ROP: A potential menace to retirement

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In the scenario used by this leading insurer in Conseiller.ca/Advisor.ca to promote the Return of Premium (ROP), we had a 40 year old consumer making $70,000 annually. This consumer was putting $12,500 towards his retirement which based on the marketing material provided would build up to a retirement fund of 703 754 $ by age 65. As illustrated, by purchasing a critical illness with a return of premium at a cost of $3467 per year, his age 65 retirement fund would only be reduced to 682 460 $ which meant that the final cost to the consumer for the critical illness coverage would only be about $21,000 over 25 years. So truly in this instance the consumer seems to be able to have his cake and eat it too.

Playing with the numbers to make a product feature fit constitute a misleading marketing practice.

1. What is the use of fixing the roof when the foundation is crumbling down? The first thing we notice based on the premise and the plan use to develop this scenario is that the amount of $703,000 at age 65 is barely enough to sustain a retirement income of 60% of the $70,000 income for more than 20 years. So there is something deeply wrong with this plan and scenario considering the consumer is saving a large portion of his income. In other words before using critical illness to bulletproof a retirement plan, the retirement plan must first be viable. In this case it is not.

2. Assumptions, Assumptions, Assumptions… Do we need to say more? Having been a Certified Financial Planner for 20+ years, I am quite puzzled by the assumptions used in the marketing materials to position the Return of premium. There are two set of assumptions that cause great concerns:

a) In the scenario, the consumer is putting $7000 towards an RRSP and $5,500 toward an unregistered account. Why? If the client is not saving enough, should he not maximize RRSP contributions to create the maximum amount of taxable refunds? In this case, I assumed that the assumption of $5,500 was decided based on the availability of the TFSA but however a rate of return of 1.65% was used versus a rate of 3% for RRSP and this indicates that the assumptions are not based on the tax sheltering of the unregistered savings offered by the TSFA. The rate of return of 1.65% results from the application of a 45% tax rate. Was this scenario of having unregistered savings created in order NOT to factor in the loss of tax refunds when taking out the $3467 per year out of the retirement contributions to pay for the Critical Illness with the ROP?

b) I have a lot of questions with the 3% and 1.65% rate of return use in the marketing materials. First correction to these assumptions would be to use an overall rate of return of 3%. This small change would increase the opportunity cost from $21,000 to about $43,000.

Is the use of 3% warranted in this example? In fact in checking the rate of return used in the retirement tools offered by this leading insurer, we see that the default rate of return used is 4%. Using this rate of return the opportunity cost would increase to about $63,000

Four per cent is a default rate. However in 25 years of career, I don’t remember if I ever saw a retirement plan with a 4% return. The fact is that most consumers would believe they are able to achieve this type of returns on their own by saving on management fees and not using an advisor. So a consumer would assume that by using the knowledge and experience of an advisor, this would translate to a higher rate of return. Let’s assume that in this case, the added value offered by the advisor is the opportunity to achieve a 6% return, the opportunity cost of the Critical Illness would increase to about $115,000.

WARNING TO THE FINANCIAL INDUSTRY: FSCA offers this warning. The use of rate of returns must be consistent across the various illustrations and strategies created and used by an advisor. For example, if it is proven that an advisor consistently use a rate of return of 8% in providing retirement advice to clients and that he uses a rate of 3% to calculate the impact of the Critical Illness on the value of retirement funds, it is clear that the only goal here is to mislead the consumer as to the opportunity cost of the Critical Illness with the ROP. This is a serious infraction.

The opportunity cost of the tax refunds

By choosing to invest in a Critical Illness with the Return of Premium rider, this means the consumer is unable to maximize his RRSP contributions. This opportunity cost must be added to the analysis. If the tax refund of $1,075 was not reinvested and not spent, the opportunity cost would be about $27,000. If it was reinvested it would be about $63,000.

Effective tax rate versus marginal tax rate

Advisor should also be cautious with the use of marginal tax rate. In this case, as an individual tax payer, the effective tax rate is the same as the marginal tax rate for the income of $70,000. However for a family with children, reducing RRSP contribution which increases taxable income would result in a loss of taxable benefits therefore increasing the effective tax rate above the marginal tax rate. The effective tax rate could reach as high as 80% and increase significantly the opportunity cost.

