guaranteed for life. The reasons are the same as last year plus a desire to increase ROIs. According to industry watcher, Byren Innes “any publicly traded carrier will jump at a chance to pad its margins”. External factors make ideal scapegoats.

Once again, the instigator is Manulife.  The new rates take effect at 5:01 PM on October 14, 2011.

On average, the level COI [Cost Of Insurance] rate increases are as follows [at Manulife]: 9% on InnoVision; 12% on Security UL; and 7% on Limited Pay UL. The largest increase is among clients aged 35 to 45, with an increase of 20% to 25%.”
— Advisor.ca, Sep 23, 2011

Once again, other companies will likely copy.

Dilemma

At times like these, the behaviour of salespeople is fascinating to watch because of the conflict they face. Commissions are based on the premiums you pay. As rates increase, total commission dollars usually do too.

That's makes smokers lucrative prospects. They know they must pay more than nonsmokers. They know they may not get approved. If they have a genuine need for insurance, they want to buy. Price is less important.

Act Now?

If you're a prospect for new coverage, your advisor is probably pushing you to buy now before the increases. Even if you're considering a company which has not announced rate hikes, do you want to risk paying more next week?

Insurance is considered sold, not bought: more supply than demand. To motivate you to buy, salespeople like enticing strategies which make insurance look like a no-lose, too-good-to-be-true deal. Here are the top five strategies . The problem is that there's no real urgency for you to act. A price hike might be, when coupled with the usual closing techniques.

If you're being sold an appealing strategy when you don’t have a clear need for insurance, higher rates hurt. Your salesperson has motives to push you to buy now.

Wait?

If you are already a client and have no imminent plans to buy more insurance, you may get ignored. It's more lucrative for your advisor to close new sales.

An Exception

What if you are planning to convert term life insurance to permanent coverage? You'll be stuck with the higher rates while your salesperson gets rewarded with more commission dollars. There's no incentive for him or her to spend time with you now.

Here, you benefit by calling your advisor. Just be wary of attempts to top up your coverage unless you need more.

Your Best Course

If you need more permanent life insurance, buying before the newest round of rate hikes will save you money. Also, new products may be worse in less visible ways such as weaker guarantees.

Case study: Coke Classic deviated from the original recipe by replacing expensive pure sugar with cheaper high-fructose corn syrup. You probably can't taste the difference but you're not getting "the real thing". If the population gets super-sized too, that's a nice side benefit. Bigger people can consume even more.

Insurance policies can take a couple of months to get approved. Your premiums are generally based on the date you apply, rather than when you get accepted. You can’t lose by acting now.

Did You Know?

If you're getting proper after-sales service, you'll already know about the upcoming rate hikes, even if they don't affect you. A newsletter or email is quick and cheap to send.

Links

• Three reasons life insurance prices are shooting up (Oct 2010) [podcast 90]
• Why life insurance premiums are rising (Moneyville.ca, Aug 2011)
• Life premiums: on the increase (Investment Executive, Sep 23, 2011)
• UL commissions on the block (Advisor.ca, Sep 23, 2011)
• Universal Life: level cost still rising (Insurance Journal, May 2011)
• Tax planning: The top five insured strategies
• Why after-sales service stinks
• RIP: What happens if your insurance advisor dies? (new)
• image courtesy of Pikajane Poketaku (US)

Podcast 136 (5:41)

direct download | Internet Archive page | iTunes

PS Not all rates are increasing but that doesn’t mean any are going down …

THE FINE PRINT TAKETH AWAY … EXCEPT IN LIFE INSURANCE

We’re sceptical because even the simplest offers have fine print. You're enticed but the many conditions take away the charm.

Not only do you spend money to get the offer, you often spend money to use the reward.

A Common Example

Here’s the fine print in a free movie ticket offer from a pizza chain.

