The current environment

Investors rely on fixed income (bonds) to provide income and capital preservation benefits to their portfolios. Declining interest rates over the last 40 years have resulted in gains on fixed income and provided a strong tailwind for investors. Currently, bond yields are at or near historical lows, and there is a strong sense that interest rates may rise as central banks consider tightening monetary policy to combat potential inflation and ensure that they have tools for dealing with future market events.

 

Figure 1. Evolution of interest rates

 

As a result, investors find themselves:

 

  1. Struggling to generate acceptable yields from fixed income without taking on excess and undue risk 
  2. Re-allocating fixed income to shorter bonds to limit any short-term capital losses should yields rise, resulting in lower current yield 
  3. Seeking alternatives to replace the portfolio protection that was historically available through conventional bonds but is reduced in the current environment

At Mercer, we are continually seeking methods to enhance and improve the effectiveness of wealth management strategies for our clients. Each client has different goals and objectives and therefore requires tactics and solutions specific to their personal circumstances. The current fixed income environment is making it necessary to challenge the use of conventional portfolio solutions, and our approach has evolved as a result.

 

Many clients also have specific needs and/or the desire to protect their families and their personal wealth from the financial adversity that may arise from the main income-earner being unable to work, as well as erosion from taxes and inflation. There are various tools available, such as life insurance, that can assist in mitigating these concerns.

 

Potential solution

Currently, adding an allocation to permanent life insurance can improve the overall financial strategy for certain clients and help address the two major issues identified above, namely, combating low interest rates and supporting the need to protect and preserve both family and estate.

 

Figure 2. Effective after-tax rate of return

The process

This strategy will not be appropriate for everyone, so the first step is to conduct a comprehensive wealth review and financial plan. If that review identifies a need for insurance — or there is already an insurance policy in place that has the appropriate attributes — the next step would be to consider the integration of the insurance strategy into the Investment Policy Statement as a proxy for a portion of the fixed income allocation. The insurance strategy has similar characteristics to an investment in fixed income, but in the long run, it would be expected to provide an enhancement to terminal wealth and increase the net after-tax value of an estate. As funding of the investment into an insurance strategy takes place over a set number of years, the investment allocation would be modified concurrently to ensure that the overall Investment Policy Statement remains consistent with risk tolerance. This integration works to reduce any potential redundancy and optimizes the overall financial strategy.

Figure 3. Net estate value in $

 

Illustration

Kelly recently sold the family business, and a large portion of the family assets is now held inside a corporation. The family has historically invested personal and registered assets in a portfolio with a moderate asset allocation, including 30%–40% fixed income. Kelly is 55 years old and in good health. After a wealth review, it was noted that there would be a large estate tax bill due on Kelly’s death. It was also determined that there were more assets in the corporation than the family needed to satisfy its lifetime spending requirements, and the income on these assets would be exposed to a high rate of corporate tax. Based on a detailed financial plan, the net (after-tax) value of Kelly’s estate was estimated to be $7.5 million. It was suggested that corporate assets, which would have otherwise been invested in fixed income, be re-allocated to a participating whole life insurance policy owned and paid for by the corporation. The policy had a face value of $3,000,000 and would be paid for over 10 years in equal installments of circa $193,000. Estimated benefits were as follows:

 

  1. The effective after-tax rate of return earned on the insurance policy was anticipated to be 4.5% (at age 90), compared to 0.5% if invested in conventional fixed income (at today’s rates). 
  2. Kelly’s net estate value (at age 90) is estimated to be at least 75% higher, or roughly $13.1 million versus $7.5 million.

Pros and cons

In addition to the normal use of life insurance — that is, providing for a benefit to support family in the event of the untimely death of an income-earner — additional benefits of this strategy include the following:

 

  1. The expected after-tax rate of return (relative to conventional fixed-income solutions) is higher over the life of the policy, enhancing terminal wealth. 
  2. The estate value is higher, as all income and growth in the policy is earned on a tax-free basis. 
  3. Diversifying the source of return as a “participating” insurance strategy not only generates income and gains from underlying investments in the investment pool, which are professionally managed, but also benefits from any excess mortality gains experienced. 
  4. When used in a corporation with active business income, it can offset some of the increased tax resulting from recent tax changes relating to passive income. 
  5. Proceeds from insurance are not typically subject to estate probate. 
  6. When properly implemented in a corporation, tax-preferred benefits can accrue to the estate through the capital dividend account of the company, further enhancing the value of the estate for the intended beneficiaries.

 

To ensure that we provide a balanced view of this opportunity, it is also important to highlight some of the potential drawbacks, which include:

 

  1. Funds that are committed to this strategy are not typically available to meet lifestyle needs, so a client must have sufficient assets outside the strategy to meet required spending. (Note: In certain cases, it is possible to obtain loans against these strategies when funds are required.) 
  2. The costs of insurance consume a larger amount of premium payments in the early years, so the strategy needs to be maintained for the long term to achieve the benefits. 
  3. A medical review is typically required, and instances of poor health and/or prior medical events may result in higher premium payments that can reduce or eliminate any benefit from this strategy. 
  4. Rates of return are not guaranteed.

If you are interested in learning more about this opportunity to see whether it may be applicable to your circumstances or would like to discuss other issues related to your strategy, please contact your private wealth counsellor team.

Authors

The Winnipeg Team



Dave Holt, CFA
Dave Holt, CFA
Private Wealth Counsellor
James R. Morden, CIM
James R. Morden, CIM
Private Wealth Counsellor
Chad Anderson, CFA
Chad Anderson, CFA
Private Wealth Counsellor
Matt Ward, CFP, CIM
Matt Ward, CFP, CIM
Private Wealth Counsellor, Associate

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