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Featured Articles

• Universal Life Insurance
• Segregated Funds

Insurance Products Update

Tax Effectiveness of a Universal Life Insurance Policy

by Allan McGlade, CLU, CFP

Last month, we discussed some issues surrounding the tax season and tax planning in general. Continuing with that theme we would like to bring to your attention an often overlooked benefit of a particular type of life insurance.

The type of life insurance I am referring to is a Universal Life insurance policy. The often overlooked benefit is your ability to accumulate assets on either a tax deferred basis or on a fully tax exempt basis. Whether the assets receive a deferral or a full exemption from taxation depends on how they are taken out of the contract. We will address the exemption versus deferral issue a little later. The first question that needs to be answered is how does the product work and why does it get special treatment?

The How and the Why?

When an individual or a couple apply for a term insurance policy or a whole life policy, they commit themselves to a set premium payment for a predetermined amount of time. Universal Life is a variable life insurance policy, which presents some interesting opportunities. When you purchase a Universal policy you are given the option to pay what in the industry is referred to as a minimum or maximum premium. The minimum premium is what is required to keep the policy in force and, if you choose to pay only the minimum, you will need to make premium payments for as long as you want the contract. However, if you choose to deposit amounts in excess of the minimum, you get the benefit of having those deposits compound tax sheltered. The excess deposits can then be used to either increase the death benefit on the policy, to fund future insurance costs on the contract or a combination of the two. Either way, you as the policyholder win on an after-tax basis. This is because when assets accumulate tax deferred, like in an RRSP, you will generally end up with a greater pool of capital than assets accumulated in a taxable environment. Alternatively, if you use the income generated from the excess deposits to fund the policy's insurance costs, you are using before tax dollars as opposed to your future hard earned after-tax dollars.

The reason the accumulation of assets on a tax deferred basis is allowed within a life insurance contract is that Revenue Canada and the insurance act says it's OK. It's that simple. The reason these policies have a maximum premium is so that the deferral feature is not abused. Insurance companies are required to test the policy each year to ensure that the contract has maintained its exempt status.

Investment Options

The objection insurers heard the most during the early days of Universal Life was that there weren't enough investment choices. The insurance industry has responded by providing a number of guaranteed investment options as well as offering several equity based investment options. A point worth mentioning, when you are considering a policy and comparing companies: it is wise to look closely at how the investment returns are credited to the contract. Not all contracts are created equally. This is where you can really benefit from the services of an insurance specialist who does not have ties to any one company.

Who Should Consider This Type of Insurance

There are two categories of individuals who should consider a Universal Life insurance policy. The first is anyone who has a long-term need for insurance, is using all of their RRSP room and has additional disposable income to invest for a long term objective. The second individual is anyone who has excess capital that is attracting unnecessary taxable investment income. Rather than losing control of the capital such as when assets are gifted or placed in a trust, the capital stays in the control of the owner just in case it is needed at a later date, and in the meantime the assets will not be subjected to income tax. This type of situation quite often calls for a joint and last to die Universal life contract.

Tax Deferred or Tax Exempt?

As already mentioned, the assets compound tax deferred while they are inside the policy. When the owner of the policy makes a withdrawal, a portion of that withdrawal will be considered taxable. The taxable portion will depend on the percentage of the investment funds assets withdrawn that are considered contributed capital and the percentage that is investment growth. However, any investment income that is paid out as part of a death claim does not attract income tax. So if you are looking for ways to effectively plan your estate, this might be the answer.

The bottom line is that life insurance, and in particular Universal Life can be an effective tool in anyone's overall financial plan.

Segregated Funds Update

Over the last six months the industry has seen several more segregated (seg.) fund products become available to the public. Most notable are AIC and Templeton who came out with a segregated version of their most popular funds. So if you like the idea of having a portion of your investment capital in a higher risk fund such as the AIC Advantage fund but are not comfortable with the risk, have no fear. You can now purchase the seg. version and have either 75% or 100% of your capital guaranteed.

How to Beat the 20% Foreign Content Rule

Recently, Revenue Canada handed down a ruling that allows international seg. funds to qualify as domestic content inside an RRSP until 2001. So if you like the idea of having more than 20% of your RRSP assets invested outside of Canada, you can achieve the objective by investing in seg. funds. Revenue Canada has said they will review the ruling in 2001. If they do change the rules, our guess is that they will treat the change like they have done in the past to insurance related products and grandfather any existing contracts. At the very least, you get a couple of years of participation in what have traditionally been better performing markets.

Who Says Seg Funds Don't Perform

There has always been a perception that segregated funds under perform their cousins, mutual funds. While it is true that some seg. funds have higher management fees than mutual funds, this does not always translate into underperformance. A recent review of seg. fund returns showed that they are quite capable of competing. For example, Transamerica's 21st Century fund (a NASDAQ linked index fund) showed a whopping 67% return for one year and a two year return of over 54%. In fairness to mutual funds, it should be mentioned that they are not allowed to offer funds that are linked to the NASDAQ. However, BPI's American Equity Value returned 40.1% over one year, ManuLife's AGF American Growth Class fund returned 38.6% and their Fidelity Int'l Portfolio Fund has returned 12.5% over one year and 19.7% over two years. All numbers are as of February 28th, 1999.

Seeing those types of returns furthers the argument that Canadian investors should be doing whatever they can to maximize their foreign content. Seg. funds might be the solution. After all, you get the potential upside of higher returns and the safety of the guarantee that you cannot lose most or all of your invested capital.

We would be happy to discuss further the merits of Universal Life insurance or holding seg funds inside your portfolio. Please contact our insurance specialist, Allan McGlade (Allan_McGlade@scotiacapital.com, tel. 416-862-3066 or 1-800-387-9273), for a personal consultation.

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