Premium Advice — Will the TFSA kill or help insurance sales?

With the new Tax-Free Savings Account (TFSA) offering clients another place to park their dollars, it’s likely insurance advisors are wondering how this savings vehicle will affect their business. So, will the TFSA help or hurt insurance sales? In short, it will do both.

First, a brief overview of the proposed structure for tax-free savings accounts. Effective January 1, Canadians will be able to save up to $5,000 per year in an account and have this money grow on a tax-free basis. Contribution room will be added each year for any contributions not made. As money is needed for purchase of a home, education, retirement, or any other lifestyle needs, funds can be withdrawn on a tax-free basis.

This withdrawal also creates “re-contribution room,” allowing your total potential pool of tax-free savings to never be depleted. At death, the entire account can be paid out free of tax as well. That’s the quick version — grow tax free, withdraw tax free, re-contribute withdrawals, and pay out at death tax free.

The bottom line is that the TFSA gives clients another way to save. It’s not better or worse than other financial tools, so it should be added to your arsenal of investment options. Advisors have the luxury of being able to offer a wide range of options for our clients, and they all make sense for certain needs and priorities. TFSAs are simply one more excellent tool for us to consider for use with our clients.

One of the questions a client might ask is, “if I can withdraw money from a TFSA tax free during life or at death, should I simply self-fund my risk of health events or estate costs?”

It’s a good question, but it’s important to remember the excellent guaranteed internal rates of return that insurance payouts provide for the guaranteed level premiums they cost.

Consider David and Eileen MacDonald, a 46-year old couple from Truro, Nova Scotia. They manage a farm equipment dealership that Eileen’s father had originally started, and will have controlling share interest in two years. As they have another two decades before retirement and potentially face a substantial estate tax liability at death, they are considering the use of insurance to cover off risk of illness and disability before retirement, and to pay taxes in their estate.

They each want $200,000 of critical illness (CI) coverage, but let’s look at David, as CI is more expensive for men, to see how insurance makes more sense than a TFSA in this case.

David could acquire a level premium to age 75 policy for approximately $2,800 per year. Assuming a heart attack, stroke or cancer in 15 years, he would need to have earned 17.8% guaranteed in his TFSA to have access to $200,000. If he had a health event in 26 years, he would have needed a rate of 7.3%.

For Eileen, let’s consider disability insurance, since DI is more expensive for women. To keep the numbers simple, let’s assume she purchases $5,000 per month of coverage, with a 5% “cost of living adjustment” rider built on. This costs her approximately $3,200 annually. If she had a disability one year into her contract (unlikely, though a possibility), her contract would have a potential payout to age 65 of over $1.8 million. If she had a disability 10 years into her contract, it would have a potential payout of almost $650,000. Even if we only considered a two-year disability for her, she’s looking at an inflation-adjusted total payout in excess of $120,000, which could have been bought for under $300 per month.

If she had invested those premiums in a TFSA to self-insure a disability risk, and she achieved a 10% rate of return, she would have accumulated only $56,100 after 10 years, or $180,080 after 19 years.

Now consider their estate needs. Assuming they need $1 million for estate liquidity, they could purchase a joint last-to-die policy for under $4,300 per year. If they were to invest those same premiums in a TFSA, they would need to have a guaranteed rate of return of 11.5% if the second death was at age 76, 7.5% for death at age 86, and 5.3% for death at age 96. That would be very difficult to accomplish, and any early death would have created a large gap in their need for capital.

I think it’s quite easy to see that the more straightforward areas of insurance will not be impacted by TFSAs. However, the tax-sheltered aspect of permanent insurance is a different story.

Should someone deposit $5,000 into a TFSA before considering a universal life plan or whole life? In my opinion, the answer is a very simple yes. The money would grow tax free in either case, but withdrawals in excess of the adjusted cost basis of the life policy would be taxable as income. Withdrawals from a TFSA are tax free.

So how do insurance professionals work with TFSAs in a harmonious way? I’d suggest considering repositioning the old adage of “buy term and invest the difference” into “buy term or term 100 and shelter the first $5,000 of the difference with a TFSA.”

There is no arguing with the fact that clients should park the first $5,000 they have to save in a TFSA. However, many successful Canadians have much more than that per year to invest. The insurance industry should end up seeing the smaller end of the permanent insurance market gravitate toward TFSAs instead of over-funding permanent insurance contracts. But, due to the cap on contributions, over-funded life insurance should still be considered for many Canadians, and will continue to thrive in this market. And, on a long-term basis, thanks to the advent of TFSAs, more people will understand the value that tax-free growth and tax-free payout at death offers, which will lead to more insurance sales.

Insurance planning has always depended on the financial validity of creating large payments of capital when an unfortunate event happens. The examples above prove that this will still be the case, regardless of the flexibility and efficiency TFSAs provide.

While there may be some disruption in the smaller end of the market of permanent life sales, ultimately the adoption of TFSAs by financial advisors will only help to strengthen insurance planning. We now have four tax-efficient methods of creating assets for our clients — RRSPs, TFSAs, tax-efficient capital gains-oriented investments, and permanent insurance. The future has never looked brighter for our clients and our businesses.

Chris Paterson is vice-president of sales for Manulife Financial.

(11/04/08)

This Advisor.ca Special Report is sponsored by: