Many Canadians rely on life insurance to protect their loved ones from the financial consequences of premature death. However, most life insurance policies sold in Canada are term life insurance policies. This is because term life insurance offers the lowest premiums, at least in the initial term of the policy.
In most cases, Canadians have between 10 and 20-year term life insurance policies, which are usually never revisited by the insurance agent who sold their term life policies. As a result, a lot of Canadians get trapped with the exorbitant renewal term life insurance costs at old age and risk outliving their term life insurance policies in their older years.
In this article, we’ll take a look at how universal life insurance works in Canada, and whether it’s the right choice for you.
What Is Universal Life Insurance and How Does It Work In Canada?
Universal life insurance is a type of permanent life insurance that offers more flexibility than whole life insurance. Similarly, it also allows you to build wealth from within your policy over time, however, you can also increase or decrease your monthly contributions (within limits) depending on your financial situation. Unlike, participating whole life insurance policies, the rates of return on your cash values are usually variable because your returns depend on your investment portfolio’s performance.
Participating whole life insurance, on the other hand, allows you to grow your cash values over time through guaranteed cash values (based on policy premium surplus), and policy dividends (participating).
With a universal life insurance policy, you have access to both fixed income and equity (stock) portfolios. This allows your policy cash value to potentially earn a higher rate of return over time than a whole life insurance policy, provided that you have a long-term outlook.
In layman’s terms, the easiest way to understand a Universal life insurance policy is that it is:
- A cash value insurance policy, and a
- Life insurance with an investment component.
In essence, a universal life insurance policy is: “life insurance with an investment component.”
Most insurance advisors explain Universal life insurance as a life insurance policy where your premium goes into two buckets, one is to cover the cost of insurance and policy charges and the other bucket pertains to your investment account within your policy.
If you are to strip off the technicalities, Universal life insurance is simply life insurance with flexible premiums and compounded asset growth potential through your policy’s portfolio’s average market returns.
The basic premiums can be as low as a term life insurance but keep in mind that if you’re only contributing the minimum premiums, your policy may not last you a lifetime of coverage as there are not enough funds to keep the policy in force and may eventually lapse at some point in time.
To better understand how universal life insurance work in Canada, let’s take a look at how it works in practice:
You are a 35-year-old non-smoking male who purchases a $500,000 universal life insurance policy. Your monthly contribution is $600. After the cost of insurance and other fees are taken out, the remainder of your contribution is invested in a mix of fixed income and equity portfolios.
Assuming a 5% annual rate of return, your policy cash value would grow to $453,354.72 by the time you reach age 65. Your total invested capital would have been $216,000 at this time, and your universal life insurance death benefit coverage would have already increased to $953,354. At this point, you could stop making contributions and start leveraging your policy to access funds, tax-free to supplement your retirement income, while still allowing your cash value and death benefit to grow tax-deferred inside the policy.
The above computation is based on a $500,000.00 worth of pure universal life insurance coverage.
There are ways to structure your coverage for lower monthly contributions like decreasing your policy’s death benefit to between $50,000.00 and $100,000.00 to cover final expenses such as funeral costs and topping up your coverage with a term life insurance rider of between 20 and 25 years to cover your loved ones’ need for income replacement in case you or one of the breadwinners’ pass-away prematurely. We can help you design a plan that’s specific to your financial situation and goals, simply book an appointment with us and we will work with you in coming up with a solution that works for you.
Universal Life Insurance – Costing
There are costs associated with any life insurance policy and universal life insurance isn’t an exception.
When acquiring a Universal life insurance policy, you have the option of going with the “yearly renewable term” cost of insurance (COI) or the “level” cost of insurance.
Yearly Renewable Term COI
The yearly renewable term is a cost of insurance option where the insurance costs start at their lowest or the bare minimum but increase over time.
The level cost of insurance, on the other hand, calculates your lifetime cost of insurance and levels it throughout your payment period.
In effect, your cost of insurance remains “level” and does not increase over time; hence, the term “level cost” or “level COI”.
