As mentioned in an earlier post there are three types of life insurance: Term, Whole life and Universal life. This post will contain quite a bit of information and discuss why I think a Universal Life (UL) policy is a mistake.
A UL life insurance policy is two things. It is life insurance and also an investment. You pay your premiums to the insurer and that money is used in three ways.
• First, a portion is used to pay an administration fee.
• Second, a portion is used to pay for the insurance.
• Thirdly, the remaining portion is deposited into a so called “investment” account.
We’ll start with the good stuff.
Just like term and whole life insurance, upon your death your named beneficiary will receive tax-free the face value of the UL policy and also whatever is in the investment account. (Some policies include the investment account and some only pay out the face value. Read the fine print).
Unlike term insurance the policy lasts a lifetime and you can withdraw money from the “investment” account or you can use the cash surrender value of the policy as collateral for a loan. In this way you can use the money in your life insurance policy for yourself.
Still on the good side, the money in the “investment” account grows tax-free so long as it stays in the account. However, withdrawing from the account or borrowing against the cash value MAY be a taxable event, you will want to consult a tax professional before doing so.
On the flip side there will be fees involved in withdrawing the money from the “investment” account (as well as setting up a loan at prevailing rates), and you need to be careful not to overdraw or your insurance will lapse.
The insurer will usually offer you a choice of mutual funds that are available within the “investment” account. Some of these investments will be guaranteed (where they guarantee the principal invested) but the rate of return is likely to be less than inflation. Other investments will have a variable rate of return, usually tied to a market index of your choice. The two most common are the S&P 500 index and the TSX Composite Index.
The S&P 500 index is down 27% over the last 10 years (Jan 3, 2000 close at 1455. Feb 4, 2010 close at 1063)
The TSX Composite index is actually up over the past 10 years just about 32% (Jan 3, 2000 close at 8413 points. Feb 4, 2010 close at 11128 points) However if you had checked in March of 2009 this index was down 9% over the 9 year period. (Yes, there have been some terrific gains in the Canadian market since March 3rd 2009).
My point here is that it is possible for you to make nothing in their so called “investment” account. In fact, it is worse than that. It is possible that your insurer will call you requesting more money to prevent your policy from lapsing! This sounds like a margin call from your broker and is something you never want to receive. As your investment losses keep piling up you need more and more premium to make up the difference (and maintain the insurance and administration costs).
Actually it is even WORSE than that. The S&P 500 index that you tie your “investment” account to has its own MER (Management Expense Ratio) which will be in the neighbourhood of 2.5 – 4%. The insurer will always take that expense right off the top. So if the index lost 10% one year your account would be down 12.5 -14%.
One of the ways that UL policies are marketed and sold is to pay a large sum of money up front and then forget it. The idea here is that with a one time payment you will buy an investment and insurance and never have to make any payments. The insurer will maintain your tax-free status by opening up an interest bearing account for you and transfer the annual premiums as they become due. Of course, if you had tied your investment account to the S&P 500 index as thousands have done you would have lost 27% (more once you account for MER) and possibly have even lost your insurance.
Think of your UL policy like a bucket. The water in the bucket is your money. There is a leak in the bucket and the money coming out of this leak is used to pay for your insurance and the administration fee each year. The leak gets worse each year as the cost of insurance increases each year you get older. Additionally, the bucket can only hold so much water and maintain its tax free status. If you put too much water in the bucket it overflows in the form of fees and taxes. The water in the bucket is your investment account. As such that water can rise or fall depending upon the market. If it falls too much then there isn’t enough to go through the leak and maintain the insurance. If the water dries up then the insurance lapses and the contract (the UL policy) is closed.
I would argue that you can do much better just paying for insurance and investing on your own.
• Don’t pay that heavy MER, and
• Don’t get tied into a limited selection of funds to invest your money.
• Separate your life insurance (term and possibly a small whole life policy) from your investments.
• And monitor both.
Yes both, your insurance needs will change when you have a life changing event like a new baby, new marriage or divorce, new job, new house, etc. Investments of course should be monitored at least every few months (or daily if you are really involved and enjoy it).
