Doing The Term/Perm Squirm Part 4: Universal Life Insurance

I describe permanent life insurance as a multi-function jackknife that combines many useful tools into a single sleek package. Universal Life (UL) policies are the ultra-deluxe army knife that includes enough attachments to do anything from performing minor surgery to opening wine bottles. On the other hand, unless you are supremely confident in your surgical skills or don’t mind a little cork in your chardonnay, perhaps this mythical pocketknife isn’t always the best tool for the job.

Arguably, the same is true for UL insurance; although it is capable of many different uses (which is a wonderful thing), it isn’t always the ideal solution for every problem. All the same, since we don’t always know what to expect when wandering through the forest of life, having something in our back pocket that can be useful in a variety of different scenarios is a very attractive option. On a similar note, UL may sometimes be a secondary tool you can use in conjunction with your preferred implement to improve your overall results. Of course, despite these cautions, maybe sometimes a UL policy is exactly what you need.

A Thumbnail Sketch Of How UL Policies Works

A. The Face Value And The Accumulating Fund

UL policies are able to weave their magic by separating your life insurance policy into two separate parts: the face value and the accumulating fund. I’m going to talk about each separately, starting with the face value.

The Face Value

The face value is the amount of pure life insurance you own, against which you are charged an annual premium. The money you pay for that portion of the premium goes to the insurance company. This money is pooled and invested with that of other clients and is used to fund the face-value portion of your death claim. You have no control over how this money is invested and you don’t get any of it back if you cancel your policy.

To make things more interesting (or at least more complicated), the face value of your policy can actually go up or down, depending on the details of your policy and your needs. You might want to hold a policy that allows you to increase the face value when appropriate even though this increases your premiums. At other times, you may want it and your related insurance costs to decrease. Although I’ll explain the benefits of this flexibility shortly, let’s not focus on why this is so for now. Just remember that both the face value of your policy and your basic insurance costs can increase or decrease over the life of your policy if you select this option at the time of purchase.

If you are worried about providing a minimum benefit to your heirs but still want this flexibility, you can get the best of both worlds; in addition to selecting the ability to increase or decrease the face value, you can also restrict the maximum reduction. In other words, if you want to ensure that there is at least $500,000 left for the kids, you can limit the maximum reduction of the face value to this amount. You’ll still need to ensure that you can continue to pay the minimum insurance costs for this reduced amounts, either by continuing to pay into the policy each year or by using money inside the accumulating fund to pay the premium. I’ll explain how to use the accumulating fund to this when I change directions in a few short paragraphs.

Before turning to the accumulating fund, I thought I’d better explain why you might want to increase or decrease the face value along the way. Unless you’re worried about running out of money to pay premiums, your decision is related to the accumulating fund. In many cases, the purpose of owning a UL policy is to grow the size of the accumulating fund as much as possible until you need it. The accumulating fund is the total of any extra money you contribute above the minimum premium and subsequent investment gains minus any premiums for the face value that you don’t pay for directly. Increasing the face value increases the cost of insurance, but it also allows you to tax shelter more money inside your accumulating fund; the bigger the face value, generally, the more extra money you can contribute towards a rainy day.

Conversely, if you don’t need any extra room to shelter all the extra money you’d like to contribute to the policy, it might make sense to decrease the size of the face value so that as little of the money as possible is spent paying insurance premiums. Strangely enough, these reductions in face value might ultimately increase your death benefit over time! This can happen if the money that would have otherwise been spent to pay for a higher face value if you die ahead of schedule is reinvested inside the policy and grows in value over time so that it eventually is larger than the decrease to the face value.

If all this still seems a little foggy, hopefully learning more about the accumulating fund will pierce through the mist.

The Accumulating Fund

The other piece to the UL policy is something called the accumulating fund. Once you understand how it works and how it is connected to the face value, you’ll understand why varying the face value can work to your advantage and how UL policies can be used for purposes other than just providing payouts at death.

To begin, the actual payout at death (the “death benefit”) may be higher than the face amount of your policy. This is where the accumulating fund comes in. Most UL policies top up your death benefit by adding the balance of the accumulating fund at death to your face value. To put this in insurance-speak, your death benefit is often the total of the face (the face value of your policy) and the fund (the value of your accumulating fund at that time.)

