Some people reject life and disability insurance, and they may be right, if they are alone or have minimal means or the people around them are financially independent or, God forbid, if they don’t care about other than themselves.
There are two types of life and disability insurance needs one may have. First, there may be an income replacement need in the years when you have limited assets and your surviving family would have substantial income needs. The second reason for life insurance typically may come later in life, when you had accumulated significant assets. Due to the timing of taxation on capital gains, you may reasonably expect to accumulate a substantial tax liability triggered by death and payable shortly after by your estate. If the size of this expected future tax liability is large and could only be satisfied with the sale of a valuable asset, which you prefer to retain by your heirs, the most straightforward solution may be to purchase permanent life insurance for the expected tax liability in the future.
Insurance for Income Replacement
Before the age 40 and, for most of us, prior to accumulating substantial assets the biggest financial loss that your family would suffer, should anything happen to you, is the loss of your income.
If you have a family and you have a huge mortgage, relatively small savings in RRSPs and TFSAs and substantial debt on a line of credit or credit cards, if anything happens to you, your family will have to adjust its lifestyle drastically. What I mean about “anything happens to you” is that either you are disabled or passed away in a car accident or due to a serious illness.
To reduce the financial risk of the above kinds, it is wise and straightforward to purchase life insurance and disability insurance on the income earner(s) in the family. Purchasing the proper insurance coverage ensures that, if anything happens to you or the other income earner, the surviving spouse or partner and children, before finishing their education, if any, will not have to drastically alter their spending habits and lifestyle.
The first question is that: how much life and disability insurance you need while you are relatively early in your working life, with a young family, relatively low net-worth, sizeable debt level and significant income loss if anything would happen to render you disabled. The need for disability insurance is relatively straight forward. You usually need around 60% of your regular before-tax income in case you are incapacitated. Note that if you pay your disability insurance premium yourself, the income you get from your disability insurance is tax-free, so 60% of your gross income typically is sufficient.
In case of death, you need to calculate the sum of the annual income shortages until retirement. In summary, for your surviving family to carry on with the same lifestyle, or close, I would estimate the yearly shortfall of incomes, between the expected and needed after-tax incomes to maintain the same lifestyle, for each year until retirement and sum them together.
To understand this more clearly, consider the following example: Jane and John are both 40-year-olds and make $80,000 gross income per year and they have two twins who are 5-year-olds. They want to provide for their children’s university education, which they believe will cost $100,000 per child in today’s dollars. The best estimate of how much life insurance coverage each parent should have, on their own life, I would calculate $60,000 per year for the next 15 years until the kids will start their university and retirement will altogether be close to $900,000 plus $200,000 for the kids’ education in total $1.1 million. Since I believe that the insurance proceeds will be enough to accumulate savings for retirement and after the kids finishing university there is not much need for any more additional income. If you want to be even more generous for the survivor you should insure your mortgage, but that is probably not necessary. This insurance need will have to be periodically adjusted, typically downwards, as you get older and will likely accumulate more assets and retirement will be continuously closer. The above insurance needs are temporary as they are being reduced, eventually to zero, as you advance in age and also accumulate assets and get closer to retirement.
The actual actuarial cost of insurance is increasing every year (see table below). When you are younger you can buy the so-called term life insurance relatively cheap, but as you age it will become progressively more expensive. The most common insurance type is Term 10. Term 10 insurance premiums are calculated on a level premium basis for 10 years and will increase exponentially every 10 years until your age of 85 or death.
Regardless of the age of the life insured at purchase, the premiums in the first 10 years are quite cheap but will become very expensive at the age of 60 or older. Because they are becoming progressively more costly they are rarely kept beyond retirement. However, as you age the need for income replacement will eventually decline to zero for the following reasons: 1) you get closer to retirement; 2) you, presumably, accumulated assets for drawing an income after retirement; 3) your previously dependent kids are either independent or close to it.
Insurance for Estate Planning
In addition to the need for life insurance for income replacement, there may be a need for estate planning that is covering the anticipated tax consequences of death. This is mainly for the tax on capital gains triggered by death resulting in deemed disposition for the estate. These capital gains may stem from owning real estates, like cottages or rental properties, that experienced substantial gains since they were bought, non-registered investment portfolios invested in stocks with substantial not-yet crystallized capital gains and significant gains in values of privately held corporations. Depending on your situation, these taxes can be quite large and increasing over time. Whether you are concerned about the taxes on your estate is a personal preference, some people do and some don’t. But, it is essential to note that having no life insurance for future expected capital gain taxes could have severe consequences for your heir(s).