I get this question all the time. The answer is that “it depends”. The insurance company will tell you that a good rule of thumb is 10 times your annual income. But if you make $100,000 per year do you really need to consider taking out a million dollar policy? Again, the answer is “it depends”.
It depends on several factors. You need to consider what you want the death benefit to do. Most people think it should be used to pay off debts, taxes and take care of loved ones and perhaps also to help out some charity that is particularly meaningful to them. You can of course name just about anyone as a beneficiary in your life insurance policy and they get the money tax and probate free (just make sure your will concurs). There is lots of grey area in ‘taking care of loved ones’.
As for debts this usually means paying off the mortgage, lines of credit, car loans and credit cards or other loans. Another debt to consider is your terminal tax return and your funeral expense. A funeral can cost anywhere from $7,500 to astronomical so you want to plan for that. The government will also tax you upon your death – and the government is greedy.
Your assets will be deemed as being sold on the day of your death for fair market value and you will be taxed at your marginal tax rate, which can be quite high if the value of your assets has increased since you bought them (i.e. summer cottage, boat, etc). In the USA it is actually worse as the government can tax your estate and inheritance at a 55% rate. Strangely enough, in Canada, there are currently no estate or inheritance taxes – for now anyways. Canadians get taxed enough throughout their lives so the government gives them a bit of a break at death. How nice.) There are number of things you can do to reduce this tax bill. One is to pass it all on to a surviving spouse tax free (but then they will have to manage the tax bill upon their death). Another is to establish a trust in each of the beneficiary’s names, thereby reducing the tax rate per individual. Or you can donate the assets to a charity as they are taxed at a more favourable rate. Of course you should consult with a professional tax planner well in advance to help in reducing estate and personal taxes.
Taking care of loved ones might mean ensuring that the children get a university education or that the surviving spouse can quit their job. Or it might mean none of those things. Although it might be nice if your family had enough money to grieve for your loss without financial worries interrupting the process. If your spouse is working outside the home perhaps he or she would like to continue working and therefore doesn’t really need as much money.
As you can see the answer truly is ‘it depends’.
Group insurance usually comes in the form of company benefits and can include life, critical illness, and health insurance. Typically this covers the employee and their family and usually you have no option but to participate in the coverage. Premiums are taken right off your paycheque. Larger companies will contribute a portion (or all) of your premiums which makes group insurance a wonderful thing for the employee.
However there are a few things you need to be aware of about group insurance. First and foremost is that it only covers you if you are employed. If you leave for any reason your coverage is cancelled. Secondly, if you are a young and healthy non-smoker your group rates are probably going to be higher than if you took out individual insurance. Although this may not matter to you if your employer is picking up a portion of the premiums, I would argue that it does matter because it becomes a cost to the business. If the business has too many costs and not enough revenues or profits then the business is no longer viable and you are out of a job.
Of course if you are older or not healthy (or God forbid smoke) then group insurance is Heaven sent, as the premiums will be much more affordable than individual coverage. Keep in mind however that coverage is only while you are employed and once you reach retirement age you are cut off. (There are some plans that you can continue coverage after you have left the company if you assume all the premium payments – essentially converting to individual insurance. While this may be very expensive usually you do NOT have to prove that you are medically fit. What this means is that if you have cancer or diabetes or some other illness and want to covert from Group to Individual coverage they cannot deny you insurance. Although the cost can be quite high it may still be better than going without coverage).
Another point to consider with group insurance is the details of the plan. No two plans are alike so check the fine print. Life insurance is usually mandatory but coverage is only while employed or until age 65. With mortality rates being much higher than that (here in Canada and the USA), the odds are in the insurance company’s favour. Additionally the death benefit is usually a multiple of your annual salary. This might be fine if you make $150,000 a year and your multiple is 2 or 3 times, but it is a different story if you make $30,000 a year and your multiple is 1 times. In the latter case I would argue that you need additional life insurance and should take out individual coverage.
Do NOT buy mortgage insurance.
