Back in mid-1990's the insurance industry came out with a new concept called the Insured Retirement Strategy. The idea is that you build tax-deferred investment values inside a life insurance policy during your earning years. Upon retirement, rather than withdrawing funds from the insurance policy (which would trigger taxes) you instead use the policy as collateral for a bank loan. In other words, you get your cash from the loan instead of the policy, thus minimizing taxes. The loan simply accumulates and is paid off by the proceeds of the life insurance policy when you pass away.
Here's an example.
You purchase a Universal Life Insurance policy at age 45. Over the next 20 years you accumulate $1,000,000 inside the policy, tax sheltered. Upon retirement, you use this million dollars as collateral to withdraw $50,000 every year. The $50,000 is of course tax free (because it's a loan). The loan accumulates with interest and when you pass away your $1,000,000 insurance policy pays the bank off for the loan.
The pitfalls of the Insured Retirement Strategy
If you are being pitched with this concept, it's important that you assess the risks. The insurance industry will provide you with lots of information on the benefits of this strategy so I'll skip that. Insteat lets look at some of the risks and pitfalls that you should consider.
- High MER's and DSC: The life insurance policy investments used in this strategy can have much higher MER's (expenses) than comparable investments outside an insurance policy. They also frequently have deferred sales charges (DSC). In layman's terms that means you make less money and have less flexibility.
- RRSP's and pensions are better: Insurance industry brochures will suggest that Insured Retirement is suitable for those who have maximized their RRSPs. The corollary to that is that you should only consider Insured Retirement strategy after you've ensured your RRSPs, TFSAs and pensions are all brimming full. To put it another way, Insured Retirement should not be a pillar of your retirement planning it should only be a secondary or additional option.
- CRA Risk: The strategy works because you're accumulating funds inside a tax sheltered investment and then effectively accessing them without triggering taxes. The CRA has some stringent rules about doing stuff that takes advantages of tax loop holes. The insurance industry suggests you can mitigate this risk by ensuring you have an actual need for the life insurance. Still, the CRA could change the regulations in the years between now and when you retire and prevent you from using the insurance policy as collateral. How likely is that? There's no way to measure, however it may be worth noting that you can't use an RRSP as collateral on a loan.
- Interest rate risk: It's clear to most of us that there's some risk inherent in the investments as they grow. But what about the interest rate on the loan upon retirement? The banks will only let your loan grow to a specific percentage of your collateral. With a high interest rate on the loan at retirement, the amount of the loan could outstrip the value of the insurance policy, forcing the bank to call the loan. Now instead of taking a tax-free annual payment, you're stuck coming up with a huge chunk of money to pay off the loan early – probably requiring you to cancel the policy and pay the taxes on all that money you've been sheltering.
- Bank risk: You diligently build the investments over 20 years, then hop into the bank to take your first loan. The bank informs you that the rules have changed – and not in your favour. Perhaps instead of letting you take a loan of 75-90% of the value of the policy they now cap it at a maximum of 50%. Or maybe they've been burned at some point and simply refuse to use a policy as collateral. Either way, what's going to happen with taxation, banks, and insurance in 20 years is unknowable, and that brings some risk into the process.
In the end, Insured Retirement Strategy can look attractive for the right investor. But be careful that you have the financial wherewithal to weather the storm if things change to your detriment. If you're looking at the strategy, remember this should only be considered as a secondary strategy after RRSP's and TFSA's. And always do a worst case scenario check – what happens if none of this comes about as projected?