Performance figures for each account are calculated using time weighted rate of returns on a daily basis. The Composite returns are calculated based on the asset-weighted monthly composite constituents based on beginning of month asset mix and include the reinvestment of all earnings as of the payment date. Composite returns are as follows:

When the Reward is not Worth the Risk: Part Two

By Brent Thomson BBA, CFP

IN THIS ISSUE: Beginning with the last installment of our newsletter, we explore two different aggressive tax savings strategies and present you with two conservative alternatives — we hope these newsletters help you clarify how much risk you’re willing to take (or not) in order to build your wealth. 

In last month’s newsletter, David Sung reviewed the concept of “Salary to Capital Gains”, the fi rst of two tax savings strategies featured in “Just for BC Doctors”. This month, Brent Thomson will continue our assessment and examine how “Shared Ownership Insurance” might result in a few more risks than are necessary to take. As with last issue, we want to help you become aware of the various outside factors that can shape these strategies and help you make an informed decision as to whether they are worth the risk.

It’s easy to see the potential upside, but when considering approaches such as these, it is important to keep Aesop’s proverb in mind – “Sometimes we can be too clever for our own good.”

Furthermore there are often simpler, safer and more effective solutions to investment strategies. In this study, we will show an alternative to “Shared Ownership” that accomplishes the following:

  1. Increases after-tax income by more than 1/3rd at retirement
  2. Reduces or eliminates the potential tax risks
  3. Reduces both loan and investment risks But first, a look at what shared ownership is about.

Shared Ownership Insurance

This strategy was highlighted in the January 2005 edition of “Just for BC Doctors.” Also known as a Split-Dollar arrangement, it involves an arrangement wherein a policy is jointly owned by a corporation and an individual (employee/shareholder) and annual cost of life insurance and the benefi ts under the policy are ‘split’ between them. This strategy has been designed to allow shareholders to take funds from their companies on a tax-free basis versus a taxable dividend with a tax rate of as much as 31%.

The steps to implement such a structure are as follows:

  1. Shareholder purchases a Universal Life insurance policy and splits the ownership of the policy between themselves and their company. The shareholder would own the cash value of the policy, while the company would own the death benefi t and be the benefi ciary of that death benefi t.
  2. A legal document called a “Shared Ownership Agreement” is prepared, which lays out all the rights and responsibilities of each party (without such an agreement, the shared ownership strategy might not be effective and the tax risk is that some of the premiums used to fund the program would be taxable personally to the shareholder).
  3. The corporation and the shareholder deposit amounts into the policy in excess of what is required to pay policy charges, creating cash value – the policy is usually funded on a “quick-pay” basis (higher premiums for a short duration of time).
  4. At retirement, the shareholder arranges with a bank to borrow on the policy an annual amount that, including interest, will not exceed 75% of the policy’s cash value before death. The annual loans are “tax-free income” that supplements income from other sources. 5. At death, the insurance benefi ts are used to repay the accumulated loan. 

Let’s look at the Shared Ownership Life Insurance strategy through John Smith’s case:

John is a 50-year-old incorporated physician who is 15 years away from retirement. He has just put his last child through university and is now able to leave more of his after-tax income in his corporation for savings since his spending needs have been reduced. John was told by his insurance advisor that he is able to save money inside a universal life policy and that all the earnings compound tax-free.

Better yet, he is able to access all of the tax-deferred savings inside this universal life policy tax-free when he retires! How is this possible?

John would pay an annual premium of $31,482 over the next 15 years with his company making deposits of $25,000 per year while he personally pays $6,482. At age 65, the policy will have a cash value of $422,392 (based on guaranteed rate of 3%) inside the universal life policy (face value plus – of $1,000,000).

This strategy argues that the cash value in the policy is owned by John (even though his company has funded the majority of the proceeds), because of how the costs have been allocated (as shown below) and will also be paid out tax-free upon his death.

Splitting Dollars

A breakdown of John Smith’s Shared Ownership Insurance plan

Proponents of the shared ownership concept believe that the pre-payment account (total premiums paid minus cost of T100 insurance) resolves the issue of the corporation paying an artifi cially increased premium, because it serves to keep track of overpayments made by the corporation in the event of an early death or surrender of the policy. In theory, if policy proceeds are paid out prematurely the corporation would be entitled to a refund of its overpayments.

In order for John to access the cash surrender value tax-free, he will have to assign the cash value component of the policy to a lending institution as collateral for a loan, which in turn will allow him to borrow (at an assumed bank loan rate of 5.0%) up to a maximum of 75% of the cash value of the policy at John’s age 65.

  • The deposit rate of 3.0% applies to ten year deposits (as of October 2005), if the plan is put into one year deposits then the interest on the insurance plan drops to 2%.
  • The banks will not make a series of increasing loans unless they do so as an operating line of credit which has a fl oating rate. Today that rate would likely be between 5% and 5.5%. That is competitive, but is about 3% more than the interest one can earn on a deposit that is also short term. The typical illustrations used in this program assume an interest spread of 2%, which is about 1/3rd lower.
  • There were no banks who would guarantee that they would make a loan like this for one’s lifetime with all interest accruing (so no need to make loan payments of any kind) and with no possibility of the loan being called. If the bank does either, this program will not work.