1. the buy-one-to-get-one-free condition
2. limited provinces
3. limited theatre chains
4. no IMAX films
5. no IMAX digitally remastered presentations
6. no VIP room
7. no 3D films
8. no Real D 3D films
9. no non-feature film entertainment
10. no advance tickets
11. no midnight performances
12. no reward points
13. no pass-restricted movies
14. no refunds
15. not redeemable for cash
16. no reselling
17. no extensions
18. no reproductions
19. not combinable with other promotions, coupons, vouchers or special discount offers

If you get through all that, be sure to go to a participating theatre by the April 29 expiry date.

Okay, some conditions won’t affect your life. Yet someone felt the need to spell them out. There’s no warning that the movie might be a waste of your time even for free and that you’ll be subjected to commercials. That doesn't warrant a mention?

The Surprising Exception

We’re so used to fine print that we don’t notice one surprising exception. In Canada, personal life insurance contracts routinely guarantee everything except

1. government actions
2. investment returns
3. the availability of investment options

Fine print: Products differ and practices change. We’re looking at what’s common to help you in discussions with your advisor.

Government Actions

Provincial governments set the premium tax rates. They range from 2% in most provinces to 4% in Newfoundland. These rates are far below normal sales tax and the federal government doesn’t add a surcharge.

Insurance contracts are usually guaranteed to be tax exempt based on the tax rules when your coverage takes effect. Governments can change the rules but they might compromise and allow existing contracts to operate as before.

Investment Returns

Permanent life insurance plans allow tax-sheltered investment growth. With whole life, the insurer makes all the investment decisions and you get the rewards and penalties for their judgement. With universal life, you pick all the investments and take responsibility for the returns.

The insurer can often remove investment choices from a universal life plan. For example, if the S&P 500 disappears so will indexes based on it. That’s fair but the new indexes might have higher management expenses --- they rarely go down.

The Guarantees

Whole life has the fewest guarantees and is more like insurance on your car or home. You foot the bill for higher claims by others, pricey computer programming (remember Y2K?) and lousy investment returns.

In contrast, term life and universal life insurance routinely guarantee whatever the insurer can:

• premium rates per $1,000 of coverage
• administration expenses
• tax exempt status (under the rules in effect when you got your contract)
• no new conditions or restrictions

Something to think about when you’re back from the movies.

Links

• Check your pizza literacy (new)
• What's worse than fine print? (new)
• The best tax sheltering in Canada
• The four steps in wealth management
• The two drawbacks of investing in life insurance
• How advisors fool you (and what you can do)

Podcast Episode 64 (4:43)

direct download | Internet Archive page

PS The movie coupon expires on a Thursday, which means you can’t see the new Friday releases like A Nightmare on Elm Street or Furry Vengeance. Thank goodness.

Secret 7: The Best Tax Sheltering in Canada

Don't you judge a book by its cover? And title? I picked up The 15 Secrets The Taxman Doesn't Want You To Know by Dwayne Daku at Costco.

The Mysterious Author
Who is the author? An accountant or tax lawyer? There's no biography of Dwayne in the book. Nothing meaningful online either. That's strange. Why hide? Publicity sells more books and boosts credibility.

There are no online reviews of the book either, despite the intriguing title.

Let's look at the suggestions on their own merits. After all, many Canadian financial bloggers are anonymous but have readers.

The Conventional Suggestions
You'll find the usual tax planning ideas like

• splitting income with a lower income spouse
  
• contributing to RRSPs
• looking at after-tax investment returns

You'll also see newer ideas like the

• $5,000 Tax-Free Savings Account (TFSA) (see CRA)
  
• $500 tax credit for children's fitness (see CRA)
  

What Is The Best Tax Sheltering?

"... you can shelter your money and let it grow within the RRSP without any tax liabilities until you take the money out ... Life Insurance Tax Shelters ... will not only permit your money to grow tax-free, but if structured properly, will permit you to access the funds without tax ramifications. So instead of just a Tax Deferral you can have Tax-Free money." (pg 63)

This "secret" is cash value life insurance, generally universal life. You've read about the advantages here before

• tax-sheltered growth
• tax-free income
• tax-free death benefit
  

It's nice to have an outside source agreeing.

