When designed properly, indexed universal life insurance can
be a great savings vehicle for investors who have the keen ability to conserve.
Indexed universal life (IUL) is a type of permanent life insurance that allows
policy holders to build a cash value. The cash value can be invested in a fixed
account that often has a guaranteed minimum interest rate, or the owner can
derive their returns based on several different equity indexes.
There are several crediting methods that can be used to
generate returns on the cash inside the policy. The most common method I see is
an annual point-to-point calculation based on the return of the S&P 500,
with a cap rate that protects your principal and limits your upside. When you
pay your annual premium, the insurance company deducts some of the premium for
state taxes, cost of insurance and a sales load. After the fees are taken, most
of your money goes to the insurance company’s general account and a small
portion buys derivatives on whatever index you select.
Let’s say that the insurance actuary believes that they can
earn 5.27% on their pool of investments. They would invest $95 of your $100 in
their general account expecting that in one year, the $95 would grow to $100.
This is how they can guarantee your principal. The $5 in my example would buy
derivatives that could make up to a certain return, or they could expire and be
worthless if the index you chose has a negative year. The costs of the
derivatives help determine the cap rate — or the maximum — that you can make
per year. Most companies have a 10-15% cap rate on the S&P 500 index
currently. If your insurance policy has a 12% cap rate on the S&P 500 and
the index does 30%, you will have 12% credited to your account for the year. If
the index does 5%, you will make 5%. If the index loses 20%, your return will
be zero for the year. You do not receive the dividends of the indexes you
invest in.
Principal
Protection
Some people are very critical of the fact that IUL limits
their upside. There is no free lunch. In order to protect your principal, you
have to give up some of the upside. These critics point out that because of the
cap rate, IULs would have earned between 5-8% per year over the last few
decades, during which the S&P 500 has averaged 9-11%.
I agree that it’s possible to make better returns IF you are
willing to stomach the risks of owning an all-stock portfolio, and my
experience has taught me that very few people are able stay invested when the
financial world is in a state of panic. The latest study from Dalbar shows that
the average equity investor has averaged 3.79% over the last 30 years while the
S&P 500 has averaged 11.06%. Even worse, the average fixed income investor
made 0.72% per year, which is only 1/10 of the return of the Barclays Aggregate
Bond Index.
Because it is so hard to stick with an investment plan that
does not appear to be working, I think a percentage of the population would be
better off in a product like IUL that limits their gains but provides principal
protection that helps them sleep better at night.
Creditor
Protection
Texas law states that the cash value in your life insurance
is protected from creditors. This is a very important feature for people in the
medical profession and business owners alike. Money held in your bank account
or brokerage account is generally not protected. This may not seem like a
benefit to you, but consider the fact that a home owner and tree-trimming
company were successfully sued for millions of dollars because an oak tree fell
on the current Governor of Texas in 1984, rendering him paralyzed. I didn’t
know I needed to worry about the trees in my yard bankrupting me until I came
across this case.
Did you know that when you sell your car, you can be held
liable for tickets and criminal and civil liability if the new owner doesn’t
change the title of the vehicle to their name? It is important to go to the tax
office with them or submit a vehicle transfer notification to the DMV right
away. The more experience I have under my belt, the more I realize how risky
life can be.
Tax Benefits
The cash value inside indexed universal life insurance grows
tax-deferred, and if designed properly, it can be pulled out as tax-free loans
that don’t have to be paid back during the insured’s life (the insurance
company uses some of the death benefit to pay off the loan). The only return
that really matters is what you keep after taxes and inflation. If you’re in
the highest federal income tax bracket of 39.6%, you are now subject to an
extra 3.8% Medicare surtax on investment interest under the Affordable Care
Act. If you make 6% inside your tax deferred IUL policy, there is a 10.6%
tax-equivalent yield for the highest tax bracket.
In addition to tax deferral, you can pay a zero capital
gains tax by borrowing against your cash value. You can borrow to buy your next
vehicle, for a real estate down payment, or to fund your child’s college. You
can choose to pay these loans back or potentially never pay them back. Page 27
of the 1990 GAO Report to the Chairman clearly states, “if a policyholder
borrows the inside buildup from his or her life insurance policy, the amount
borrowed is considered a transfer of capital, not a realization of income, and,
therefore, is not subject to taxation. This reasoning is in accord with tax
policy on other types of loans, such as consumer loans or home mortgages.”
