Using Life Insurance for Retirement Savings?
Look Before You Leap!

The Financialist • Issue 84 • October 2004
BY CLAY GILLESPIE & JIM ROGERS

Many Canadians are aware of the need to save for retirement.  Higher income individuals also realize that it will be difficult to maintain their current standard of living based solely on the income they’ll eventually receive from RRSPs, Registered Pension Plans, and government plans such as the Canada Pension Plan and Old Age Security.

One of the savings options which has been heavily promoted by the life insurance industry is the use of a tax-exempt life insurance policy as an additional savings plan. Basically, the idea works like this:

• The client uses after-tax income (personally or in a private company) to fund payments into an “exempt” life insurance policy. The deposits to the policy are far in excess of the actual insurance costs and these “surplus” funds are invested within the policy, often in accounts linked to stock market indexes, bonds or mutual funds.
• As long as the deposits to the program remain within limits specified by the government, any investment income will not be taxed as long as it remains inside the plan.
• If the investments remain inside the insurance plan until the client’s death, then they will be paid out tax free to the beneficiary, in addition to the face amount of the policy.

The client is encouraged to use the policy at retirement as collateral for a series of loans from a bank or other lending institution. These loans will be exempt from tax and will be used to supply the client with income during retirement – and the assumption is that the loans, and any compound interest owed on the loans, will be eventually repaid by the taxfree insurance death benefit.

If all goes according to plan:

1. the investments in the plan will grow free of tax;
2. the client will be able to draw a tax free retirement income;
3. upon the client’s death, a tax-free insurance benefit will pay off the loan, likely with money also left over for the family.

So what’s the catch?

In theory, this strategy sounds very appealing. But there are some potential concerns that need to be carefully reviewed before you commit to any such program. Remember that it is much easier to get into these programs than it is to get out (some plans include a cancellation penalty that may last up to 11 years). These concerns include:

• Fees and expenses:

Administrative fees, investment fees and insurance costs vary among companies and can dramatically reduce the amount of your deposit that actually makes it to the investment account and the rate at which it grows. In addition, life insurance costs may be higher inside these plans than a term insurance policy purchased on a stand- alone basis. All of these costs will reduce the return you will receive on your investment.

• Borrowing risks:

When the life insurance policy is used as collateral for loans during retirement, the client is betting that the investments in the policy will continue to grow fast enough so that the accumulated loan(s) will not exceed the value of the policy. If the loan(s) does exceed the cash value of the policy (because of poor investment performance or an increase in loan interest rates), the client is still liable for the debt and may have to provide additional collateral or sell other assets to pay down the loan, or, in a worst-case scenario, surrender the policy to repay the outstanding loan. This could be a serious problem for a retiree who discovers the problem at age 75 or 80!

• Interest deductibility:

In many cases, these plans are illustrated to potential clients based on the assumption that the compounding interest on the  loans will be tax deductible (which would, effectively, reduce the rate at which the loan balance grows - assuming that any tax savings are applied as repayments). In fact, when the policy is used as collateral to secure a loan intended for retirement income, the interest charged by the bank on the loan  will not be tax deductible.

• Loss of flexibility:

This strategy requires that the funds accumulate inside a life insurance policy, restricting the investment options to only those offered by that insurance company. It is not possible to switch investment managers (i.e. insurance companies) without surrendering the policy. A policy cancellation may trigger tax on the policy gains (cash value minus the policy’s adjusted cost base) or a cancellation penalty. Investment choices will be limited to what the life insurance policy contract makes available. This is why it is very important to read and understand the contractual provisions relating to investment options in particular when considering such strategies.

Life insurance is a very valuable planning tool and should be considered part of any prudent financial or estate plan.  Whether life insurance is an appropriate vehicle for long term retirement savings is much more open to question.

So what to do?

In most cases, a balanced portfolio of investments combined with a separate term or term-to-100 life insurance policy will provide superior results with much less tax and loan risk, while maintaining your flexibility for future investments. Please let us know if one of these “insurance for retirement” plans have been proposed to you, (or purchased by you). We would be happy to review this matter with you, and comment on the appropriateness of the arrangement in your specific circumstances.