Tax Shelter vs Tax Sheltering
Technically, life insurance provides tax sheltering (which is good) but is not a tax shelter (which can lead to extra scrutiny from the tax authorities --- see CRA definition). You'll often see imprecision in common usage. In the book, the chapter is titled "The BEST Tax Shelter".

What About Buy-Term-and-Invest-The-Difference"?
For the first $5,000 you invest each year, you'll probably use the Tax-Free Savings Account. You can cover your insurance needs with term insurance and then invest the rest of the money in a TFSA. However, wealthier Canadians have much larger amounts to invest, which makes life insurance an attractive investment vehicle to consider.

Links

• How Pink Floyd's Insights On Mortality Help You (the rationale for the tax incentives)
  
• The Original And Overlooked Tax-Free Savings Account
• The Overlooked Advantages of Universal Life
• Does Warren Buffett Buy-Term-And-Invest-The-Difference?
• ISBNdb.com info
• CRA Denies $2.5B in tax shelter gifiting (CRA Tax Alert)

Podcast Version

What Happened on Take Our Kids To Work Day?

Take Our Kids To Work Day is an an opportunity for grade nine students to see what their parents do. This year, my son Jeevan accompanied me in anticipation of what he called a "businessman's lunch". I planned a (slightly better than) typical day. 

I wanted Jeevan to see elite life insurance advisors with revenue of at least $1 million. Since there are many in downtown Toronto, I tried to arrange a presentation for in a prestigious office tower like Brookfield Place, First Canadian Place or Scotia Plaza. The timing didn't work out.

9:00am Left Home (Etobicoke)

We were both nicely dressed with shiny shoes. I normally arrange meetings after most of the morning traffic has passed. This saves travel time.

9:45am Meeting An Advisor (Markham)

We arrived on time to meet an advisor who asked for help with "10-8" Leveraging, which uses life insurance to magnify the benefits of financial leveraging while shrinking the risks. We were then meeting his client.

The advisor arrive late for no good reason --- around 10am. This is very rare. During our meeting, he kept jumping between topics. He also kept answering his phone, which is rude. That's not how you treat an invited guest. I avoid advisors who behave like that. I focus on advisors who apply the four habits of highly referrable people. 

My son got a gift which he better not use: a wine bottle opener.

11:40am Meeting A Client (Markham)

Although scheduled for 11 am, the client arrived 40 minutes late He brought his accountant. As discussions began, the client kept checking messages on his Blackberry. However, he became more engaged within a few minutes. Both he and the accountant asked thoughtful questions. They had seen proposals for 10-8 leveraging before. 

Although questions remained, we left around 12:10pm to keep on schedule. In the car, Jeevan said that he followed most of the discussions. He asked what "YRT" meant. It's short for Yearly Renewable Term, a type of insurance scale in which rates increase every year to mirror mortality rates. To minimize the costs, the death benefit decreases each year to the minimum that Canada Revenue Agency requires for tax-exempt status. Who would want this? Wealthy clients who want to maximize tax-sheltered growth by minimizing insurance charges. Typical deposits are $100,000 to $500,000 a year for three to five years. 

1:00pm Lunch With An Advisor (Oakville)

Where can you get root beer in bottles?

Most leading insurance advisors are in their late 50s or older. They prefer wine over root beer. I wanted Jeevan to see there are successful younger advisors too. So we had lunch with an advisor under age 30 who is part of a very successful team (mainly selling "10-8" leveraging). We all had root beer in bottles. 

3:30pm Harry Rosen (Mississauga)

We made a pit stop between appointments. Two of my Italian suits needed unusual repairs: one has a broken zipper (which I didn't notice until I was in Sudbury just before a group presentation) and the other has lining that came apart at the seams in a sleeve. This proves that things go wrong regardless of price. While there, I bought an overcoat from the broken zipper company, the triumph of hope over experience. Do we ever learn?

