For an investor who has maximized their other tax efficient retirement savings vehicles, the insured retirement plan can provide an excellent stream of after tax retirement income.
Life Insurance as an Asset Class – Better than Fixed Income?
Working with a financial planner, you will have your assets in a variety of asset classes. Equities, real estate, perhaps some speculative, and almost certainly a small amount of fixed income – commonly bonds.
The intention behind mixing these asset classes is diversification. By diversifying asset classes that are either negatively correlated or non-correlated a number of benefits results. The most obvious one is smoothing of returns (reduction in volatility). If equities drop substantially, asset classes that are negatively correlated will increase.
Using life insurance as an asset class is often overlooked, but can potentially increase your investment returns. Noteably, life insurance policies are expected to compare very favourably against bonds. In this example we’re going to compare bonds and life insurance policies in terms of potential returns and guarantees. The conclusion is that life insurance policies can be used in place of your bond allocation in your investment portfolio, providing diversification, better guarantees, and potentially greater returns.
This strategy works due do the tax free nature of death benefits (and by comparison, returns on bonds at some point will be taxed).
The strategy is straightforward. A life insurance policy is purchased and maintained for life. Upon death, the death benefit is viewed as the after tax investment return. While we don’t know when you will die, we do know that given a specific year that an after tax rate of return can be calculated – and that those rates of return are expected to noticeably outperform bonds.
Requirements for this strategy to work:
- You have a portion of your portfolio on bonds, and are OK with redirecting part or all of that allocation to a life insurance policy.
- You have no expecation of ever needing the funds (the life insurance premiums) during your lifetime.
In the following example we’re going to purchase a life insurance policy. Then, based on a particular age at death we’re going to calculate the rate of return should you die in that year. Those returns are what will compare favourably against expected bond returns.
Guarantees – life insurance vs bonds
Returns from a guaranteed life insurance policy will be better than a comparable bond investment. Bonds are often considered to be relatively safe in the sense of being non-volatile, however their guarantees over long timeframes are non-existent. If you invest in a 5 year bond, the returns over the 5 years may be guaranteed. But in year 6, you’ll need to invest in bonds, at the prevailing rate of return at that time which are not guaranteed. So while bonds may be guaranteed in the short term, they are not guaranteed in the long term.
By contrast, a guaranteed life insurance policy is guaranteed in the long term. For any particular year of death, we know the guaranteed premiums and the guaranteed death benefit, and can thus determine a guaranteed rate of return. Given a year of death, these life insurance returns are guaranteed.
A non-guaranteed investment should be expected to return a better return than a guaranteed investment, but in our following example we’ll see that this is actually not expected to be the case (life insurance policies will have better guarantees, and be expected to have a better rate of return than bonds).
Life Insurance as an Asset Class Example
We’re going to purchase a permanent life insurance policy with premiums of $50,000 guaranteed for 10 years (after which no premiums are due). The insured is a male age 50, non-smoker in standard health, and purchases a $1,245,000 life insurance policy.
Sort of a good news bad news strategy – the earlier you die, the better your rate of return is. More importantly, the comparison here isn’t immediately which one of those specific returns the insured will receive. Instead the comparison is against long term bond returns. As of time of writing, Bank of Canada lists long term bond returns as 2%. Without going into specifics, the 2% return on bonds would be expected to be taxable in some fashion, resuling in a <2% long term rate of return. At a life expectancy of age 80, we can see that a life insurance policy would potentially return almost twice what a long term bond yield would likely yield.