(Originally published October 27, 2008)

It is a combination of term insurance and an investment vehicle which is tax-deferred to the investor or even tax-free on death to the beneficiary of the estate.

We will use a specific situation as an opportunity to understand the pros/cons of Universal Life policies. A semi-retired couple has assets in a private corporation. Assets are used to pay dividends, to co-owner spouse, which is taxed in her hands at 16%. They don’t need insurance and don’t need the assets in the corporation to meet their retirement needs. However they have a strong desire to maximize the value of their estate for the next generation. A number of planners/insurance-representatives suggested the use of a Universal Life policy as a means of increasing the after-tax value of the estate.

Study of existing UL policy of the investor and try to project outcomes of various scenarios for a new investment. Starting dollars are before tax dollars in the Private Corporation. If starting point used was after tax dollars, the UL outcome would look even more disadvantageous. The illustrative numbers were based on ages 55(wife) and 60(husband) for the couple. The policy analyzed is a last to die life insurance policy.

Returns available from the market and cost of term insurance are identical in and out of the UL; under most reasonable circumstances, the tax advantages of the UL policy cannot overcome the heavy costs incurred in the UL.
Generally, if you are contemplating a UL policy, make sure you understand all costs (Fees, explicit and implicit MERs, Cost-of-Insurance, etc) and benefits. Also, make sure to request from insurance company not just ‘illustrative’ future values of the policy, but also a comparable benchmark/reference (i.e. a comparative table of portfolio value outside of the UL, in a taxable account, constructed with same returns but ETF-like MERs and no fees). If you are still thinking that the UL is advantageous, you may want to hire an independent fee-only financial planner to perform the analysis for you. (The UL policy used for this analysis was one of the most opaque documents that I have read in years. If you don’t understand it, don’t buy it!!!)

-tax deferral for investor and tax free for the estate (but still unable to overcome other disadvantages) -may make sense if you are exclusively investing in fixed income (GIC/bonds) only, because here tax advantages would dominate (in UL taxes on interest income are deferred or not taxed, whereas out of UL, in a taxable account, annual income taxes are payable on interest at up to 46% rate) -if you die during first 10 or so years, higher estate value because of the insurance component; you can achieve the same outcome if you invest outside of UL and buy equivalent term insurance and get higher ending value. -no probate fees (red herring- as it of the order of 0.5-1.5% of estate) -protection from creditors (little value to most) -can take out a loan against UL (borrowing your own money at higher than market rates)

-MERs (1.5% used in this example for calculation, however actual MERs were at least 2.25% for specified index funds or 1.5% for actively managed 3rd party funds which already likely have embedded MERs of 2.5-3.5%; 1.5% MER is used as a conservative representative estimate to include effect of specified ‘bonuses’ under various performance scenarios and the impact of small charges associated with the ETF alternatives) -cost of insurance (a drag for the life of the policy) -liquidity (access to funds especially poor during first 10 years due to penalties) -if insurance not needed why waste money on it
-fees -premium tax -lack of transparency (fees, MERs, cost of insurance, etc…) -complexity -counterparty risk (insurance company rating, will it be around to pay in 40 years?) -for index funds Total Return or dividends excluded (this example included dividends)

Assumptions (cost of insurance $1400 for life of policy; premiums paid cover cost of insurance for initial 20 years and after year 20 the yearly cost-of-insurance is charged to portfolio) Return available from the market= 8% -MER of 1.5%, results in return of 6.5% -Tax rates: 16% to extract dividends from Private Corporation (if recipient’s taxable income is less than about $60,000)                 46% for income                 23% cap gains tax (i.e. 50% cap gains inclusion rate) -Annual UL premium= $3000 for 20 years $1400 insurance and $1600 investment -Outside of UL, investments are left unsold until maturity (i.e. capital gains taxes only paid at the end)
-Recall that out of UL, only $0.84 invested for each $1.0, due to 16% taxes on dividends

The following table summarizes the results (in Thousands of Dollars), based on the above assumptions.

Note (Case #0) the “pretax” UL line is not a realistic option and only given for reference, as this would be fully taxable amount at up to 46% rate. Similarly the “GIC/Fixed income” line (Case #4) is not an attractive option, as currently available interest rates are much lower than 8%.

The “Equity+ Term Life” line (Case #3) is a realistic alternative where investor makes a trades off between a higher estate value in the first 30 years (by using $1400 for $100,000 20 year level term insurance and remaining $1600 for investment for 20 years), and a higher estate value after 30 years (no term insurance and $3000 invested for 20 years).

So UL (Case #1) comes in THIRD (last of the three realistic options), following the two ‘No UL’ scenarios, one without insurance (Case #2) which is the FIRST (best option for these inputs) and the No UL with Term Life (Case #3) which is SECOND.

-the No-UL (i.e. taxable) scenarios win in all realistic cases

-if policyholder/investor dies soon after establishing investment, Cases #1 and #3 (with life insurance) come out ahead of Case #2, because of the life insurance component of those policies. (If this is a consideration, select the No-UL Case #3 with term insurance)

-there is significant doubt that there are any situations where UL outperforms other mechanisms of achieving same objective outside of a UL (with the possible exception of an ultraconservative investor who invests exclusively in GICs and fixed income securities, but even this would occur only if rates were competitive, and fees, MERs and other charges did not erode any advantages of having the tax advantages on interest income)

-furthermore, one would have to determine if there is value to holding even existing policies considering the ongoing investment MERs and the continuing life insurance cost charged against the policy (in the situation when you don’t need the coverage)

-the tax free transfer to next generation via the estate is the most favorable outcome for the UL and its value is questionable even there

-if tax 16% rate associated with withdrawal from the company would in fact be 46%, the UL may be advantageous under some MER/Fee scenarios!

“Universal Life: The answer or the problem” “Universal life: Separate insurance and savings products premium erosion- The sequel”