4:00pm IFB Summit (Toronto Airport)

To end the day, we went to Independent Financial Brokers Summit to see the final speaker: Heath Slawner on the Power of Persuasion. This was based on the eye-opening work of Dr. Robert Cialdini, who I've seen twice. We all need reminding. I wrote about the six universal principles of infuence earlier. 

6:00pm Heading Home

Even though everyone was leaving the parking lot at once, we were on time for Take Our Kids Home For Dinner.

HOW AN ACTUARY INVESTS

Many financial bloggers write about investing. Despite regular contact with investment advisors at different firms and access to other experts like fund managers, I keep my thoughts to myself. 

Months ago, a reporter for a major newspaper asked how I invested. I explained but my approach lacked pizazz. You can judge for yourself from the notes I prepared for the interview.

Occupation
Actuaries measure and manage risk. I focus on financial risks. Here are the four "obvious" ones:

1. living too long (longevity)
2. dying too soon (mortality)
3. getting sick (morbidity)
4. getting disabled (disability)

A fifth risk often gets overlooked: overpaying taxes through ignorance or inertia (taxevity). Few realize how effective life insurance can be when properly structured.

Portfolio
Mainly mutual funds bought years ago. I use two investment advisors in London Ontario. I've never met them. I'd like to consolidate with one advisor in town but have not found the right person. Rather than investing more, we've focused on paying off our mortgage to increase cashflow for investing. On my own, I invest through universal life insurance, which allows tax-free growth like RRSPs (but without the restrictions on maximum deposits or forced withdrawals).

Start of Career
In 1984, I graduated from the actuarial science program at The University of Western Ontario. I worked at several major life insurance companies, starting with Metropolitan Life in Ottawa. I specialized in the design, manufacture and marketing of life & health insurance products. In mid-2005, I switched to a nontraditional actuarial role: helping advisors reduce the financial risks of their key clients. I donate time to help the general public by writing this blog. There is very little similar content online.

Start of Investing
My parents gave me a solid grounding in the importance of saving. As a child in the 1970s, I started putting money into a savings account and then GICs. My 14 year old son is following this pattern too. He likes compounding: your interest earns interest.

Thanks to scholarships, summer jobs and support from my parents, I graduated from university debt-free in 1984. I started working and making maximum RRSP contributions. I found an investment advisor by walking into an investment firm (a reverse cold call) and began investing nonregistered savings in mutual funds. As a novice, I didn't realize that loads were negotiable. I got charged a hefty 9% up front. I didn't know that investment advisors got hidden perks like cruises. I thought my advisor had the training and obligation to put my interests first. When I smartened up, I switched to my family's investment advisor in London, ON. This new fellow advised me to buy "can't lose" shares, options and warrants. And lost. By the late 1980s, I decided to stick with mutual funds.

Investment Strategies
Unclear. Over the years, I have known many experts: investors, investment advisors, fund managers, etc. I see many different approaches to investing. Each has merits but they conflict. No one knows what's going to happen. For example, we knew that gas prices could only go up (diminishing supply, insatiable worldwide demand) but now gas has dropped below 90 cents a litre again. 

Emotion leads to bad decisions.  We're reluctant to sell and buy at the "right" times. Yet we get excited about investments and agitated by blips in the returns. Many want to "get rich quick". At the 2007 Real Estate and Wealth Expo in Toronto, audience members were enticed to buy foolproof investing secrets for $995 or more. It is better to learn investment basics, sow seeds, nurture them and wait for the harvest.

Portfolio Returns
Unknown. I generally buy/hold but will make changes on the rare occasions where my investment advisor makes recommendations (one does, the other doesn't).

