Indexed universal life insurance (IUL) is an innovative, low risk type of permanent life insurance policy intended primarily for people who are interested in long term life insurance coverage that can generate tax advantaged distributions in retirement. IUL policies are well suited for life insurance buyers seeking large policies, often referred to as jumbo life insurance policies. For some considering premium financing, they may benefit by considering a properly designed IUL (see reasons below). The use of indexing strategies guarantees there will never be market losses, making it appealing to many risk averse and high net worth consumers. Although some are unfamiliar with the detailed mechanics of indexing, the fact that 0% is the lowest credited rate possible in any given year makes it attractive. When the stock market is down 30%, the interest credited to the IUL policy will never be below 0%.
Do IUL policies reduce risk for life insurance buyers? None of the policy’s cash value is ever invested directly in the stock market. The indexes provide a buffer against normal market volatility. “Zero is your hero” feels pretty good when markets are down 25%.
The use of indexing strategies puts Indexed Universal Life in a special life insurance category. It may have the lowest net cost of any policy in the medium term and the long term, depending on how the markets perform and the policies are credited. Some people consider it to be the best life insurance policy because of its unique design. In order for it to be managed successfully, it does require a greater level of understanding and responsibility for the policyowner. With the proper amount of education about indexing principles, indexed universal life is worthy of consideration for suitable life insurance buyers, especially those meeting some, or all of the following criteria:
- Between ages 25-65 (ideally).
- Need, and/or desire, for permanent life insurance.
- High income earner.
- High net worth.
- Desire to create flexible, low maintenance future income, for retirement.
- Considering premium financing.
- Amenable to routine policy review.
Like other permanent life insurance contracts, IUL builds up cash in the policy, in the form of cash value from interest credited to the selected indexes. This asset is never exposed to market risk and it grows on a tax deferred basis. Those are two powerful features within one contract! The cash value can be accessed on a tax advantaged basis and the policy can be designed to add the cash value to the death benefit. These policies offer a number of well-known indexes, such as the S&P 500 or the Nasdaq-100. There are no government imposed restrictions or limitations on distributions, like there are with qualified retirement plans. The cash value can be accessed without penalties or taxes, unlike a 401(k) or IRA, whenever the policy owner needs or wants it.
There are policy expense charges or fees in IUL policies that should be understood by the agent and the policyowner. In the good contracts, the fees are capped which means they are less impactful as the premium levels increase. Indexed Universal Life is not an alternative to term insurance or low premium, maximum death benefit coverage, like guaranteed universal life. It is most beneficial for younger consumers who want permanent insurance, flexibility, strong potential upside and tax free withdrawals near retirement.
The advantage of a policy that guarantees you will never lose principal due to market performance is quite compelling. Another reason insurance companies offer IUL to life insurance buyers is because it is a powerful tool that smooths out returns. “The key to minimizing sequence of return risk is to reduce volatility, which IUL does far more than the S&P 500”, says Sam Rocke, SVP at Ash Brokerage.
Insurance companies share in the index’s upside when markets are up. They do this with simple cap rates and/or participation rates. For example, if the S&P is up 20%, the cap rate may be 12% which would cause the policy to be credited with 12% interest that year. Essentially, cap rates and participation rates create a partnership between policyholders and the insurance company by aligning the interests of the insurance company and the life insurance owner. At each measuring point (annually or monthly), the total cash value is credited with the earned interest from increases in the index that was selected by the policyowner.
The results are impressive as consumers are flocking to the safety of indexed universal life insurance. The product had $2.3 billion in sales for 2019 and the first half of 2020 saw more of the same record breaking growth.
What is Indexed Universal Life Insurance?
The retirement vehicle of choice for many corporate employees is a 401(k). At the same time, the market risk with 401(k)s is well understood by investors. In addition to the market risks, there are contribution limits, taxes that are deferred until withdrawal time and there are substantial fees. For many, a 401(k) is not the perfect retirement solution, by itself. Many people want the ability to make flexible contributions and much larger contributions than 401(k)s and IRAs allow on an annual basis. For them, an IUL can be an excellent addition to an overall financial plan.