Diversification
Stocks and safe government bonds often have low to negative
correlations. There are very few years where the U.S. stock market and U.S.
government bond market both lose at the same time. However, many take comfort
knowing that in down stock markets, they can pull money from their insurance
policy that has principal protection. This can be a very useful tool when
considering the risk of the sequence of returns when distributing money in
retirement. Pulling money from stocks in a year like 2008 can seriously hamper
one’s ability to maintain their standard of living during the rest of their
retirement.
There are also periods where the U.S. stock market is a
lousy long-term investment. The S&P 500 hit 1,552 in March of 2000, and was
at the exact same level 13 years later because of the tech wreck in 2000-2002
and the Great Recession in 2008-2009. This was an ideal environment for indexed
universal life insurance because your principal was protected during the
crashes and the crashes made stocks cheap where they had a good chance of going
up and hitting the cap rates on IUL policies. During long-term bull markets
(think 1982 to 2000), you would expect a capped IUL policy to do worse than the
return of the U.S. stock market.
Arbitrage
When you withdraw money from your brokerage account or
401(k) and spend it, the money is no longer invested and working for you. This is not the case with indexed universal
life insurance. When you borrow from your policy for retirement income, the
insurer is lending you money and using the cash value in your policy as
collateral for the loan. This means that you could have a $200,000 loan at 5.5%
interest against the cash value in your IUL policy. If over the course of your
loan your policy averages a 6.5% rate of return, you are making a 1% rate of
return on all the money you spent to live on.
The chance of being able to make a small spread on what you
have borrowed and the downside protection of the product could potentially
allow you to withdraw a higher percentage of your cash value per year than you
could from volatile investments that don’t have principal protection. I ran an
IUL illustration on a 37-year-old male who had an average return of 6% per year
until age 65, and found he could borrow 4.8% of the cash value in the first
year of retirement and continue to increase that initial amount by 3% each year
until age 100. In simpler terms, the arbitrage and principal protection may
allow you to pull $48,000 indexed for inflation from $1 million dollars of cash
value in an IUL.
That 4.8% is a lot higher than most financial planners would
be comfortable pulling from a traditional portfolio. One of the most common
amounts planners consider safe to pull from your investments is 4%; this has
even come to be known as the 4% rule. Retirement researcher Wade Pfau recently
estimated that retirees should consider pulling only 2.85% to 3% initially from
their investments. That would mean you should only pull $30,000 indexed for
inflation from a million dollar portfolio. If Pfau is correct, having a maximum
funded IUL for retirement could be a nice addition to your retirement.
Death
Benefit
The last benefit of saving into index universal life
policies is to remember that you are buying a life insurance policy. If you pay
one month or one year’s premium and die prematurely, your heirs could see a
1,000% return on the money you invested. If this unlikely and unfortunate event
happens, life insurance is the best thing that you could possibly have invested
in. And the best thing about life insurance is its tax free-policy for your
heirs.
Along with these advantages, I appreciate how many IUL
policies have a free accelerated death benefit rider, which allows you to take
a portion of your death benefit while you are alive if you are terminally ill.
You could use part of your death benefit while you are alive to take your
family on one last vacation, or help pay for a long-term care facility.
Disadvantages
The biggest disadvantage to IUL policies is that they
usually have 10 to 15 years of surrender charges or fees to get your money out.
You need to fully understand the product and be committed to it. The products
also front-load their costs and most illustrations that I run at 6% don’t break
even until year 7 to 10. Hence why it’s usually a bad idea to apply for a
policy and cancel it early on.
The second disadvantage to IUL is that the cap rates can and
will change throughout your ownership of the policy. Many policies only
guarantee a minimum cap rate of 3% or 4%. As mentioned previously, the cap rate
is a function of the cost of buying derivatives. Volatility was substantially
high in 2008 which made derivatives more expensive. I didn’t see any companies
dramatically drop their cap rates at that time and don’t see this as a huge
risk. If for some reason your IUL dropped cap rates near the minimums, you
could change to a different index crediting method or you could invest your
cash value into the fixed account for a period of time.
Lastly, life insurance illustrations always show guaranteed
values and non-guaranteed values. It is very likely that we continue to operate
under the non-guaranteed assumptions, but if Ebola killed massive amounts of
people or AIDS became airborne, all insurance companies could raise their
charges for insurance and administrative costs after receiving approval from
your state. In this hyper-rare event, life insurance contracts would be
considerably less attractive than policy owners were expecting.