Stages Of Life
I've had a lifelong fear of outliving my savings during retirement. How horrible to have nothing left because we are living longer. What if an illness strikes or we need expensive long term care? A lifetime of savings can quickly disappear. How horrible. This fear of poverty --- the most basic of the six fears Napoleon Hill identified --- provides a strong incentive to save, spend prudently and increase earnings. 

Best Decision
Real estate. We changed our principal residence three times during down markets. We are close to paying off our mortgage. This would give a great sense of accomplishment ... unless we move again.

Worst Decision
Trusting my first investment advisor to put my interests first. I deserved unbiased advice but got high fees and poor returns. My advisor got nice commissions and hidden incentives like cruises. Where's the sport in taking advantage of someone who know less?

Investment Hero
Probably Warren Buffett. He invests for the long term, skips fads, shares his insights and understands insurance. I favour passive over active, low MERs over high, indexes over mutual funds. 

Who can I really trust for investment principles? I have decided that's going to me and I am learning. I'm reading financial blogsand classic books like The Richest Man in Babylon. The general advice is 

• pay yourself first: live on less than you earn
• invest
• never spend the invested money
• harness the power of compound interest
  

My extension is to invest inside universal life where growth is tax-sheltered (like RRSPs) and savings are accessible tax-free using bank loans. We will take advantage of the Tax-Free Savings Account too. None of this is exciting but neither is a financial rollercoaster.

Links

• Actuary invests in himself: beyond The Globe and Mail interview (new)
• The Four Steps In Wealth Management
• Secrets To Billionaire Success
• Three Reasons The Rich Get Richer
• The Four Financial Risks
• The Six Basic Fears From 70 Years Ago (Napoleon Hill)

The Four Steps In Wealth Management

The way to wealth depends in just two words, industry and frugality. – Benjamin Franklin

There are four steps in wealth management

1. Create wealth
2. Grow wealth
3. Preserve wealth
4. Transfer wealth

Simple to say but hard to do. Reducing taxes and reducing risk helps in each step.

Create Wealth

Ability is a poor man's wealth. — John Wooden

To create wealth, you develop, apply and improve your unique skills by getting through what Seth Godin calls the dip. Easier to say but certainly doable. And well-worth doing.

What if your opportunity to create wealth gets stolen by

• premature death
• disability
• a critical illness like a heart attack, cancer or stroke

Insurance maximizes your potential wealth in several ways.

Life insurance immunizes your heirs from your premature death by providing cash to repay debt such as a mortgage, cover living expenses for your family. Your business partners can use insurance on you to buy your shares so your heirs get cash and the partners get ownership of the company.

Disability insurance replaces income lost through disability. Some universal life (UL) insurance policies have a disability benefit which can pay out the cash value of your policy tax-free. You can also use the savings in permanent insurance as collateral for tax-free loans.

You can offset the financial losses from a severe illness with a critical illness insurance (see The Basics). This can take the form of a separate policy or an add-on your universal life.

Grow Wealth

The way to become rich is to put all your eggs in one basket and then watch that basket. – Andrew Carnegie

You invest your wealth to multiply your wealth. Compound returns do wonders, especially when tax-sheltered, yet most investors have

• nonregistered investments with taxable growth
• registered investments with temporary tax deferral until accessed
  

To improve results, you can reallocate a portion of your nonregistered investments into universal life. Why? For permanent or temporary tax deferral. Investment growth is tax sheltered as with an RRSP or the Tax-Free Savings Account (TFSA). But you're not limited by government-mandated maximum contributions, which are inadequate for the wealthy.

Preserve Wealth

It requires a great deal of boldness and a great deal of caution to make a great fortune, and when you have it, it requires ten times as much skill to keep it. – Ralph Waldo Emerson

To preserve your wealth, you want protection from taxes and creditors. With universal life insurance, your investment growth is tax-sheltered until withdrawn. You get permanent deferral if the growth is paid out as part of the tax-free death benefit.

You can get protection against your creditors by proper structuring (see the companion Riscario wiki).