The stock market is volatile and it has been known to punish short term and medium term investors. Once people can see retirement in their future, a growing number of them begin to feel differently about the inherent risks in the stock market. Principal protection becomes their main concern, rather than maximum yield. No doubt, yield is important but an extra 1% of yield is not worth exposing principal to additional risks.
What are the costs? Funded properly, these policies should have sufficient internal growth to handle annual cost of insurance charges and other internal fees. The current cost of insurance expenses and fees are subject to change and they are deducted from the cash account each year. Managed and funded properly, the cumulative account values should outpace annual deductions by a lot. I have many younger IUL clients who began funding their IUL contracts with oversized premium contributions. They benefit in two ways. Overfunding creates a cushion of cash value that can be used if income takes an unexpected hit and overfunding in good years can help in smoothing out the returns.
What is Universal Life? Some insight into this fascinating product is beneficial. In the 1970’s, the rate of return of whole life insurance was historically in the low single digits. When interest rates shot up to historic rates in the late 70’s and the 1980’s, EF Hutton created a flexible, interest sensitive product to compete against whole life. Other life insurance companies followed, with some crediting more than 12% at the time. Sales of universal life were meteoric. Billions of premiums poured into these contracts. As an agent during this time, I can attest to the fact that there was insufficient agent education about the impact of interest rates on long term policy performance.
As interest rates decreased, new projections should have been created and explained to policyholders, by their agents. If a policy was purchased using illustrations based on 9% assumptions, it should have been re-projected again when rates fell to 6% and again when rates fell to 4% and again when they fell to the guaranteed rates in the contract. LOWER INTEREST RATES SUSTAINED OVER TIME WILL CAUSE THE POLICY TO NEED MORE PREMIUM TO MEET THE PROJECTIONS THAT WERE BASED ON HIGHER RATES. WHEN THESE POLICIES WERE NOT FUNDED WITH ADDITIONAL PREMIUMS EACH YEAR, THE POLICIES TURNED INTO GRENADES WITH THE PINS REMOVED.
Adding insult to injury, the looming crisis in each policy isn’t detected until there are no options. It’s like driving towards the edge of a cliff in the dark. You have no idea until it’s too late. For most agents, companies and policyholders, these were tough lessons. They taught us to project life insurance conservatively and to encourage reviews often, re-assessing both internal factors as well as external ones. Things change that affect policies. The problem is not universal life. The problems were aggressive insurance company projections, not adjusting as rates decreased and the failure to do annual reviews.
Indexed universal life (IUL) is not a “set it and forget it” type of policy to own. There are other policy types that are much easier to manage. For those who do not wish to learn the benefits of indexing in a life insurance policy, it may not be the right policy choice. Every potential IUL buyer should work with a life insurance professional experienced in indexing strategies as well as representing all the providers of these policies. In fact, when it comes to IUL, choosing the right life insurance company is more critical than with any other policy. Some companies are new to IUL and others have been real innovators and pioneers over the past 20 years. These are things the right life insurance professional will share with you. Of course, it can be more nuanced and complex than that. The life insurance professional and the underwriting company matter a lot in all life insurance purchases but even more so with IUL.
In addition to death benefit and cash accumulation, some IUL contracts offer living benefits or accelerated death benefit options. Simply, this gives policyowners the ability to tap the face amount of the policy for health and medical purposes such as chronic or terminal events. Most of the good policies out there make these features available at no extra cost. There is no reason to consider a policy without accelerated benefits.
Indexing Strategy Offers Best Of Both Worlds.
Most people may know that the stock market index has returned approximately 8% over the long term but less than 4% for average investors over the same time frame.
A variety of reasons are attributable for this gap. The biggest factor is emotion. Investors make all types of investment mistakes for many different reasons. Some are due to panic and some are due to their understandable inability to devote enough time and attention. Not only do investors have to be willing to commit the time, they also have to be ready to act every time action is required. Too many find that impossible while they are working, running businesses and caring for families.
Individual investors can never take their eye off the ball. Failing to buy and sell at the perfect times make it impossible to attain the average long term historical rates of return.