For example, if you own a successful privately owned corporation, the value of it will be assessed for the estate and taxes will be levied on the deemed capital disposition of the business less its adjusted cost base. If your heirs want to carry on with the business, this sometimes could be quite tricky. For example, if your incorporated business was worth $10 million at death and you built it up from scratch the taxes that need to be paid by the estate to CRA will be roughly $2.5 million. If your liquid financial assets like cash, non-registered investments, RRSP/RRIF and TFSA assets combined with your heirs’ liquid assets have substantially fewer funds to pay this and also they are unable to borrow a sizable difference, they may be forced to sell the business to pay the taxes.
If you care about the sometimes very substantial tax consequences of your death, the only way to cover for it is to buy life insurance for the expected tax consequences of your estate. When you are considering calculating the anticipated tax on capital gains the amount will likely increase over time. To estimate the annual expected increase in real estate prices a good annual growth rate to use is the long term annualized rate of return on real estate prices in your city or region. The value of your business could rise substantially depending on the growth and success of your business and so does the potential tax on its capital gain. If you expect substantial capital gain taxes for your estate you have permanent life insurance needs.
There are two types of permanent life insurance policies “whole life” and “universal-life” or UL life insurance. Without getting too much into the technicalities, the main idea is to initially pay more premiums than the cost of insurance and the difference is invested in such a way that eventually the return on these investments added to the level premium, you are paying, will cover the increasing yearly insurance costs. The main difference between a whole life and UL policy is that there is no choice you can make where to invest the difference between the premium what you pay and the cost of insurance in the case of a whole life insurance policy while you have a wide range of choices where to invest these monies in the case of a UL policy. Hence in the case of a UL policy, you are assuming the risk that the investment portion of your life insurance will perform poorly and you may be required to pay more premiums to keep your policy in force. On the other hand, if your investment does better than anticipated, within your life insurance policy, you may be able to reduce your annual premium or increase your death benefit.
Here is an example: Mary and John are both 50 years old. They bought a cottage 20 years ago for $100,000 and its current estimated value is $350,000. They also own a privately owned business corporation that they established 10 years ago that is currently worth roughly $3 million. Also for simplicity, assume that they both have used up their respective lifetime capital gain exemptions. Let’s suppose that the most likely time period that Mary or John will both live is 30 years and that both the value of the cottage and the business will increase to roughly $1.1 million and $9.75 million respectively in 30 years with a combined capital gain of $10.65 million. If the estate tax is triggered in 30 years, the likely extent of the tax that the estate needs to pay to CRA will be around $2.7 million. If they want to fully cover their heirs for the expected $2.7 million taxes in the future they can buy either a whole life or an UL insurance policy on their lives that would pay the death benefit at the point of time of the first death. The below table shows the approximate insurance costs, using three possible insurance solutions to cover for this expected tax liability:
In the above example, the choice of insurance may seem to be simple as UL policies are somewhat cheaper. But not so fast! In the case of a UL policy, the amount of premium that you need to pay to keep the policy intact may increase or decrease depending on the average annualized rate of return of your investment inside your UL insurance policy. It can happen that your average annualized rate of return will be so dismal that you will end up paying more than you would have paid if you would have applied for a whole life insurance policy.
Why Proper Life and Disability Insurance Could Be More Important Than Investments
Typically there are a large number of investment choices to invest the excess premium over and above the cost of insurance in the case of UL policies. Unfortunately the fees on these investment choices are normally between 3% and 4% annually, and a few have not been performing great over the past 10 or 20 years. Which one of them will do well is anyone’s guess. When you consider buying a UL policy, consider the implication and extra cost if your average rate of return is 1% or 2% annually and only then decide which type to buy (UL or whole life).
Determining the kind of life and disability insurance and the coverage you need require careful analysis and planning. Fin-Plan can help you in this regard. To ask any question about this article or to book an appointment to look at your particular case, please contact Miklos at nagy@fin-plan.ca. Miklos is a fee-only financial planner, best selling author, finance-related educational course writer, statistician and former Chair of the Canadian Institute of Financial Planners with over 25 years of experience in financial planning for high net-worth and middle-class Canadians. His Fee-Only financial planning website is at www.fin-plan.ca and his Linkedin page is at https://www.linkedin.com/in/miklos-nagy-fee-only-financial-planner/.
Copyright © 2019 by: Miklos A. Nagy
The views expressed in this material are the opinions of Miklos A. Nagy through the period ended October 23, 2019 and are subject to change based on market and/or other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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