Insuring a child

Question

I need some advice on a potential investment for my two-year-old niece. It is a life insurance policy that comes with a cash value component. I am thinking about getting a $300,000 policy for her, which means a premium of $280/month for 20 years. At that point the premiums end and it pays for itself with dividends—$3,360/year or $67,200 in payments after 20 years. The insurer offers returns of about 7% to 9% annually on this investment, which will go towards the life insurance and the cash value account. By the time my niece is 22 the cash value account would be worth about $104,000, assuming rates continue as they have since 1952 when this product started. Each year the cash value account compounds and when she is 55 years old it would be worth approximately $885,000. Is this a worthwhile investment?

Answer

Your niece is lucky to have you for an uncle. Your foresight is admirable and your generosity is enviable. I have a two-year-old daughter so I can appreciate your desire to give your niece a helping hand. Of course, good intentions don’t always yield the best results. For instance, when my daughter and I fly together, the flight attendant always stresses how important it is that I put my oxygen mask on first, should the need arise. I worry that you are ignoring the prudent flight attendant’s advice, by doing what feels right rather than doing what will give her the best outcome.

I would ask yourself a few questions before you commit to this plan:

What are the tax issues?

When it comes to your niece you should ask yourself, “What are the tax issues?” It’s worth calling a tax accountant on this question, because it might make sense for you to set up an in-trust account. There are certain tax advantages to this idea, related to income splitting and capital gains. The more you save on taxes, the more you can contribute to your family members over time.

I’d also use this as an opportunity to look at your retirement savings. If you haven’t used up all of your RRSP contribution room or saved sufficiently for retirement, then it might make more sense for you to put this money into your own RRSP to maximize your tax deferral and then make provisions for your niece in your will.

Is this 7% to 9% rate of return realistic?

Let’s say, from a tax standpoint, there is no downside to this cash value insurance policy. The second question I would ask is whether this rate of return realistic? You say that this insurance product “offers returns of 7% to 9%.” That might be accurate historically, but I’d be very cautious about using that range in forward-looking calculations. I reviewed the historical returns for one life insurance company’s cash value product and while they did deliver 10.2% in 1981, they have declined every year since. Ask your agent to show you the chart illustrating historical returns so you can see the downward trend for yourself. Next, find out why he or she believes that the rate of return will be higher in the future than it is today.

I asked benefits consultant Jason Conley with the Rogers BenefitLink Resource Group to take a closer look at your question. He ran a quote based on the details you provided. “The internal rates of return are way lower than 7% to 9%, especially in the early years of the contract,” he says. “Not all the premiums are used to accumulate cash value. Some are used to pay the risk charges, which are substantially higher than, say, a term policy. This is not as big of an issue when you’re buying a child policy, but for you or I, the premiums would be a big bite to chew every month.”

How much would you have if you simply invested the money instead?

You should also consider what would happen if you simply invested the money yourself and put that $280 a month into a tax-free savings account. If you earned 7% on your investment you would have $147,000 in two decades. While you wouldn’t have the potential death benefit, the value of the investment portfolio would be worth 40% more than the cash value of the insurance policy. Plus, if you invest the money on your own, you would get to determine when your niece gets the money, and how she is able to spend it. Not that you want to be all control freaky about it, but you might prefer to see her to spend it on education rather than a one-year around the world travel extravaganza…or vice versa.

How much would the guaranteed 20% return on RESPs help?

Instead of investing in a TFSA, you could sock the money for your niece away in a Registered Education Savings Plan or RESP. The money would qualify for a government grant of 20% on the first $2,500, up to a maximum of $500 per year. So ask yourself, “How much would the guaranteed 20% return on RESPs help?” If you start this plan now, you could make a big difference in her ability to afford post-secondary education. Unless someone else is already doing this for her, this would be the lead option if I were in your shoes.

What is the best way to provide for my niece’s future?

This all boils down to the question: “What is the best way to provide for my niece’s future?” I hold the view that insurance is best used to protect you against financial calamity rather than as an investment. So, you would insure the main breadwinner in the family because their death would mean a huge loss of income, but you wouldn’t insure the children themselves. When it comes to investments, I hold the view that simplicity is the best option for most people. Low fee products, put together in a well-diversified portfolio is the way to go versus insurance, which tends to be more complex and costly.

Whatever you choose to do, kudos to you for thinking about the little bean and her financial future. She’ll thank you one day, though not likely while she’s a teenager.