Transfer Wealth

Never forget: the secret of creating riches for oneself is to create them for others. – Sir John Templeton

You can't take your wealth with you when you die. When you transfer your legacy, why not bypass taxes, creditors and public scrutiny. Your life insurance death benefit goes directly to your beneficiaries without passing through your estate or Will. This means

• escape from the probate fees on your estate
• protection from the claims of creditors, if properly structured
• privacy, since your Will becomes a public document

The tax-free insurance proceeds can be used to offset the taxes and costs at death without burdening survivors or requiring the sale of assets like a family cottage. This leaves more of your wealth intact.

Wealth is not in making money, but in making the man while he is making the money. – John Wicker

There's more to wealth than financial rewards, but the financial rewards are nice too. All the best with your voyage.

Links

• Thoughts on The Dip by Seth Godin
  
• Are You Entrepreneur Material?  (Thicken My Wallet)
• How To Be A Better Employee (Thicken My Wallet)
• Losing Your Livelihood: Insuring Against The Risk
• Why Critical Illness Remains Unsuccessful
• The Overlooked Advantages of Universal Life
• The Original and Overlooked Tax-Free Savings Account

"10-8" Leveraging: Turbocharging the Top 5 Insured Strategies

We've looked at the perennial top five insured strategies for tax planning. We've also seen how "10-8" Leveraging reduces the risks over conventional financial leveraging.

This time, we'll look at the interrelationships, combining

1. tax advantages of life insurance
2. tax advantages of borrowing to invest

Lower Costs or Higher Returns?
If you want life insurance primarily for the tax-free death benefit, you look for low cost. If you're an investor, you focus on higher returns.

With "10-8" Leveraging both become possible while you bypass the two drawbacks of investing in life insurance by investing externally --- the way you already do. You can use the tax deductions to

• reduce your cash outflow --- usually less than the cheapest products available, or
• increase your yield by reinvesting the tax savings

The Top 5 Strategies
As we saw, the top 5 strategies account for about 80% of the concepts the wealthy use.

Here is how "10-8" Leveraging helps active investors.

1. Legacy Bond: no effect (used by passive investors)
2. Insured Retirement Strategy: enhance returns
3. Estate Protection: reduce costs
4. Income Shelter: enhance returns
5. Insured Annuity: no effect (used by passive investors)

Users of the remaining strategies may also benefit.

Can you see the appeal that "10-8" Leveraging has for wealthy active investors who want tax deductions?

Links

• "10-8" Leveraging: Creating Tax Deductions
• "10-8" Leveraging: Are Tax Audits On The Way? (new)
• Tax Planning: The Top 5 Insured Strategies

"10-8" Leveraging: Creating Tax Deductions

Here's a special offer. For $10 you get an $8 gift certificate. Buy as many as you want.

No takers?

Okay. Give me $5.50 and I'll give you the $8 gift certificate. So you make $2.50 each time. How many do you want now?

This insurance strategy is generically called "10-8" leveraging and used by wealthy Canadians personally or through their private corporations. You get tax deductions while

• investing the way you normally do
• reducing the risks of leveraging through insurance
• increasing the size of your estate

For over 25 months, most of the requests I get have been about "10-8" leveraging. I've done dozens of seminars to attendees from across Canada, trained advisors, met clients, and learned how to make the concept simpler without being simplistic. The appeal is greatest in Alberta, where tax rates are lowest (which reduces the value of the tax deductions). Ontario gets more active each month. Let's explore.

Normal Financial Leveraging
With conventional leveraging, you pay interest and perhaps some of the principal. You face two unknowns:

1. market risk: what your investments earn
2. loan risk: what your loan costs (often fluctuates with the prime rate)

You can't eliminate the market risk but you can eliminate the loan risk with insurance.

