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 Pros and Cons of Financial Leveraging

Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.
— Archimedes (220 BC)

Leveraging isn't new. Leveraging isn't complicated.

Leveraging means doing more with less. Doesn't that sound environmentally-friendly?

We leverage time, space and money:

• time: listening to your iPod or radio while commuting (when not eating or drinking or phoning)
  
• space: filling your SUV with passengers and garden supplies on different trips

Yesterday, I saw a BBQ lighter with an LED flashlight. You've seen Swiss army knives. Leveraging is all around us. So why such concern with financial leveraging? When used properly, leverage can be quite advantageous.

What is Financial Leveraging?
Simply put, financial leveraging is borrowing to invest. The most familiar use of leverage is using a mortgage to buy a home. In return for a down payment and ongoing payments, you receive money to buy an asset that would otherwise be too expensive. You hope your home will appreciate in value so that when you sell, you realize a profit over what you bought it for (including interest payments).

This is the principle behind financial leveraging. You gain access to a larger amount of capital and invest to earn a return high enough to make a profit. If your investments perform well, the use of leverage can greatly magnify those returns. This is the appeal.

The Risks

When we pick up one end of the stick, we pick up the other.
— Stephen Covey

Just as gains are magnified, so are losses. As well, increases in loan interest rates may also cut into your profits or add to your losses. It is important to enter into any leveraging strategy with these risks in mind, and take steps where possible to lower the risk level. For example, investing in a well diversified portfolio will help guard against losses and enhance returns. Choosing a fixed-rate loan over a variable rate will also protect you against rising rates (but not falling rates).

There are a number of ways you can benefit from leveraging:

• Investment loans: This is leveraging at its most basic. You use borrowed funds to invest with the hope that returns outpace the interest on the loan. In Canada, you can deduct the interest paid on loans for certain investments, which makes this strategy more appealing, and reduces the effect of interest rates eating into your returns
• RRSP loans: When you borrow to invest in your RRSP, you get two advantages. First, you get the tax deduction for the larger RRSP contribution. Second, the growth of your investment is tax-sheltered within the RRSP which will enhance your returns.
• Universal Life Insurance: The tax-advantaged status of Universal Life makes it an excellent vehicle for many leveraging strategies. The cash value in the policy provides the collateral. You can borrow to invest. You can also get tax-free retirement income (see the Insured Retirement Strategy, the #2 strategy).
  

Is Leveraging for You?

Leveraging strategies range from the basic to the very sophisticated and involve varying degrees of risk. Whether or not you could benefit depends on your financial situation, goals and comfort level with taking on risk. It's definitely not for everybody but nothing is.

Links

• The Problem of "Trapped" Retained Earnings
• Tax Planning: The Top Five Insured Strategies
• "10-8" Leveraging: Creating Tax Deductions