How do you get this extra bump to your death benefit and how is it calculated? As you probably expect, it doesn’t come for free. The value of your accumulating fund is based on how much extra money you pay into your policy and its investment performance. In other words, the value of your accumulating fund is largely up to you; how much extra money do you contribute and how much the investments inside the policy that you select grow over time. Although your choices are confined to the different options provided by your insurer, you generally have numerous choices with different levels of risk to select.

Expanding on this, the real benefit of the accumulating fund is that this investment growth inside the policy compounds tax-free and, on death, is paid out tax-free as well. If you put enough into your policy and the investment gods cooperate, you can eventually have a total death benefit that is many, many times the value of the original face value of the policy.

Many funding strategies for UL policies call for substantial contributions to the accumulating fund in the years immediately after purchasing your policy. A typical strategy might call for 10 years of extra contributions of many times the minimum premium. After this point, the hope is that the extra money and subsequent investment gains continues to compound over time even after some of this money is deducted each year to pay the insurance costs for the policy’s face value.

Now that we’ve learned more about the accumulating fund, I wanted to add one final point regarding increases or decreases to the face value of the policy. Although this is a very useful advantage in many cases, there are limits as to how much you can increase the face each year. As you might expect, insurers aren’t keen on the idea of you tripling the face value of your policy the day after you start feeling chest pains. Generally, the maximum yearly increase to the face value (unless you want to go through another round of medical tests) is about 8%.

Other Uses Of The Accumulating Fund

Before elaborating on some of the other surprising things you can do with your accumulating fund, I wanted to reiterate one final time that UL policies are usually better suited for people who also have life insurance needs. In other words, be sure to consider other options for achieving goals like disability protection and retirement funding if either of those is your main goal, before turning to life insurance. Although (as I’ll explain shortly) UL policies can help address these problems, there are other products that might provide a better solution.

On the other hand, if you do have a need for life insurance, maybe you might also benefit from the side benefits life insurance can provide, such as:

(a) Disability Protection. Tax rules may allow you to withdraw your accumulating fund tax-free upon disability. In other words, you might build up the value of your accumulating fund so you have extra cash to supplement your other health care benefits. The money you withdraw reduces your death benefit since your accumulating fund is reduced. Moreover, if you withdraw the entire balance, you would need to continue paying into the policy so your beneficiaries will still receive the face value someday (unless the policy waives premium payments upon disability and you stay disabled for life).

Interestingly, it is easier to qualify as “disabled” for this purpose than it is to qualify under a disability policy, CPP disability benefits or even for waiving future premium payments for the same insurance policy. Potentially, this could mean getting at your accumulating fund tax-free but still having to pay to keep your policy in force. Finally, it is also important to know that you may only be able to make one withdrawal per disability. Accordingly, you might want to err on the side of caution, knowing that you will likely be able to put any extra money you don’t need back into the policy over time if your needs are less than anticipated.

Although this is a valuable feature, I suggest that it shouldn’t take the place of a package of other health insurance options, such as Disability Insurance, Long Term Care Insurance, Critical Illness Insurance and Extended Health Coverage. It takes time to build up the value of your accumulating fund to a useful size. Moreover, if your disability is long term, you might really appreciate getting disability benefits until 65 or Long Term Care benefits for life rather than hoping that the balance of your accumulating fund is big enough to last for many years or even decades.

(b) Creditor Protection. If you own your policy personally and the beneficiaries are qualifying family members of the person insured, the policy is creditor-protected during the owner’s life and from estate creditors as well. This might be particularly enticing to people who are in risky businesses or who simply don’t want to leave anything to chance.

Unfortunately, the protection provided by a life insurance policy isn’t absolute. Money squirrelled away less than a year before bankruptcy or similar money struggles isn’t safe. Money contributed one to five years beforehand is also potentially at risk but only if the creditors can prove that you knew of your impending financial doom at the time you socked away an extra $50,000 into your life insurance policy. Also, don’t count on your policy being safe if your marriage dissolves. Finally, it’s also important to remember that your beneficiaries’ creditors may still be able to swoop in someday. For example, assume you own a policy on your life that names your partner as beneficiary. Both of you are jointly liable for a debt. The policy might be safe during your life and successfully pass to your survivor on death, but the creditor would still be able to pounce when your partner got the insurance cheque. It’s also important to get professional legal advice if you want to change beneficiaries during a financial crisis. Theoretically, this could cost you your creditor protection.