With these steps in place, and assuming he can obtain the loan from his bank, John will then be able to supplement his retirement income by borrowing against the cash value of his personally owned universal life policy which will pay out $17,314 per year, or $294,338 over his expected life time (using actuarial assumption of life expectancy to age 82), which equates to an internal rate of return at death of 4.98%.

As with many complex strategies, there are also potential caveats to be aware of:

  • C.R.A. could consider this to be a shareholders benefi t and impose severe tax implications.
  • You are locked into a long-term plan.
  • The shareholder may only be able to leverage against the policy values as long as it remains within the parameters of the shared ownership agreement (such as the maximum collateral available to the shareholder, which will be the total policy cash value less the value of the “pre-payment” account) and could limit fl exibility.
  • Investment rates might not live up to expectations.
  • Borrowing rates might exceed expectations.
  • Banks may not be willing to lend using the cash value as security; and if they do, they will likely expect the loan to be paid off during one’s lifetime.
  • Tax laws may change to prevent such securitization.

Leveraged Insured Annuity: An Alternative Solution
How it works…

  1. The corporation acquires a Universal Life term-100 plan on the life of the shareholder which is to be paid up by their age 65. This requires a much lower funding level than the shared ownership approach.
  2. Invest the difference remaining from what would have been the shared ownership premium into a corporate investment account so that the annual investment amount is identical. This allows the shareholder to work with his fi nancial advisor and choose the best investment approach he feels will work with his fi nancial situation (i.e. real estate, mortgages, preferred shares etc…) and not be restricted to the choices offered by the insurance company.
  3. At age 65, the shareholder would have a paid-up life insurance policy and a corporate investment account.
  4. Shareholder uses corporate investment account and borrows (leverages) additional funds to purchase annuity.
  5. Shareholder services the loan interest on an annual basis (no accumulation of loan interest).
  6. At death, life insurance death benefi t pays off outstanding loan balance.

John Smith could take another approach

one that would remove any potential shareholders benefi t tax liability and yield far greater guaranteed investment returns. His corporation could take the same annual amount of $31,482 (that was earmarked for the shared ownership agreement) and invest it into two areas.

First, John’s corporation would invest $23,862 per year for the next 15 years into a universal life policy (level cost of insurance) which, based on a guaranteed interest rate of 3.0%, would purchase a $1.4M policy (paid up till his age 90) so as to create an estate benefi t comparable to that of the shared ownership strategy.

John would then invest the annual difference of $7,620 ($31,482-$23,862) over the next 15 years into a corporate investment account, which would grow to a value of $177,363 at his age 65 (based on a 6% after-tax return).

At John’s age 65 he would have:

a)a paid-up life insurance policy with a face amount of $1.4M

b)a corporate non-registered account worth $177,363

John would then create his own retirement supplement by purchasing a corporate annuity from an insurance company for $500,000. In order to purchase this $500,000 annuity, John would use the corporate investment account of $177,363 and borrow the remaining $322,637. Based on today’s interest rates, this annuity would pay out $40,715 per year, or $24,261 after tax.

Unlike the shared ownership strategy, where he would have an outstanding loan balance accruing, John’s company would service the debt annually. Banks are much more likely to fund this type of loan since collateral is provided and the loan interest is paid annually.

The results are shown in the chart below.

Insuring a Better Tomorrow

An alternate view using the Leveraged Insured Annuity

*assumes 50/50 split with shareholder spouse (household income of $70,000)
Source: Manulife Financial – Annuity quote provided by Cannex – as of October 7, 2005

In this example, the leveraged insured annuity strategy generates $6,947 more after-tax spendable income in John’s retirement on an annual basis and $118,091 over the lifetime of the plan, an increase of 40% over the shared ownership strategy. As well, the internal rate of return at death is 5.44% or 9% greater than the shared ownership strategy.

Not only has John signifi cantly increased his rate of return on his investments but he has also

  • isolated himself from any potential taxable shareholders benefi t – lowering risk.
  • avoided exceeding the cashvalue / loan-to-value ratio

Insured annuity arrangements like the one illustrated here have been successfully used for more than 30 years with very low tax and investment risk when compared to other more expensive and complex structures.

While the two alternative tax saving strategies outlined in these last two newsletters might be presented as sound structures, potential risks associated with both of them far outweigh any immediate benefi ts. We have illustrated for you, two viable and conservative tax saving options, which will provide predictable outcomes with minimal risk – and mitigating risk is one of the most important steps we can help our clients take.

And if we listen to Aesop, we might realize that there is a way to be just clever enough.

When traveling the road to your financial destination, you can’t take shortcuts. Avoiding and mitigating risk is about having the right map and taking the proper routes. Ask Aesop, and he’d tell you the tortoise would agree.