YRT vs Level Cost of Insurance
There are a lot of different schools of thought when it comes to life insurance planning. You have the buy term, invest the difference, you have the UL YRT only, you have UL Level only and of course, you have the whole life all the way to avoid any forms of risks.
So within the realm of Universal life insurance alone, there are a group of advisors who prefers one over the other; there are those who only recommend Universal life with a level cost of insurance for fear of policy lapses and there are those who only recommend Universal life YRT due to low initial cost of insurance thereby giving the client(s) the opportunity for higher cash values
With SmartWealth, what we usually do is discuss and illustrate these different scenarios and let you decide whichever type of insurance or insurance costing you’re most comfortable with.
What we suggest to our clients is that they should have permanent coverage to cover their permanent financial obligations and a term life coverage to cover their temporary obligations.
For a lot of Canadians, their most permanent financial needs are their final expenses which oftentimes come in the form of:
- Funeral Costs, and
- Final Taxes.
Their permanent life insurance policy can come in the form of whole life insurance or universal life insurance and their term life insurance policy vary in length of coverage depending on their current age and how long their temporary financial needs like income protection are.
Universal Life Insurance - Death Benefit Options
There are basically two types of death benefit options when it comes to universal life insurance policies:
- Level Death Benefit,
- Increasing Death Benefit (Face plus fund)
Level Death Benefit
With a level death benefit, the payout to the beneficiary is fixed and does not change. This can be a good option if you want a consistent payout, regardless of how the policy performs over time. The only drawback is the fact that your cash values don’t get added on top of your death benefit, hence the benefit stays level.
Increasing Death Benefit
With an increasing death benefit, the payout to your beneficiary increases over time. This can be a good option if you want your loved ones to benefit from the policy’s growth potential. If you have the cash flow to fund the policy, this is usually a better option since none of the cash values built inside the policy will be left to the insurance company in case you pass away because the accumulated account value automatically gets added to the death benefit and is therefore paid out to your beneficiaries as part of your death benefit, tax-free.
The computed scenario above is based on an increasing death benefit option.
Universal Life Insurance – Flexibility
One of the key factors of a Universal life insurance policy is premium flexibility as it allows a person to afford an otherwise more expensive life insurance coverage when purchased through a whole life policy.
This flexibility, however, is where the misconception lies…
A lot of Universal life insurance policies are sold and purchased at minimum or near-minimum funding which of course, isn’t a bad thing but calling it a permanent policy gives the policyholders the wrong expectations.
You see, when you purchase a Universal life insurance policy and you’re only contributing the minimum premium doesn’t necessarily buy you lifetime coverage.
It gets you in but if you’re only paying the minimum premiums, you can’t expect that the policy will cover you for the rest of your life that’s why you have to make it a point that your Universal life insurance policy is well-funded.
If you have universal life insurance and you don’t contribute enough premiums to your policy; you don’t have permanent life insurance in your hands, as such policy may eventually lapse, which may behave like a term life insurance policy, which will only stay in force as long as you have enough cash values inside the policy.
In such a case, you can talk to the insurance advisor who sold you the policy and ask how much you need to contribute to keeping the policy in force. Since premium contributions are flexible with universal life, you can “over-fund” your policy to catch up on the years you’ve only made minimal contributions. If you’ve been underfunding your policy in the last 10 years, catching up on over-funding the policy may no longer be an option for many Canadians since the necessary contributions may be too high, in which case, decreasing your universal life coverage or even getting a new policy may be better options.
Understanding A Universal Life Insurance Illustration
Some insurance agents believe that a Universal life insurance policy is only a life policy for the wealthy but that entirely depends on policy design.
As mentioned earlier, a Universal life insurance policy is a flexible type of permanent insurance, not just in terms of insurance costing but with coverage as well.
In essence, a Universal life insurance policy can be both permanent insurance or a term policy depending on funding.
Universal life insurance coverage can be topped-off with a term life insurance as a rider to effectively manage costs and the assumed rates of return to compute the monthly premiums should be as conservative and realistic as possible.