Moreover, a life insurance policy is not the only way of getting this type of protection. Other options include using trusts, corporations, segregated funds (the life insurance industry’s answer to mutual funds but with the same creditor protection as life insurance funds) and transferring assets to lower risk family members. Accordingly, while the creditor protection that goes with life insurance is extremely useful, this protection might also be used in conjunction with other planning techniques

(c) Retirement Funding. Although you may need some life insurance to pay your final taxes or to maximize what you leave behind for the next generation, maybe you would also like another pot of money to draw upon when you’re old and grey. Even better, what about a product that allows your investment to grow tax-free until then and, in some cases, can be withdrawn tax-free to fund exotic vacations or the latest electronic device without reducing your OAS pension?

There are various planning techniques out there that use UL policies to do just that. I’ll say more about this in a future article. One option suggests maximizing contributions over the first 10 years of the policy or less, then using the accumulating fund to both pay the yearly insurance costs and to provide retirement cash, although it usually requires several more years for the money to compound into a meaningful amount. During retirement, the accumulating fund becomes collateral for a bank loan or a series of yearly bank loans that you use to fund your retirement dreams. You either pay interest along the way or have this added to your debt. The debt continues growing until death, when it is paid with the tax-free death benefit from the policy. As an additional perk, if it turns out that you don’t need to use the money for retirement after all, that cash continues compounding inside the policy to grow the death benefit you leave behind for loved ones or the cause of your choice.

There are some risks that go along with this retirement strategy, but I’ll save the details for my future article. For now, I’ll just warn you about the risk of the bank calling in your loan during your lifetime, which can mean disastrous tax consequences and cancelling your policy before death if you can’t provide other collateral or pay the loan using other sources. I’ll also add a final reminder that in many cases, it makes sense to also be maximizing contributions to your RRSPs and TFSAs as well.

Rules Governing The Size Of The Accumulating Fund

The extra amount we can contribute and the ultimate size of the accumulating fund at any one time is capped by a series of eye-crossingly intricate rules known as “the MTAR Line.” These rules that create the MTAR line limit how much extra loot you can contribute that year, which is influenced by factors like the policy’s current face value, how long the policy has been around and, once the policy is in its 10th year onward, how much the size of the accumulating fund has increased from its balance three years earlier. Let’s just say that the rules limit how much you can increase the face value of your policy in order to shelter extra money, as well as how much extra money you can pay in from year 10 onward if you haven’t been funding the policy at significant levels previously. These rules will likely be changing in 2016, although policies purchased before that date are allowed to enjoy the benefits of the current rules. Needless to say, the new rules will further limit extra contributions into the accumulating fund.

Don’t worry if you aren’t following all of these intricacies; you don’t need to master them in order get a general idea of how ULs work. The important thing to know is that ULs allow you to contribute extra money to a tax-sheltered side account that may be creditor-protected and that you can use this extra cash for a bunch of different purposes.

Premium Options

UL policies generally allow you the choice of initially low premiums that increase yearly as you age or level premiums over the life of the policy. In fact, some policies even combine both approaches so that premiums may increase then plateau in stages. Your policy may also allow you to start with yearly increasing premiums (known as “yearly renewal term” or YRT premiums) and switch to a level premium at a later date based on your age at that time.

Earlier UL policies generally favoured YRT premiums, as lower initial premiums left more money to compound in the accumulating fund. The theory was that investment gains inside the accumulating fund on the extra money freed up by lower initial costs would more than offset higher premiums in later years.

On the other hand, if the clients weren’t able to commit as much as they’d planned originally or if the investments inside the policy didn’t grow as planned, these UL Policies could be ticking financial time bombs; the yearly increases in premiums that outstripped investment growth ultimately made some polices unsustainable.

