Best Indexed Universal Life Insurance Policy Quote
Indexed universal life (IUL) insurance is often pitched as a cash value insurance policy that benefits from the market’s gains – tax free – without the risk of loss during a market downturn. While the sales pitch certainly sounds compelling on the surface, critics warn that market returns are far from guaranteed and the term nature of the insurance could make it expensive to maintain the policy later in life when premiums tend to rise sharply. In this article, we’ll take a look at the pros and cons of IUL policies and some other options that might be worth considering as alternatives. Benefits Indexed universal life policies put a portion of the policyholder’s premium payments toward annual renewable term insurance with the remainder added to the cash value of the policy after fees are deducted. On a monthly or annual basis, the cash value is credited with interest based on increases in an equity index. The gains are applied based on a participation rate that’s set by the insurance company, which can be anywhere from 25% to over 100%. (he Best Type of Life Insurance for You Right Now.) Let’s take a look at IUL policy:
“Indexed universal life insurance provides death benefit protection and the opportunity to build money inside your policy, called cash value, based in part on the increases of market indexes. Even if these indexes dip, you’re still safe with a guaranteed minimum interest rate.” – Voya Financial “Indexed universal life insurance combines life insurance protection with equity-linked accumulation potential. It has some of the same features as universal life, like premium flexibility, and offers more growth potential, but with potentially less risk than variable universal life insurance.” – AXA
Key benefits of these policies include:
Higher Return Potential – These policies leverage call options to gain upside exposure to equity indexes without the risk of losses, while whole life policies provide only a small interest rate that may not even be guaranteed. Greater Flexibility – Policyholders can decide how much risk they’d like to take in the market, adjust death benefit amounts as needed, and choose between a number of riders that make the policy customizable to their needs. Tax-Free Capital Gains – Policyholders do not pay capital gains on the increase in cash value over time unless they abandon the policy before it matures, whereas other types of financial accounts may tax capital gains upon withdrawal. Downside There are several gotchas that are associated with indexed universal life insurance policies that critics are quick to point out. For instance, someone that establishes the policy over a time when the market is performing poorly could end up with high premium payments that don’t contribute at all to cash value. The policy could then potentially lapse if the premium payments aren’t made on time.
Using Indexed Universal Life for Retirement Income
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. A study from Dalbar showed 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 California 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.
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. (For related reading, see: Diversification and Lessons From a Normalizing Market.)
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.
The Bottom Line IUL is not a correct choice for everyone. But if you design a policy that buys the least amount of insurance to get the maximum amount invested, you can add diversification to your portfolio, have tax flexibility in retirement and make attractive after-tax returns.