Finally, when we do the tally, the opportunity cost of the Critical Illness with the Return of Premium could go as high as $200,000. This is 10 times higher than what was published in Conseiller.ca/Advisor.ca.

The Right way to show the Return of premium to a consumer

You believe in the Return of Premium and you want to show this feature to a consumer; how do you do it? First you have to understand that the ROP is an investment option and it is not an insurance option. As a result like any other investments, its selection must be based on the Internal Rate of Return of this feature and all the opportunity cost with a best case and worst case scenario.

In any illustrations provided to the consumer, the IRR should be shown or at least enough information for the consumers to determine the value of the IRR. In the marketing materials provided by the leading insurer this could not be done. The insurer only showed the full premium and did not show the cost of the Critical Illness and the ROP separately. FSCA is against this practice. Premium must appear separately so that the consumer is aware of the cost of buying the Critical Illness individually without the ROP.

Conclusion

The sad thing is that as a past Certified Financial Planner of more than 20 years experience is that I believe that based on the scenario provided, it would have been a simple matter to convince the consumer to bulletproof his retirement portfolio by buying Critical Illness WITHOUT a Return of Premium. Just by taking the $5,500 unregistered retirement contribution and making a registered contribution, this would create a taxable refund probably sufficient to pay the premium of the Critical Illness with little opportunity cost. Being efficient through sound financial planning often allows you to have you cake and eat it too.

I will not be surprised if this leading insurer uses as an excuse that it is up to the advisor to choose the right assumptions. However insurers are responsible for their agents and advisors and also have a responsibility to the insurance industry. This leading insurer chose to publish in an industry publication an analysis of a feature based on a set of unrealistic set of assumptions in order to deceive the consumer in buying an additional feature that has nothing to do with insurance. By doing this, this leading insurer is sending the message that it is OK to play with the assumptions to make it work. FSCA expect insurers to lead by example and to use exemplary standards in their marketing materials. It is clear this was not done in this example.

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2 comments

  1. Hello Richard,

    Interesting article.

    ROP (Return Of Premium) riders are offered by insuers in various forms, including:
    -ROP at the end of a contractually specified policy year X (assuming no claim is made during the policy period and that the contract is terminated);
    -ROPS if the policy is surrendered (terminated) after Y number of years of being in force
    -ROPD if the insured dies but no claim has been made under the CI policy

    …and various permutations, adjustments and combinations of the above.

    ROP, as such is IMO best defined as a contingent investment (the contingency being the conditions under which the investment is redeemable (“convertible to cash”) by the contract holder. Therefore, ROP, is an investment that is in part “insurance” in the sense that the part of the premium that pays for the ROP rider insures the premiums in case there is no claim.

    For “best scenario” situations (in the sense that it’s best to have the insurance but not to suffer the critical illness), IMO, the best way to assess the efficacy of the ROP rider cost is on a net of tax basis and by IRR.

    For example (all on the basis of net of tax (aka “after tax dollars”)), if the same contract cost $X per year without ROP and $Z per year with the ROP, then $Z-$X=$Y which is the annual cost of the ROP element. So far simple math assuming that the identical contract for CI is being considered with and without the ROP..

    Next, examine what the IRR is for the ROP on a net of tax basis by iterating for the rate of return that would need to be achieved annually, net of tax, on the investment of $Y yearly in advance (at the beginning of each policy year) to collect the ROP sum in arrears (at the end of the policy year at which the ROP sum is to be realized).

    However, and this is important to keep in mind, “all bets are off” if (unless the policy contract states otherwise) you have a claim under the policy before the eligibility for the ROP kicks in (I wish there was a way to put “and this is important to keep in mind” in bold text in this forum).

    Disclaimer and notice: Richard, the above is a general comment and unrelated to the ad referenced in your article (I don’t know which ad that may have been or if I’ve even seen it). Also, to anyone reading my comments, my comments above are to be viewed as general in nature and are not advice nor recommendation on any specific individual case.
    By Ami Maishlish

  2. Chad Martin
    Financial Security Advisor at Freedom 55 Financial

    It is also important to take into account the possibility of a rating on the policy. If the return of premium rider has a rating, it makes even less sense to add that rider keeping in mind the idea that the rider is viewed as an investment rather than insurance. It would be like having a ridiculously high management fee.

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