When considering a Universal life insurance policy, always ask to see the actual illustration for your specific policy and make it a point that your illustration doesn’t indicate a lapse scenario even when it’s computed at an average of 3% rate of return.
Of course, you can ask for a more favorable rate(s) of return of between 5% and 6% which are realistic expectations but always make sure that your policy illustration still works even at a low rate of return scenarios like 3% and even 2% if you’re really conservative.
Illustrating your universal life insurance policy at a lower expected rate of return protects your interest as a client as this protects you from potential market downtrends in the long term.
If you want to totally eliminate the risk of policy lapses, you can have your universal life illustration tested at a 0% expected rate of return. This will result in a much higher monthly/annual contribution but you know that your policy works regardless of market fluctuations.
What to Avoid in a Universal Life Insurance Illustrations
If you encounter someone illustrating a Universal life insurance projection at rates of between 8% and 12%, you should avoid this at all costs because even though the cash surrender values look promising in these presumed scenarios, this is not necessarily good for you as a policy owner.
Not only does these type of illustrations give you the wrong expectation(s), these actually jeopardize your policy.
While it’s good to have a positive outlook in life, over-estimating future rates of return is a formula for disaster because if your policy fails to achieve such rates of returns, your policy lapses.
Conservative projection and making sure that your Universal life insurance is well-funded is the key to making a Universal life insurance policy work. If it performs better than the conservative assumptions, then that’s a bonus.
On average, most investments will average between 4% to 5% over the long term. You may have seen 45% growth from last year’s statement, but in reality, it isn’t always the case. Whether you’re investing in stand-alone investments like an RRSP or your TFSA, it is important to understand that you’re investing for the long term and not trying to time the market as no one can really perfectly time the market consistently. The best way to invest is to have a realistic expectation of the long-term market performance. If your money grows compounding on a 5% average return in 10 – 20 years, you will have a lot more money than when your funds are just sitting in a savings account. Again, you can average more but keeping your expectations realistic will help you plan better and will save you a lot of heartaches later on.
How Can Universal Life Insurance Help You Save For Retirement?
As we’ve seen so far, a universal life insurance policy will not only benefit your loved ones in case you pass away. A well-funded universal life insurance policy can help you build wealth for retirement as it allows you to participate in market gains from within your policy.
The best way to use universal life insurance to save for retirement is to use it as a retirement planning vehicle. Instead of only paying enough monthly contribution to keep the policy in force, save a percentage of your income on top of the required contribution to keep your policy as a permanent policy.
When properly funded, you take advantage of tax-free asset growth and your accumulated wealth stays tax-free as long as they are within the policy.
Unlike investment accounts outside a life insurance policy, you can actually use your funds for retirement without withdrawing money from your universal life insurance. You can simply leverage your policy and use another institution’s money to fund your retirement through policy or a bank loan strategy. As you may already know, when you use loans against an asset to fund your retirement, there are no tax implications since you’re technically using borrowed money, which will be paid for by your policy when you eventually pass away.
This goes without saying that you should have enough funds in your account by then, otherwise, such a strategy will not be available to you.
After age 65, most of us will have between 20 to 25 years to live. Many Canadians risk outliving their retirement funds. If you plan ahead and fund your wealth well while you’re young, you must have more than enough funds to supplement your retirement income during your retirement years.
You can book an appointment with us here to learn more about this strategy.
In the meantime, you will have to commit to saving and investing toward buying your financial future, because, regardless of where you invest, you will always have more options at old age than when you didn’t invest at all.
Using universal life insurance for retirement planning is a valid strategy but you have to commit to funding your project while you’re actively working – this means that you have to be comfortable with making larger contributions than what you’re going to pay with a term life insurance policy so you cash values grow tax-deferred over time.
For example, let’s say you’re in your 40s and make $100,000 per year. You could make annual contributions of $25,000 to your universal life insurance policy, which is 25% of your gross income. Assuming a 5% annual rate of return, your cash value would grow to $1,068,289 by the time you retire at age 65, and your life insurance policy’s death benefit will be $1,947,284 by then.
