Ben Franklin Made a Mistake

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:

  1. A nicely balanced portfolio of secure assets. Highly secure bonds, high quality mortgages and comparatively high rate loans against policy values, (Fully secured. You borrow your own money. Hard to have a default) are typically more than 80% of all assets in the pool. The other 20% includes cash, some high quality equities and possibly a little real estate.
  2. Exceptionally small management expense ratio. Typically less than 0.20% of assets. Better yet the management fee is limited by the government and is a percentage of earnings not assets. The insurer has billions of assets and they have skilled people who treat this pool as only part of their overall management task. Think economies of scale. A large insurer buys huge quantities of fixed income assets. Per dollar of principal, their costs are insignificant compared to the costs an individual will incur.
  3. Growth in the policy is a function of two things. Guarantees and experience. First the growth in cash value that is guaranteed is usually not large. Second, add to that the “dividend.” This is not like a dividend on a stock but is more like a patronage dividend at a co-op or credit union. A share of the profit. It is the policy owners share of the excess profit that was earned above the guarantee. It arises because the insurer’s “experience” was better than that guaranteed in the policy. Death benefits paid were a bit less, expenses were a bit less, income was more, some people lapsed their plan and lost some money in so doing.

The Asset Class. So what are the characteristics? An asset class that:

  • grows but does not produce taxable income to the owner while doing so
  • the proceeds of which, avoid probate, thus saving costs and providing privacy
  • that is capable of being used as security since it is highly liquid,
  • provides fixed-income-like performance
  • has very low volatility
  • provides a little mix of equity
  • provides it all at very low cost
  • includes a performance kicker based on bio-tech developments

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.

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