This is a topic that comes out of the woodwork, almost every three or four years. Almost like clockwork, at least since I’ve been in the business. The scenario is this, I get a call from a client or a prospective client and they proceed to tell me about this new strategy that they are being pitched that usually projects higher or more consistent rates of return than an RRSP and is “Guaranteed”. Amazed (skeptical?), I listen on. Perhaps folks are looking for some sort of validation, but I’m always keen to learn about how the strategy is being presented (pitched) and by what firm. The answer most always is the same, the pitch is usually a variation of the Insured Retirement Plan. The Insured Retirement Plan allows you to pay an insurance company a premium and then eventually borrow against the policy cash value. There is absolutely nothing wrong with this strategy, BUT it can have a lot of moving parts and is certainly not for everybody. Moreover, I am it being improperly sold time and time again, which leads me to the writing of this blog.
While multiple strategies exist using an insured retirement plan, the basis of this strategy is to eventually leverage the insurance policy itself and borrow against it in retirement or at a future date. In this case, the policy itself becomes security for a collateral loan. Further, the earnings on the money placed within the insurance plan itself and the loan are considered non-taxable.
So why doesn’t everybody do this? Well, because its not designed for everybody…
As a Chartered Life Underwriter, I am well versed on the Insured Retirement Plan (IRP) and its advantages (and disadvantages). A Universal Life or Whole Life Insurance policy is purchased which projects to have cash values at a later date either by way of investment earnings or dividend cash value. Later on, instead of cancelling the policy and withdrawing the cash (which may trigger a taxable event), a collateral loan is taken out which uses the cash value of the policy itself, thereby leaving the policy itself and the cash value intact. The policy death benefit guarantees the collateral loan, and any residual money over and above that loan would be paid to the beneficiary or estate. A collateral loan is never permitted to exceed the cash value of the life insurance policy; therefore policyholder can feel confident that the death benefit would be sufficient to cover the loan obligations. This reduces risk to both the lender, the insurance company, and the policyholder. At the same time, if interest rates rise and the loan holder is not paying 100% of the loan payments, the policyholder needs to be aware that they may have to put up additional collateral or make additional loan repayments to this plan. As I said, there are lots of moving parts to an IRP.
So lets back up for a minute then..What are some reasons why a client would want to do this?
Most Saskatoon financial planners will tell you that it is generally good practice to maximize your RRSP and your TFSA before you look at alternative strategies such as the IRP. This is not to say that an IRP should not be considered at the same time you’re putting money into an RRSP or TFSA; however generally the latter should take precedence. While an IRP could offer a supplementary retirement income, it is first and foremost an insurance policy that provides a tax-sheltered investment environment.
For 2021, the maximum RRSP contribution limit is 18% of your earned income to a maximum of $27,830. Add in a $6000 TFSA contribution and you are looking at $33,830 of tax advantaged retirement savings opportunities. As you can imagine, an IRP would be best suited to an investor who has an insurance need, AND has the ability to invest money over the basic annual RRSP/TFSA contributions. Generally, in this scenario, the ideal client would be a higher net worth investor or high income earner that is maximizing other tax strategies.
Not everybody is able to invest in an RRSP, however. Those individuals may take dividend or investment income instead of salary income. Individuals with a high salary and good pension plans may receive a pension benefit adjustment which prohibits much of an extra contribution to an RRSP. There are also some people who just don’t like the RRSP as an investment strategy, and that’s okay too! In those cases, a combination of a TFSA and IRP might be suitable, so long as there is an insurance need. For an incorporated person, an Individual Pension Plan (IPP) might be a great idea in combination with a IRP and TFSA strategy..More on an IPP another day..
There are drawbacks which should be taken into consideration before purchasing an IRP.
- The loans associated with the IRP carries a prescribed rate of interest. Even though the lender will not allow the loan to exceed the policy’s cash value, it is important to note that the interest does accrue on an annual basis and the investment earnings and/or cash injections need to be satisfied to keep the loan on side. Failure to do so could result in a reduction of the available credit limit and even worse, a possible calling of the loan.
- Laws change, taxation changes, lending practices change. The risk with all insurance strategies is that the strategy itself does not stand the test of time. While we have been very lucky in Canada to be afforded some ‘grandfathering’ rules with regards to insurance policy taxation, the same does not necessarily hold true for lending on these policies or future tax rules. One should be aware that if the IRP is a major component of the retirement plan, there is a risk that changes in lending practices and/or tax laws could prevent access to the strategy in retirement.
- If you are a high income earner that has maximized his/her RRSP and TFSA and is looking for alternative strategies, an IRP might be a great compliment to a financial plan.
- Some firms think its acceptable to use high interest rate assumptions on insurance illustrations (8-10%+) which will make the IRP strategy look really appealing. Using these high interest rate assumptions is not generally recommended as it can lead to clients making investment decisions based on returns that are not sustainable. Ask your advisor to use a 4-5% interest rate on all illustrations, and then see if the IRP strategy still makes sense.
- If you do not maximize your RRSP/TFSA currently and are approached by an ‘investment opportunity’ that ONLY costs $150 a month called an ‘insured retirement plan’, turn around and run as fast as you can. (well, first grab the sales illustration and then come see us)
Always ask yourself before purchasing an insurance or investment product, who is benefiting more from this transaction: me or the advisor?