In many cases, this problem was compounded by clients who didn’t understand what was happening as their accumulating funds steadily shrunk like the polar icecaps and the time to take corrective action, such as putting in additional funds, converting to level premiums (if permitted) or reducing premium costs by lowering the face value had long passed. The typical result:

a) Many years of paying into the policy with nothing to show for it, other than the few dollars rescued from policy before it collapsed completely;

b) Dashed or downsized retirement or estate planning dreams; and,

c) A pathological dislike for the life insurance industry.

Fortunately, that doesn’t have to be your UL experience. Just as with RRSPs, you are able to dictate the amount of market risk you’re willing to bear. Moreover, I strongly suggest that you illustrate the future investment returns inside the policy at realistic and conservative rates of return. Fortunately, the insurance industry has long since stopped showing illustrations that assumed 12% annual investment returns. On the other hand, back when this was being done and inflation was running rampant, many assumed that this rate was actually conservative!

On a similar note, I suggest at least considering level insurance costs so you cap the size of the annual insurance premiums or switching to level premiums while you’re relatively young unless:

a) You are contributing scads of extra money for the long term so that the chances of the policy exploding are minimal; or,

b) You purchased a special policy designed to drastically reduce the cost and size of the face value along the way (but sustaining a healthy accumulating fund) so that insurance costs will no longer remain relevant by the time your rates per dollar of coverage skyrocket.

Investing Inside The Accumulating Fund

Unlike other types of permanent insurance, you get to decide how all your premiums minus the minimum payment are invested. You are provided with a significant number of different choices, which are a variety of mutual funds and something like a GIC. As a result, it is up to you to decide whether you want shoot for the moon with your investment choices, just to play it safe or a bit of both. Just be careful to understand the minimum size of every contribution to the underlying investments inside the policy.

Some investments require that you invest in minimum increments, which means parking some of your extra contributions into savings account inside the policy until you meet this minimum, which can be $250 or more. This problem can be even worse if you allocate your contributions to multiple investments. For example, if you select 10 different underlying investments, each with a $250 minimum, you may need to wait until your savings account grows to $2,500 before any of it gets allocated to your actual investment choices. For smaller policies, this can often cause a lag of many months until you have reached the critical mass. If this is a potential concern, look for a single investment option rather than picking multiple investments so more of your money can be put to work sooner. You might be able to always transfer some of the money to other investments inside the UL at a later date or switch how new contributions are allocated if you are worried about having all of your eggs in one basket.

Back in better investment times, the ability to select your own investments was a significant enticement to clients who drooled over the prospect of 20% returns. This made the steady but lower returns of participating whole life policies (“par policies”), where the insurers invested the money conservatively and only shared some of the reward, seem outdated. Of course, these days, many clients reluctantly select the rather small guaranteed interest accounts inside the policies in order to protect their capital and avoid the chance of their policies ever “exploding” or lapsing as detailed earlier. Furthermore, as the insurance industry moves to accommodate the public’s appetite, there is apparently a new ‘smoothed’ investment option for UL products designed to provide a steadier return, lower risk returns provided by par policies while preserving the flexibility and multipurpose functionality exclusive to UL policies.

Investment Fees Within UL Policies

The size of the fees charged to the clients on the investments inside the accumulating fund has been an ongoing criticism. Some clients are forced to pay both the management fee charged by the underlying mutual fund as well as a similar fee levied by the insurer, although this isn’t always the case. Moreover, there is increasing talk of lowered fees in the future in order to entice clients to purchase ULs. All the same, it is important to understand the combined fees charged by the insurance company and any underlying investment fund on your investments. No matter how bullish you may be on equities, the prospect of combined fees exceeding 4% is not for the faint of heart. Some insurers offer significantly lower rates on investment funds managed in-house or by an affiliated institution rather than by an outside fund. Accordingly, it is also important to understand which investment options are discounted and which are not before making your choice, especially if the insurer offers a comparable in-house option.

Guaranteed Cash Value

Unfortunately, UL policies generally do not provide any guaranteed cash value; ultimately the cash value of the policy depends on how much extra money you’ve contributed above the minimum premiums into the accumulating fund and whether these investments have gone through the roof or dropped through the floor. One way of dealing with this issue is to have a portion of your accumulating fund invested in products that guarantee a minimum return (or, at least, aren’t typically subject to those stomach-wrenching 20% drops in a single year.)

