On the 13th of November 1789, Benjamin Franklin wrote a letter to French scientist, Jean-Baptiste LeRoy. A famous, but erroneous, maxim is found therein. Translated from the French, “Nothing is certain except death and taxes.”
Why is that erroneous?
The reality is that taxes are not payable if you organize your affairs correctly and you die. The maxim should read, “Nothing is certain except death
and or taxes.”
Here is how you create the”properly organized affairs” situation.
The tool. A permanent life insurance plan. Could be any of Term to 100, Universal life or participating whole life. The choice will depend on your circumstances so talk to someone who knows. The point is the policy must be in force on the date of death.
The mechanism. In Canada the proceeds of a life insurance policy on death, where the policy is “exempt” as defined, are not subject to taxation of any gain that may have accrued. That means the money invested in the policy will grow without taxation of accruing income, also a definitional restriction, and will eventually be received by the beneficiary without tax.
The result. In respect to a participating policy (PAR), thought of solely as an investment, perhaps even a different asset class, the assets are held in what is called the PAR pool and they have some interesting attributes. These include:
The Asset Class. So what are the characteristics? An asset class that:
Kicker based on bio-tech developments? Say what?
Let’s suppose the company has assumed that a given person will live 35 years when they initiate the policy. Let’s suppose that there are thousands of these policyholders. Let’s suppose that 35 years from now there is a PAR pool of $1 billion to support the liability. Let’s suppose interest is 4% and by 35 years from now, life expectancy has become 2 years longer because of bio-tech advances. 4% of a billion for two years is about $81 million of extra return because people live longer. If you just bought identical bonds and other assets,and incurred almost no expense to do so, you could not have this $81 million. Thus a bio-tech kicker.
If bond rates go up sharply, returns on the PAR pool will follow, but not as quickly. Over time, the average rate on the portfolio will be the same as the average rate of a similar bond fund. But rates don’t change with market conditions. They change as new bonds and mortgages are acquired. Accounting for the pool includes a smoothing factor so rates will parallel but not exactly match the bond market. Plus large insurers have a significant unallocated reserve to cushion changes.
What’s the downside?
You might be one of the unfortunates who poorly estimated their ability to pay premiums for the required duration. Other than that, not much unless you are using policies issued by a company that is not big enough to perform or who may leave the market.
A recent case involved cutting out part of a fixed income asset portfolio and investing it over time into the policy. If the insured lives 5 years past life expectancy, the projected return on the money invested is more than 5% after taxes. At death 5 years before life expectancy it is more than 6% after taxes. Assuming no change in the underlying yield on bonds and mortgages. Higher if rates go up. Less if they go down.
Pretty difficult to get that anywhere in the real world.
The client pointed out that prior to now, he had thought Ben Franklin a skilled commentator so maybe he was also wrong about death being certain. I hate to tell him that if death is avoidable, then the taxes become certain again. Thus the “or”
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. email@example.com