What are reasonable interest assumptions for Universal Life plans?

Universal life consists of two components: an insurance component and a tax-deferred cash value (or cash fund) accumulation account. You and your advisor select the investment mix of the cash value accumulation.

 

The investment mix can consist of guaranteed interest and fixed income, and equity index-linked investment options. Because of the wide array of choices for investment options, it is vitally important to select an interest assumption that reasonably reflects your investment mix. This interest assumption will be used to illustrate policy values in the future.

 

What is a reasonable interest assumption?

 

We feel that the interest assumption should be based on historical performance for the investment option(s) you choose, and should also reflect any administration and/or management fee the insurance company will deduct.

 

Why use historical averages?

 

To answer this question, let's examine Canadian equity returns. Their returns over several economic cycles can be measured by reviewing the past performance of the Toronto Stock Exchange 300 Total Return Index (TSE 300). This index can show significant fluctuations when viewing one-year periods. However, the index is much more stable when reviewing 30-year historical averages. The chart below shows how stable the range of compound annual returns over 30 years has been compared to one, five, ten and twenty year periods. We recommend our illustration assumptions based on the median return (the rate that's above one half the observed results and below one half the observed returns).

 

 

 

 

The above graph shows that your investment can fluctuate greatly on a yearly basis. However, it also demonstrates the effect and benefit of long-term investing. Historically, if you invested in TSE 300-indexed funds and held for a 30 year period, you would have earned a compounded interest of 10.3%.

 

Again, remember that past performance is not a guarantee for future performance, but it allows us to have a more reasonable view of future policy values.

 

Don't forget to deduct the management and/or administration fees!

 

Extra costs such as management fees, investment income tax, and/or administration fees must be deducted from the interest assumption chosen, as they can reduce your investment return by as much as 4%!

 

Ensure you know which fees apply to your chosen investment mix. Here are some general tips to remember:

• Canadian bonds and fixed income management/administration fees tend to be the lowest, generally between 2% and 3%.
• Canadian equity index-linked funds (such as the TSX) tend to have higher management fees.
• U.S. and International index-linked funds tend to have the highest management fees.

The above is just a guide. Each company will have their respective fees stipulated.

 

Because of this, two policies from two different companies with the same index-linked funds and the same interest assumption can actually yield completely different results!

 

Putting it all together, what then is the interest assumption that my advisor should use?

 

Follow these very important steps to determine your answer. Your advisor should be able to complete every step. If they can't, you need to get another advisor (seriously)!

1. Determine your risk tolerance through a risk-profile assessment. For example, how well can you sleep at night knowing where your funds are invested?
2. Identify the corresponding mix of investments that fully agree with your risk tolerance.
3. Identify the median return for that particular mix of investments for the previous 30 years.
4. Determine the management/administration fees and all taxes that apply (expressed as a percentage).
5. Deduct the fee percentage from the median interest rate.

That's it.

 

As an example, our imaginary client, Mr. Las Vegas, goes through the following steps:

1. We assess this client to have a very high risk profile.
2. We choose the TSX indexed-fund as the investment vehicle.
3. We determine that the median compound annual return was 10.3%.
4. The management fee plus investment income tax charge totals 3.0%.
5. 10.3 minus 3.0 equals: 7.3% - This is the reasonable interest assumption we will use in his life insurance illustration.

There are some serious traps to avoid. We'll address them at the end of this article. In the meantime...

What about companies that offer interest bonuses? Ah yes, we can't forget about that. And that's why you must proceed to the next page.

 

Next page >

 

How should I consider interest bonuses?

 

 

 

Click a link below to jump to another section of the article:

 

What is the purpose of life insurance illustrations?

 

What is a reasonable period of time an illustration should consider?

 

How does the interest rate chosen make a significant difference in investment returns?

 

What are reasonable interest assumptions for Whole Life plans?

 

Summary of life insurance traps to avoid.

 

Contact a professional broker for your free consultation.

 

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