"10-8" Leveraging
With insured leveraging, your investment loan costs 10% before tax savings. With a marginal tax rate of 45% (say), you get tax savings of 4.5%, which reduces the cost of the loan to 5.5% after tax savings. Here's the interesting part. Your collateral earns 8% tax-sheltered. So your after-tax cost is 5.5% less 8%, which is -2.5%. A negative cost is a gain. You pick up 2.5% from leveraging.

If you earned 7% before, now you earn 9.5% using the same investment dollars. What if your focus is protection instead of investment? Use the tax savings to reduce the cost of your life insurance below market rates.

The loan becomes a source of income.

What's more, the pretax loan cost of 2% (10% less 8%) is generally guaranteed for life. That's a big advantage over conventional borrowing. When the spread is guaranteed, you want to borrow at as high a loan rate as possible. If you could borrow at 20% , your collateral earns 18% tax-sheltered. Your tax savings double to 9%, giving an after-tax cost of 11%. And a 7% gain from leveraging.

Tax-sheltered Growth
How do you get tax-sheltered growth, using Pink Floyd's insights? By putting cash into universal life insurance policy --- if you like the limited investment choices.

How can you have both the benefits of investment flexibility and tax-sheltered growth? With "10-8" financial leveraging using a specially-constructed universal life insurance agreement.

10 - 8 = 2
There are two types of "10-8" leveraging: policy loans and external collateral loans. The 10% loan interest is paid as follows

• 2% at the beginning of the year to the insurer
• 8% at the end of the policy year to you (your reward for borrowing from yourself)

There's a fundamental difference in the level of tax deductions you can get.

• policy loans: pay 10% to deduct 10%
• external loans: pay 2% to deduct 10%

With external loans, you refinance the 8% at the end of the year by taking another loan. This increases your tax deductions, which is what you and your accountant want. As you'd expect, nearly everyone who qualifies picks this version when dealing with a knowledgeable advisor who has access to both types.

Benefits
Since your loan collateral earns 8% inside a tax-sheltered vehicle, you're getting a nice return. Since you actively invest outside of life insurance, you eliminate both drawbacks we discussed last time.

As you know, there are advantages and drawbacks to financial leveraging. Using insurance reduces the risk by guaranteeing a 2% loan cost before tax savings turn borrowing from yourself into a source of income for you. Using insurance also provides a larger estate than conventional investing. All the while, you're getting tax deductions.

Can you see the appeal of "10-8" leveraging?

Links

• The Pros and Cons of Financial Leveraging
• How Pink Floyd's Insights On Mortality Help You
• The Two Drawbacks of Investing in Life Insurance
• "10-8" Leveraging: Are Tax Audits On The Way? (new)
• "10-8" Leveraging: Turbocharging The Top 5 Insured Strategies (new)

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.

Links

• The Pros and Cons of Financial Leveraging
• "10-8" Financial Leveraging
• Canadian Life Insurance Sales in 2007
  
• How Pink Floyd's Insights On Mortality Help You
• The Original And Overlooked Tax-Free Savings Account
• The Overlooked Advantages of Universal Life
• Does Warren Buffett Buy-Term-And-Invest-The-Difference?

How Pink Floyd's Insights On Mortality Help You

you're older,
shorter of breath
and one day
closer to death
--- Pink Floyd, Time

Back To Basics
When you buy insurance on your car or home, you pay premiums which get adjusted annually (usually upwards) based on claims experience. That model doesn't work with life insurance. As closet actuaries Pink Floyd correctly observe, we get closer to death each day. Even if we take care of ourselves, our mortality rates continually increase and increase. If you pay-as-you-go, coverage becomes less and less affordable as payment of the death benefit becomes more likely. Term insurance becomes unavailable.

Tax Incentives
The government uses tax incentives to encourage behavior which reduces burdens on society. For example

• saving for retirement (pension plans, RRSP, Tax-Free Savings Account)
  
• saving for a child's education (RESP)
• saving in general (TFSA)
  

Life insurance clearly qualifies: the death benefit helps families and other survivors. While premiums are not tax-deductible, the death benefit is tax-free.