Following the 4% rule, you can start using your policy to do a series of collateral loans with a bank for an annual cost of living allowance of $40,000.00. This strategy allows both your cash values and death benefit to accumulate continuously within your policy, while you’re using another institution’s money.
Keep in mind, however, that your policy’s investments will need to be moved to a more conservative portfolio as most lenders require, and that you will have to pay interest on the money that you’re borrowing (4.5% as of this writing) – and even if you do, you will still save more on income taxes compared to when you’re withdrawing funds from an RRSP or other income sources that gets added to your taxable income.
At the end of your life, the lending institution will have to take their share of your policy’s death benefit but your heirs will still have their legacy.
What Are The Risks of Universal Life Insurance?
Universal life insurance requires long-term commitment, which means that it’s not suitable for everyone. If you need immediate access to cash or can’t handle market fluctuations, universal life insurance may not be right for you.
The most obvious risk of universal life is when you’re only contributing the minimum cost of insurance as you’re technically paying for the life insurance protection and the flexibility of hopefully turning your policy into a permanent one without having to go through the approval process. Unfortunately, for many Canadians who have implemented universal life insurance policies don’t fund their policies either due to a lack of understanding as to how their policy works or that they’re just not in the position to fund the same.
In such a case, I would suggest getting a smaller amount of universal life insurance death benefit, which can easily be funded in a 20-year period. This can be top-off with a term life insurance policy (as a rider), which allows you to have the coverage you need now and the coverage you need in the future, without necessarily breaking the bank, plus also have the growth potential and the option to withdraw more funds than what you’ve contributed into the policy later on in life.
The amount may not afford you to retire but if you’re fairly young, your cash values are usually more because your cost of insurance is lower, provided, of course, that you’re considered non-smoking at the time of the application.
To explain further, “lapsing” means, running out of coverage. It’s like when you don’t renew your 20-year term life insurance policy on the 20th year. You will no longer have coverage. That’s why it’s important to have a well-funded universal life insurance policy.
If you’re minimum-funding your policy or you’re slightly funding it. You have a universal life insurance policy, which may or may not last you a lifetime of coverage that’s why it’s important to go back to the actual life insurance illustration that you signed when you first applied for the policy. All the other illustrations your agent showed you don’t matter – it’s what you signed that matters.
Underfunded universal life insurance, isn’t the end of the world of course, provided that you’re still young, you can still use it to build wealth over time, or at least to have permanent life insurance.
Universal Life Insurance - The Bottom Line
Universal life insurance is an excellent life insurance policy and it can also be an excellent way to build wealth for retirement but like any other financial product, it isn’t for everyone. If you’re considering universal life insurance, it’s important that you understand how the policy works. Know that you are indeed overfunding your policy, either for it to stay in force as permanent life insurance (unless of course when you cash it out) or as a vehicle where you can build wealth upon.
The rates of return in a universal life insurance policy aren’t guaranteed and if you’re invested in equity portfolios, understand that they do fluctuate but a proper understanding of the markets is important if you’re looking to build wealth in the market because while the market goes up and down, the general trend is always upwards – hence, the market will always bounce up.
The worst case that you can do in any of your investments during market downtrends is to close your account or withdraw your funds because you’re no longer in the market.
Whether you’re investing funds inside universal life insurance or in a stand-alone investment such as a non-registered account, a TFSA, or an RRSP, always keep in mind that investing requires long-term commitment and that it isn’t a get-rich-quick scheme.
Universal life insurance is a life insurance policy with an investment component. The investment component is what allows you to grow money, tax-free from market gains and it remains tax-free as long as it stays inside the policy. The death benefit is of course, always tax-free.
There are several ways in which universal life insurance can be utilized. It can be purchased simply as a permanent life insurance policy, with planned premium contributions of say 10 or 20 years. After which, you can stop your contributions and have permanent life insurance that will last you a lifetime.
You can also leverage the policy’s wealth accumulation feature to build wealth and invest from within your policy as explained in this article.
If you are looking to implement well-planned universal life insurance for yourself and your loved ones, please don’t hesitate to book an appointment with us here. We will help you design a policy that works for you, your situation, and your future goals.