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Universal Life An Answer, But Not The Only One
Scott Blythe
Universal life insurance has become immensely popular, not least because of its flexibility. The concept is simple, but the nuances can be devilishly complex. That should prompt both advisors and investors to proceed with caution.
What is simple in the concept is this: contributions over and above what is required for the cost of the death benefit can be banked, either to defray future premiums or to build up cash value on a tax-deferred basis. That creates all sorts of investment, tax and estate planning options. But there's a risk associated with each of them.
Experienced advisors emphasize that universal life has to be treated primarily as an insurance product. Whether a client should use it depends on their insurance requirements, not their investment or tax goals.
"Before you can get to the product, I think you have to look at whether insurance is needed," says Brian Mallard, president of Brian Mallard and Associates in Saskatoon and a member of the board of directors of the Canadian Association of Insurance and Financial Advisors. "So if insurance is one of those products that's going to mitigate a risk, that's the first check mark on the criteria list."
There are many ways to satisfy insurance needs, including term and participating insurance. "Universal life is an answer. It's not good and it's not bad. It's just one of an array of potential answers," notes Bob Fleischacker, president of Bob Fleischacker Financial in Markham, Ont., and a former CAIFA president.
"If you wanted low-cost term insurance, if you're a young family just starting with a mortgage and a couple of kids, you probably just want a boatload of plain-vanilla term insurance," he says. "But then you get to a point where you say that 'I understand that some of my requirements are permanent and major but I don't want to get into that investment stuff, I just want something that will pay off when I die.'"
The permanent insurance Fleischacker looks at is built around a term policy with level premiums that becomes paid up at age 100.
"The simplest application of universal life," he adds,"should be: 'I've quantified how much insurance I want, I want it forever and I want to know the price to pay per year.' So what they buy is term insurance to 100 inside a universal life contract."
That's one reason to turn to universal life. Another is if a client has significant obligations related to a small business. Mallard refers to this situation as an "evolving need."
"Let's take the case of an entrepreneur who starts up a business who borrows $500,000 — not an untypical situation," suggests Mallard. "He probably needs life insurance because he doesn't have the half million dollars to pay the bank back. Over time his enterprise is successful and the half-million-dollar debt transforms into a couple of million dollars of assets. Now the assets are at risk. They're goodwill and it's not like you have a half million dollars in unmarked $20s. You don't have cash, but you still have a continuing obligation in the form of deferred taxation. Someday that debt is going to rear its ugly head. Now you probably have an evolving need for life insurance."
"If the individual has sufficient cash flow, then I think you've got to start looking at the opportunities that are provided on more permanent types of life insurance, whether that's universal life or whatever," he adds. "Universal life provides some unique opportunities. But if there's sufficient cash flow, I think you can start to look at placing more money in the product than what is necessary to pay the current mortality cost."
But Mallard warns that the insurance policy should not be confused with an investment vehicle. The two serve quite different ends.
"Most insurance policies are sold because somebody feels a certain sense of responsibility, responsibility to pay off a debt, to look after beneficiaries," he says. "Investments are purchased because of people's — in a word — greed. They're looking for the highest rate of return. What happens when you convolute the sale of a life insurance product with the sale of an investment product is that you may not get the result you were looking for. You may not get the best of both worlds; you may get the worst of both worlds."
That's particularly true when investors don't understand what they're buying. To highlight potential investment growth inside a universal life contract, insurance companies frequently provide sample illustrations of how assets compound over time, based on one of the major market indices such as the TSE 300 or the S&P 500. The problem: the illustrations, instead of showing year-to-year volatility, smooth it out to produce average annual returns and so may well understate investment risks.
"Universal life is sold on illustrations and all of the illustrations that are produced are wrong," says Mallard. "The market averages over 10 years, 20 years, 30 years, 40 years don't really give you an indication of how volatility can affect the sustainability of the contract. In other words, if you last year bought a universal life contract and you elected to use the Nasdaq as your principal funding vehicle, and you lost 60% of your deposit — which is what happened — how does that affect your contract? What does it do to your premiums? So the problem is that the Nasdaq may have averaged 12%, but the 60% downside risk that's inherent in that index isn't communicated in the illustration."
What makes this different from the concept of risk tolerance that is commonly used in conjunction with equity investing is what is actually at stake: the death benefit.
"With an insurance policy can you sustain the contract if you have a 30% or 40% downside? Is the contract going to be able to stay in force?" explains Mallard. 'It's one thing to lose your money. It's another thing to lose your life insurance benefit. Because that's what you bought it for."
Mallard thinks that a participating life product might be better for many clients. It can provide term to 100 insurance while the investment component yields policy dividends. Participating policies are often sold on the basis of illustrations, too, but falling returns won't endanger the fixed premiums.
Fleischacker also thinks participating insurance has fallen unjustly out of favour. "Par insurance is designed to provide the lowest net cost of insurance to the consumer. What happens is you're buying into a huge managed portfolio so you cannot control the investments as you would in a UL contract. The perception of these things is that they're not as flexible as universal life. They sure as hell aren't as sexy. But those are perceptions. With product evolution that's occurred, you can model with par insurance and accomplish pretty much the same things."
Adds Mallard: "Participating life insurance is going to be a low-yield product. However, it provides certain infrastructure guarantees that perhaps aren't available when you start looking at things that have a higher-yield potential. It could be for those people who are more conservative in their perspective. Having said that, universal life has investment options within it that can make it look and smell like a par product."
There are other drawbacks that advisors should be aware of. One is that the new capital-gains regime makes the investment component of a universal life contract less attractive. Only half of stand-alone capital gains are taxable. By contrast, the full amount withdrawn from a universal life policy is taxable.
"With the most recent capital gains inclusion rate, in my opinion people have to look very closely at piling up investments inside a universal life contract," says Fleischacker. "If you carve the death benefit out and you have $6,000 to invest, and I can put it inside a UL contract in equities or I put it outside a UL contract in equities, I would submit that the case is no longer as strong as it once was to have it inside the UL contract."
Another issue, Fleischacker points out, is the actual flexibility of the contract. "Where are the fire exits?" he asks. "How do I get out? What if I can't do this for ten years?"
These potential disadvantages put the onus on advisors, adds Mallard. "You're in the business of advising. You have to give people the bad news along with the good news. That's what's prudent, because the negative side of the concept is what's going to catch you and bite you later on."
E-mail:group@barkermoney.com
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