Big Opportunity
Increasing mortality rates make affordability a big problem. The solution is pre-funding. The government encourages you to invest extra money in your life insurance contract by allowing tax-sheltered growth.

The amount you can invest depends on the cryptic Maximum Tax Actuarial Reserve (MTAR), which varies with the amount of coverage, your age and your health. Since our probability of dying is 100%, you can essentially invest any amount of money --- even millions of dollars.

But why would you?

Because the tax savings on the investment growth are often more than enough to pay for the insurance charges. The government effectively pays for your insurance if

• you're healthy
• you make large deposits in the early years
• you allow time for tax-sheltered compound growth

Needs Change
Tax-sheltered growth is great but what happens if you take money out? As with an RRSP, you pay tax on the investment growth. But you have several advantages over an RRSP

• you can make much larger deposits
• you aren't forced to make any withdrawals
• you can get tax-free access to the savings
  

Suppose you want to supplement your retirement income. Banks like lending when you don't need the money. You can use the savings in your insurance policy as collateral for loans. Since loans are tax-free, you get tax-free income. You don't need to pay the loan interest either. Banks usually let the loan interest accumulate and wait for the tax-free death benefit to repay the loan. What's left goes to your heirs.

Thanks to tax savings, you can benefit from mortality during your lifetime.

Links

• The Original And Overlooked Tax-Free Savings Account
• The Overlooked Advantages of Universal Life
• Does Warren Buffett Buy-Term-And-Invest-The-Difference?

The Problem of "Trapped" Retained Earnings

The government encourages small business (technically Canadian-Controlled Private Corporations or CCPCs) through favourable taxation. Let's see the effects in Alberta, the province with the lowest combined federal and provincial tax rates. Active business income up to the Small Business Limit (generally $400,000) is taxed at 14% and the balance at 29.5%. These rates are attractive compared to the 39% marginal tax rate on personal income.

All isn't rosy. Governments discourage small business from generating passive investment income with a hefty tax rate of 44.7%. And that's in low-taxed Alberta.

What Do Business Owners Do?
Typically, small business owners and incorporated professionals like doctors pay tax on income up to the Small Business Limit and retain these after-tax earnings in the corporation (e.g., $400,000 less 14% leaves $344,000 retained). Prior to eligible dividends, income above the Small Business Limit was generally paid out as a bonus (tax deductible to the business and taxable to the recipient). Now accountants often recommend that tax be paid and the after-tax earnings be retained unless the owner wants to spend the money.

A successful small business can easily have hundreds of thousands of dollars in retained earnings "trapped" inside the corporation to avoid additional taxation. This is not what the owners want.

Uses of Retained Earnings
Retained earnings can be used in three ways

1. reinvested to grow the business (which results in more taxable income)
2. spent (goes to owner via dividends from after-tax income, effectively taxed at the top marginal tax rate)
3. saved in the corporation (and investment income taxed at rates higher than the top personal marginal tax rate)

Saved Retained Earnings
What tax-effective strategies deal with saved retained earnings? They can be invested in dividend paying shares of some Canadian companies since the dividends are received tax-free (and can be used to buy more of the same). This builds more retained earnings in the corporation, though.

Another solution is to transfer the retained earnings into universal life insurance for

• tax-free growth until death, and
  
• tax-free payout through the corporation's Capital Dividend Account.

Tax-Free Access
If the owner wants income in the future, the corporation can use the cash value as collateral for tax-free bank loans and distribute the proceeds to the owner as shareholder dividends. Since the collateral is so secure (an insurance contract backed by a multi-billion dollar insurance company), there are generally no requirements to pay the loan interest on an ongoing basis. Instead, the loan and the accumulated interest can be paid with the tax-free death benefit.

Links

• Corporate Income Tax Rates (KPMG or Ernst & Young [PDF])
  
• Capital Dividend Account (riscario.com companion wiki)