When you allow the bank the privilege of lending you money to buy a house (for most people it is the most money they have ever had at one time) they are eager for you to check the box indicating that you want life insurance on the loan. After all it seems reasonable, they want to protect their investment in the event of an untimely death (and really aren’t they all untimely?)
DO NOT DO THIS.
I cannot stress this enough. The bank is already making a large profit off your mortgage, don’t give them even more free (or nearly) money. There are several reasons not to check that box.
First, mortgage insurance is more expensive per $1,000 insured than if you where to buy individual Term Insurance. It varies by institution but rest assured it can be anywhere from 50-150% more expensive.
Second, as you pay down your mortgage the amount of your premium payment stays the same! What this means is that what already starts out being overly expensive becomes absolutely ridiculous the more you pay down that mortgage.
Third, if you do pass away the insurance pays the mortgage lender, not your designated beneficiary! While this is good for the bank it is not necessarily good for your loved ones. Perhaps they can manage the mortgage payments and would like to use the money in another way?
Fourth, when your mortgage comes up for renewal you may want to shop around. Perhaps a different lender will give you a better rate. If you do change lenders you will have to reapply for insurance and pay a higher rate now that you are older.
Fifth, if you do pass away there is the possibility that the insurance will NOT cover you. The mainstream media rehashes this story at least once a year because it generates lots of calls and controversy. It is shocking that the bank can take your premium payments and not pay a death benefit but it IS true. The reason for this is because it is deemed that you had a pre-existing condition that they never would have covered had they known about it. For example, perhaps you have a heart condition or a slow acting cancer. The insurance provider can determine your eligibility after you have passed away based on hospital or doctor records. If they determine that you would not have been covered you can lose all your premiums paid and not receive a death benefit!
It is simply much, much cheaper and easier to take out individual term insurance for the value of the mortgage for 20 years (or however long you think it will take to pay off the mortgage). Once approved it can never be taken away (so long as you make your premium payments) and the cost is fixed for a fixed death benefit. Of course you can also designate a beneficiary other than the mortgage lender so your spouse or significant other can determine how to spend the money. And you will have no hassles shopping around for new mortgage at renewal time, knowing that you are covered.
Please Please Please do NOT get mortgage insurance, you’re just throwing good money down the toilet.
If you are young and single you probably don’t need life insurance. Chances are your company benefits include some form of life insurance policy and this will probably be adequate for you.
One thing you need to be aware of though is with group insurance (like in your company benefit plan) if you are terminated or leave your place of employment then your life insurance is terminated as well. No problem if you are immediately hired on somewhere else, but what if you are not? What if you are trying to start your own business or just want to travel and explore this wonderful world?
Again if you are young and single – probably this is no big deal. You don’t need life insurance. However if you have any significant debts or obligations, like a mortgage or spouse or children you really should have your life insured. You wouldn’t think of driving your car without insurance and if you own a home you have that insured too, so why not your life? After all what is more important to you, your car or your life?
And another thing, if you do leave your company plan and you decide to purchase insurance on your own your purchase depends upon your age and your health. In the industry this is called ‘pre-existing conditions’ and basically it means that if you are not healthy the insurance companies can refuse to sell you life insurance (or if they do they charge you significantly more).
OK so now you’ve decided to get some life insurance, good for you, you don’t want to leave your debts to your loved ones. However there are lots of choices and lots of different opinions masquerading as facts. There is Term Life, Whole Life and Universal Life.
Basically Term Life insurance will pay out a death benefit so long as the contract is in force if you die before age 80. The premiums you pay for this insurance are set for a specific term (usually 10 or 20 years) after which you will still be covered but at a much greater premium. You are covered so long as you keep paying.
Whole Life insurance will pay out a death benefit so long as the contract is in force, no matter what age you are upon your death. Premiums are usually held for the length of the contract, but depending upon the policy may also increase as you get older.
Universal Life insurance is similar to whole life except that there is an investment component as well. I would argue that with the expense of the insurance and the expense of the investment management it is not really worth purchasing UL insurance. More on this in a later post.