My June 23rd, 2015 article entitled: “Fixed Income Considerations”, spoke to how Insured Deposit Funds (IDF’s) are forming meaningful portions of the fixed income portfolios of Canadians.
An excellent background paper on this subject is: “Life Insurance as an Asset Class” in which its co-authors, Wayne Miller, BMATH, ASA, ACIA and Sally Murdock, MMATH, MMF, CFA write:
This research paper examines the merits of permanent life insurance as an alternative investment class. Though known more for its estate planning benefits than as an investment tool, permanent life insurance is attracting attention among investors wishing to improve the return or reduce the risk of the fixed income portion of their investment portfolio.
Why is this so?
1) Tax Efficient Legislation:
The MTAR (Maximum Tax Accumulation Reserve) reflects Canadian legislation that draws a line between investment products and insurance investments by defining how much money can be contributed and grown in the tax sheltered environment of an IDF/permanent insurance instrument.
Regulations 307 & 1401 of the Income Tax Act define the Exemption Test Policy which establishes the upper limit of the accumulating fund (determined to be the cash value accumulation) a policy can have and still be considered a life insurance policy rather than an investment vehicle.
If the policy qualifies as an exempt policy:
– the investment earnings associated with the cash value accumulation are not subject to annual taxation
– the death benefit proceeds (including the cash value accumulation) are received tax free at death
– the death benefit is allowed to grow by 8% annually
As paraphrased by Tim Cestnick, CA in his Sep 06, 2012 article The pros of a permanent life insurance policy in the Globe & Mail / Report on Business:
You can accumulate investments inside the policy – subject to the MTAR limit. The investments grow on a tax sheltered basis inside the policy and can be paid out, along with the face value of the policy, on a tax free basis when you die….or collateralized for earlier capital or later pension access.
2) Fund Size & Composition:
Four major Canadian Life Insurance Carriers (London Life; Great West Life; Canada Life & Sun Life Financial) as of December 31st, 2014 offered open IDF Participating Funds with total assets under management of more than $38 Billion.
The investment structure is similar to that of a large institutional pension fund – thus giving individual participants access to investments normally available only to institutions/ corporations. Each fund is relatively similarly managed; the composition/standard deviation over 25 years of returns of Sun Life Financial’s fund, used as an example, is illustrated below.
3) Standard Deviation:
IDF as an asset class is based upon the Modern Portfolio Theory wherein a prudent investment portfolio balances risk and return and The Efficient Frontier Concept that an optimal portfolio offers the highest expected returns for a defined level of risk (or the lowest risk for a given level of expected return). Standard deviation (SD) illustrates the dispersion or variation from the average. Low SD indicates the data points close to the expected values. High SD indicates data points spread over a larger range of values.
4) Stability of Carriers:
Major Canadian Life Insurance Carriers are highly ranked by rating agencies and their Minimum Continuing Capital Reserves well exceed legislated minimums. No government bailout was sought or received nor were dividends cut or shares diluted during or post the 2008 global financial crisis. These 4 carriers have always paid dividends over the past 100+ years and rebalanced their risk portfolios post 2008.
5) Fixed Income Asset Diversification:
The IDF grows exempt from accrual tax; the face amount of the insurance plus the investment fund at death is paid out tax free. The cash value can be tax effectively collateralized and accessed for living capital or pension needs. The smoothing principal of the participating dividend fund guarantees long term fund stability. Estate benefits are guaranteed. Dividends are immediately vested and investment management fees within the fund are low (0.0077 basis points).
6) Smoothing Techniques:
The above historical average SP returns include the impact of smoothing techniques to ensure the effect of gains and losses in the portfolio pass through the dividend scale more slowly in order to absorb the impact of short term “ups and downs” the market would otherwise have on the dividend performance scale. The result is a dividend scale that tends to be less volatile and less extreme than the underlying equity markets.
To Again quote Co -authors Miller and Murdock :
In particular it’s primarily how insurers smooth the return with participating life insurance that makes it advantageous as an asset class on its own. In comparing par to bonds, returns are comparable due to its attractive portfolio mix; liquidity is better because there are no market adjustments and there’s less volatility because of smoothing techniques. These help keep the dividend scale interest rate more stable over time, allowing the investor to take advantage of good timing. Finally Par offers much greater estate benefits because of the tax efficiency of life insurance.
Returns of the Participating Account will generally not reach the “high Highs” or “ Low Lows” that the market might experience- but it tax efficiencies allow it to work less hard and be exposed to less risk.
Four Things You Can’t Recover:
The stone after the throw
The word after it’s said
The occasion after it’s missed
The time after it’s gone
Unknown
