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Differences between universal and whole life.

The use of Universal Life Insurance Policies may be beneficial for those who had used up their RRSP limits or whose taxable income was so low that they did not get a meaningful tax credit for RRSP contributions.

First, there are essentially four parts to both whole life and universal life insurance policies.

Mortality Cost – the part of the deposit that covers the pure cost of the life insurance death benefit. We recommend that this cost of insurance be level or the same over the insured’s lifetime.

Administration charge – this is the charge for administering the policy and premium tax.

Savings and Investment. This is what is left from your deposit after the above two charges – the cost of insurance and the administration charges are deducted. You will have been provided with an illustration of how your savings will grow – it is frequently referred to as the “Cash Value”, “Fund Value” or “Cash Surrender Value” of your policy.

Return on the savings – this is the interest rate that is credited to the cash value in your account each year.

In addition, some policies guaranty that the above costs will not change and a minimum return on investments.

Whole Life Policies were designed to provide permanent insurance (the kind that you plan to have when you die) plus have guaranteed and non guaranteed savings components at a single monthly premium. There has been a lot of this product sold over the years.

Whole Life Insurance has a level cost of insurance where the costs do not increase each year – what you pay in the first year is the same as in the last year but theydo not disclose the cost of insurance. They also do not disclose the administration costs. After the “cost of insurance” and “administration costs” are covered, the balance of the premium is the savings or investment portion. The returns on the savings or investment part is dependent upon excess interest and investment earnings, savings in mortality costs, and in the operating expenses, and the will of “the insurance company board of directors”for the dividends in a participating policy, they choose what they will pay.

To summarize, Whole life has the benefit of having a minimum guaranteed return (Cash Value), and a guaranteed level premium, but the policies do not disclose the cost of insurance, the administration costs, or how they calculate the returns on your savings portion. You can not choose where the money is invested and they do not disclose the return your money is earning. You will have an illustration showing a guaranteed “cash value” and another cash value which reflects none guaranteed projected returns. On the other hand the premiums are guaranteed, and they usually have a guaranteed cash value.

Universal life insurance policies were designed to provide an answer to the notion that you should “buy term insurance and invest the difference”. With the added benefit of making the income of the investment tax sheltered, In addition it provides an answer to some of the complaints about Whole Life Insurance’s failure to disclose how the premium is allocated between the cost of insurance, administration costs, and investment portion and to provide investment options that you can choose.

In a Universal Life Insurance Policy, the mortality charges are disclosed and, The administration charges are also identified and frequently guaranteed not to change for the life of the policy. They are generally in the $100 to $125 per annum range. Consequently, the cost of insurance and administrative costs can be shown on the illustration, but usually they are YRT (Yearly renewable term) which means that the premiums are not guaranteed, but there are also policies with guaranteed level premiums.

It is the investment options inside a Universal Life Policy that have grown dramatically over the past years. While some of the older policies did not disclose how the returns were calculated, the newer ones are offering a list of investment options that have similarities to mutual funds. In fact, some are designed to provide returns that mirror well known mutual funds and they are managed by mutual funds managers. Examples include Standard and Poor Index Accounts, Canadian Index Accounts, Canadian and American Equity Index Accounts, Bond Index Accounts, and 1, 5, and 10 Year GIC Type Accounts.

The returns inside an insurance policy are generally slightly lower than mutual funds will generate but they have four significant advantages compared to mutual funds.

1) The funds grow tax-free – you do not pay any income tax on the growth. This is similar to an RRSP; however unlike RRSP’s there are ways to have the use of the money on a very tax favored basis.

2) You can invest 100% of the savings/investment component in an index where the returns are based on the performance of an index outside Canada. Options include S&P Indexes, American and Global Equity Indexes, and Bond Indexes. Some indexes are tied directly to the performance of well known mutual funds with one policy offering access to indices that emulate over 400

3) The funds are “creditor proofed” if the policy is set up properly. Creditors can not get at the funds inside this policy, which is important for many business owners and others who are concerned about lawsuits.

4) If the policy is set up properly, the entire investment account plus the face value of the insurance policy goes to the beneficiary tax-free on death of the insured. There are not even any Probate Fees. The same applies to a whole life policy but the cash value may or may not be paid in addition to the face value depending on the type of Whole Life Policy.

Here is an example of the different tax treatment on money in an RRSP and a Universal Life Insurance Policy on death. Let us assume that Peter had $100,000 in the investment part of a Universal Life Insurance Policy and $100,000 in a standard mutual fund and died. The entire investment account of $100,000 would pass to Peter’s beneficiaries (provided they were identified in the policy) together with the face value of the policy with no taxes or probate fees. Further, the check could be issued within a few days of proof of death. The same applies to the Whole Life Policy with the caution of point 4 above.

The mutual fund $100,000 would be subject to both income taxes (likely at a tax rate of about 43%) and probate fees and the funds may not be released until after the estate has gone through probate and has been settled.

It is said by experts that Universal Life Insurance Policies are being used for estate planning as much as they are for meeting traditional insurance needs. There are numerous tax saving and estate planning strategies that utilize this type of insurance.

It may be advantageous to stop contributing to an RRSP when you believe that you already have sufficient RRSP funds for retirement and set up a Universal Life Policy. It should be noted that consideration of whether this strategy would be of benefit and then when to start it, should be part of your retirement and estate planning process.

The face value of the policy can cover anticipated estate taxes and a savings component grows tax-free and will pass on to your beneficiaries without the probate fees and a potential 50% tax hit that the RRSP funds experience. You can still get at the money in the savings portion if it becomes necessary but in a significantly tax favored basis compared to withdrawing money from an RRSP. The downside is that you do not have the tax credit that you have on your RRSP contribution but it still may make sense from an estate planning perspective.

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