Although I don’t pretend to know the bells and whistles of every insurer’s offerings, the only UL policies I’ve seen with a ‘true’ guaranteed cash value are limited pay policies, which are something of a hybrid between traditional non-participating whole life policies and UL policies. Like the whole life policies, the insurer guarantees a set cash value at certain stages. Like a UL policy, clients can contribute more than the minimum payment and these funds may be invested according to the client’s own preferences. Moreover, the balance of the accumulating fund is added to the guaranteed cash value during the client’s life to increase the amount of money available for retirement funding or to use as collateral for loan. Also like a UL, the balance of the accumulating fund may be added to the face value to bump up the benefit paid out at death.

Ultimately, this type of hybrid policy is best suited for people who want to guarantee that they won’t be faced with a minimum payment during retirement they can’t afford but still want the option of growing some additional tax-sheltered money for rainy days or to pay out to their heirs at death. Generally, the accumulating funds on these types of policies don’t have the ability to grow as much as pure UL policies and clients have fewer investment choices inside the accumulating fund, but clients may be more than willing to accept these drawbacks in exchange for the peace of mind that comes with knowing that, regardless of future investment performances, you have a policy that is paid up for life.

Bonuses

Just because U/L policies weren’t complicated enough to begin with, some insurance companies offer “bonuses” to owners who contributed extra money to their policies. Bonuses are generally shown either or both as reduced insurance premiums or slightly bumped up investment returns. In some cases, you can even lock in these bonuses for the life of the policy if you contribute enough money in the policy’s early years, even if you don’t contribute another dollar to the policy afterwards.

On the other hand, I have put the term “bonuses” in parentheses for a reason. Although I define bonuses as getting something for nothing, the life insurance industry doesn’t share my naively simple view. In at least some cases, it is necessary to pay for your “bonuses” by agreeing to higher management fees on your investments. While this may still be a good deal if you make the necessary extra contributions, I still wonder if a term other than “bonus” would have been more accurate.

Conclusion

Although a UL policy may not be able to provide a solution for global warming or premature hair loss, I still think of it as a useful and versatile tool. Just like any tool, however, it has to be used correctly and in the right situations. If you pick risky investments, don’t fund the policy appropriately and select yearly increasing premium payments—don’t blame me if this tool twists in your hand and you mangle a finger or two.

Similarly, if you focus exclusively on funding your UL at the expense of funding your RRSP or buying some of the living benefit insurances mentioned earlier, I hope you don’t use my name as an epithet if you can’t retire at the same time as your buddies or have to settle for vacations to Toronto rather than Tibet during your golden years.

On the other hand, if a UL policy is part of your plan rather than the centerpiece and if you use it correctly, it just might make your entire retirement, estate planning, incapacity planning scenario just that much better.

If UL or some other type of permanent life insurance planning strategy intrigues you, I suggest the following:

• Working with an experienced insurance professional who knows both the big picture and the fine print;
• Comparing UL, Par and other Permanent Life Insurance Policies. Don’t assume that you need the high tech jackknife until you’ve determined whether some of the simpler models might also do the trick;
• Comparing between companies. Although I continue to recommend dealing with larger insurers with a solid history, do your due diligence to determine which company is right for you. If comparing UL policies, I suggest looking at the variety of investment options, past investment performances of the underlying funds, investment fees (including the insurer’s cut), special features and premiums. Unfortunately, the premium question might be hard to determine until after you’ve submitted your information and provided medical evidence, as the companies won’t be able to tell you what rates they’ll offer you until then.
• Review your policy yearly. It’s important to stay on top of the performance of your investments, the size of your accumulating fund and whether its growth is on target. Just like the rest of your investment portfolio, you may need to buy and sell within your policy or change your risk parameters over time, especially if you are planning on using the money for retirement purposes.

Anyway, that’s more than enough for now. As always, I welcome your thoughts, questions, suggestions and future article ideas.

Colin S. Ritchie, LL.B., CFP, CLU and FMA is a Vancouver-based fee-for-service lawyer and financial planner who does not sell investment or insurance, just advice.  To find out more, visit his website at www.colinsritchie.com