First steps to financial literacy
Life insurance and related products come in many different variations. These include life insurance policies, segregated funds, and annuities. Sometimes, it seems, there are too many variations, most of them confusing and seemingly designed to be as obscure as possible. However, they do serve a good purpose in hedging against various types of risks at different stages of life. So it makes sense to understand the basics.
Term-life. These policies offer pure protection – there is no investment component. You pay your premium and your life is insured for the stated amount for the specified length of time, the “term” of the policy. At the end of the term you may either renew it for another term, convert to a permanent life policy, or terminate the policy. Term life is a cost-effective way to buy insurance, especially for young families.
Permanent insurance. Broadly speaking, with permanent life policies, you pay premiums on a monthly basis for a specific period of time, but the premium payment funds both an insurance component and an investment component by which the policy gains a cash value. The growth in cash value is tax-deferred and can be used as collateral for a loan or can be withdrawn to fund other financial goals.
There are basically two forms of permanent life insurance: whole life and universal life. The premiums for these are considerably higher than for straight term life insurance. Both whole life and universal life policies provide protection, grow your investments, and defer tax. Upon death, your beneficiary will receive the amount of the insurance policy tax-free, as well as any accumulated savings components, which would be subject to tax. But there are key differences.
- Whole life locked in. As the name suggest, “whole life” insurance does not have a term, and stays in force until you die. It has level premiums that fund both the insurance component and the investment component that builds up a cash value.
In a whole life policy, you have no choice over the investment component. The insurance company will invest the funds at a very conservative rate, and it takes a long, long time to generate positive returns. There is also some risk involved, as you are investing your money with a single company. Canadian banks and insurance companies are among the most financially sound on earth, but you still have to be aware of the risk involved, however small it might be.
- Universal life for some flexibility. Universal life also offers both insurance and investment components, with the key difference that you can alter the premiums, size of death benefit, and amount and type of investment component (as specified by the policy) if your life or financial circumstances change. In addition, unlike whole life insurance, universal life insurance allows you to use a portion of your accumulated savings to pay premiums. The major advantage to this type of policy is that you have control over the investments.
When you are ready to withdraw money from the investments held within the policy, the cost base is equal to the sum of all your premiums – the amount used for both the insurance and investments. This will increase your cost base, so you will pay less tax once you sell your investments within the universal life insurance policy.
Segregated (“seg”) funds
These are investment funds that look like mutual funds but are in fact insurance products and are regulated by provincial life insurance legislation. Your premiums (net of fees) are invested in the segregated funds of an insurer, which, in turn, invests the money in such securities as stocks, bonds, and money market investments. Insurance companies often team up with mutual fund companies to provide a “branded” seg fund whose investments are identical to an existing mutual fund.
The twist is that the seg fund provides a principal guarantee through a life insurance component, typically between 75% and 100% of your principal at the end of a specific period of time, usually 10 years or at death. Seg funds also provide protection from creditors and avoid probate (because of their characteristics as an insurance policy), while mutual funds do not. Average MER for seg funds is much higher than for mutual funds, ranging between 2.5% and 6%, in order to pay for that insurance coverage.
While not a life insurance policy, an annuity is a financial product that provides a guaranteed stream of income. Because of the “guarantee” factor, these products are typically sold by insurance companies. When you purchase an annuity, you essentially buy a contract under which the issuing company (usually an insurance company) invests the lump sum you provide and guarantees a regular payout with interest over the life of the annuity contract. Typically, monthly annuity payouts are quoted per $100,000 of the contracted amount. Very simply, an annuity provides a guaranteed income stream for life. Annuities are sometimes used as an RRSP maturity option; however, annuities have been less popular for this purpose in recent years, owing to the historically low level of interest rates.
Insurance products can be frustratingly complicated. It’s always best to consult an independent objective financial advisor with insurance-related credentials and experience who can help you decide the best product for your needs and objectives.