In retirement planning, complexity is not sophistication.francescoch/iStockPhoto / Getty Images
I recently watched a video on LinkedIn in which an insurance advisor argued that Canadians should avoid tax-free savings accounts (TFSAs) and registered retirement savings plans (RRSPs), claiming “the wealthy” instead opt for cash-value life insurance to generate “tax-free“ retirement income.
Despite the flashy video editing, I wasn’t so easily deceived. Nor were the dozens of financial professionals who took to the comments section to issue their concerns. The poster has since deleted the video, but it remains a standard sales pitch.
The strategy of borrowing against permanent insurance policies is known as an insured retirement plan (IRP). It’s frequently sold by insurance agents who lack a securities licence or an extensive background in financial planning. Consequently, they steer clients toward the one product for which they’re compensated: life insurance. To a hammer, everything looks like a nail.
On paper, it’s attractive. The client purchases a permanent insurance policy – usually whole life or universal life – and makes large premium payments for a set period, often 20 years. These premiums build cash value that grows over time through dividends or investment growth.
At retirement, rather than withdrawing the money, the client pledges the cash value of their policy as collateral for a bank loan. The interest is capitalized and added to the loan balance rather than paid out of pocket. Because loans are tax-free and insurance death benefits are often tax-free, agents market this as a retirement planning panacea. These are the secrets of the rich, they say, and now you can have them too.
But the pitch relies on many assumptions. Variables are projected decades into the future, and the selling agent chooses those variables – often without thorough analysis of their client’s unique situation. Variables such as rates of return, future tax rates, mortality ages and borrowing costs can be chosen to make the insurance policy appear better than the alternatives.
Insurance agents often compare this strategy against a guaranteed investment certificate taxed at the highest marginal rate, assuming the client has no other tax-efficient options with higher expected returns. They frequently use mortality dates lower than FP Canada’s guidelines and project stable, linear investment returns over 50-plus years.
Each of these variables should be stress-tested to present clients with various scenarios.
The risks in the borrowing phase are rarely, if ever, discussed. Illustrations assume stable policy returns and interest rates for decades, but policy returns, bank loans and lines of credit are variable. If returns are low or loan rates remain high, the compounding loan balance can hit the bank’s loan-to-value limit, triggering the bank to call the loan.
That creates a death spiral. To pay off the loan, the bank forces the borrower to withdraw the policy’s cash value. When doing so, any cash surrender value in excess of the adjusted cost basis is taxed as ordinary income. In one fell swoop, the client’s retirement and estate plans are ruined, leaving them with no insurance, no retirement income, and a residual debt.
The strategy also ignores human behaviour. These policies are often sold to younger clients who assume their risk tolerance and comfort with debt are static, but it’s common to underestimate how much our preferences will change (what psychologists call the “end of history illusion”).
As we age, our willingness to take risks generally declines, and few retirees are comfortable carrying millions of dollars in debt, regardless of what the spreadsheet says. In fact, studies show that seniors who carry debt in retirement experience increased financial stress, which can worsen health outcomes.
Beyond the apparent conflicts of interest, there’s real danger here. Salespeople rarely explain the “death spiral” risk and often leave the industry long before the client retires. To dismiss the simplicity and effectiveness of TFSAs and RRSPs in favour of a complex, leveraged insurance product is naive and egregious, and can put Canadians in serious financial jeopardy.
Part of the problem is training. Many insurance agents are educated solely by the distribution firms that employ them, leading them to genuinely believe they’re doing the right thing for their clients. But any objective financial planner will tell clients that an insured retirement plan is rarely – not never, but rarely – optimal. That an insurance agent miraculously finds only those clients for whom this strategy is optimal is statistically impossible.
I recently reviewed a case in which a wealthy professional was sold several universal life policies for this exact purpose. The strategy was further complicated by the fact that a corporation owned the policies, yet the plan relied on the shareholders borrowing personally.
The agent allegedly failed to explain the additional costs and tax risks of using a corporate asset for personal benefit. Worse, just 10 years into a 50-year projection, the investment fund was already 30 per cent below its expected value. If that gap persists, the client’s retirement will look nothing like the rosy tax-free plan hand-scribbled on the application.
I don’t mean to paint every insurance agent with the same brush. I have worked with brilliant insurance strategists who put clients first and do incredible work. Unfortunately, insurance regulation rests on a “suitability“ standard, meaning agents don’t have to provide you with the best option, just an option. It’s a low bar, akin to a car salesperson selling me a luxury SUV instead of a lower-cost sedan, as both can get me to work.
In the life insurance industry, six-figure commission cheques await those willing to sell these complex plans. Overcoming this incentive requires monumental integrity. In my experience, few meet this high bar.
Ultimately, complexity is not sophistication. The wealthy are not hoarding the secrets that made them rich, fearful that ordinary Canadians will discover them. But it sure makes for compelling marketing.
Mark McGrath is the founder of Phynance, a fee-for-service financial planning firm focused on physicians based in Squamish, B.C.