Timing the market is tough, even for professionals. When mistakes occur, they impact the overall yield. Warren Buffett says the first rule of investing is to never lose money and he’s right. But to do that, you must be laser focused at all times. Using an IUL prevents investors from ever losing money due to stock market returns.
IULs have a minimum rate of return, usually between 0% and 2%. For example, if you have $200,000 in a stock account and it drops 20%, you will be down by $40,000. The account value starting in the next year would be $160,000 (minus any fees). In the IUL policy, the same 20% market loss would result in the cash value remaining at $200,000 (minus any fees).
The Concept of Stacked Gains. The importance of stacked gains can not be stressed enough when markets are up. A 10% gain in the following year would result in new interest being credited to the policy in the amount of $20,000, putting the policy’s value at $220,000 at the end of the second year. In the stock account, there would be $160,000 plus the same 10% for year two growth (minus fees). The stock account value at the end of the second year would be $176,000 (minus fees).
The comparison is $220,000 in the IUL versus $176,000 in the stock account. From that point forward, the new base in the IUL is $220,000, never to go lower than that from market losses. Over time, protecting your principal from market loss, makes a huge difference in the policy’s accumulated savings. The cash value in an IUL can drop due to cost of insurance charges and/or fees. It shouldn’t happen but it is something to discuss with a life insurance professional at the point of purchase.
The Upside (cap rates) and the Downside Protection (the floor).
If never losing any principal due to negative market returns still sounds too good to be true, let’s peel back the onion a little bit. Quite simply, they are buying options to insure the downside guarantee that your policy will never lose principal from market losses. Life insurance companies employ some of the sharpest minds in the investment world to manage these assets. The people they have working for them are dedicated to nothing else. There can be billions of dollars allocated in these strategies.
Life Insurance Premium Financing
Using IUL contracts for premium financing is another strategy we use when it is appropriate for individuals to finance a policy. Today, it is the lure of low interest rates that makes financing a consideration. Premium financing should only be for high net worth individuals with at least $5,000,000+ of net worth. A person who needs permanent life insurance but does not want to use their own capital to pay the premiums is a good candidate for premium financing. An arbitrage should exist between the cost of the premium finance loan and the policyowner’s return on investment. For example, HNW people with an ROI of 10% on their assets can borrow the premiums today at 2% and for them, that may be ideal. That creates an 8% arbitrage and some lenders will gladly lock in longer term rates with favorable terms.
The goal of a premium financing strategy is to pay off the loan and be left with a properly funded life insurance policy, payable at death. With more than 30 years of premium finance experience and having placed over 600 financed policies, I have strong relationships with traditional lenders and specialty lenders that work with our clients to finance these policies. Many of our clients have their own banking relationships and they prefer doing business with them. In those cases, our job is to guide them through the insurance company requirements. You can learn more about premium financing here.
The way in which an IUL is initially designed is determined by the goals and objectives of the policyholder. For example, when using the policy to maximize tax-free income in retirement, the policy should be maximum funded, meaning the initial death benefit is low. A lower death benefit will result in less cost of insurance charges.
Is there a “best index or design” to choose? There is no way to know which indexed strategy will perform the best, either over the long term or the short term. We encourage our clients to work with professionals who will follow “best practices” when recommending index strategy allocations. That includes proper understanding of the index choices in order to make the right decision about which fund or funds to select.
Taxation – Indexed Universal Life Receives Favorable Tax Treatment which should be discussed with your insurance professional. Qualified plan distributions from a 401(k) and an IRA are subject to income tax while the death benefit is income tax free. If an estate is large enough to trigger estate taxes, the policy can structured in trust to avoid estate and gift taxes.
Loans are not income, according to the IRS. Therefore, any withdrawals taken as loans are not taxable. For retirement purposes, this is advantageous as the distributions from your IUL are not reported on your income tax returns because they are not treated as income. As a result, this money does not affect your social security taxes or Medicare.
The IUL Loan Structure
Tax-free loans are one of the most compelling reasons to consider IUL, especially for retirement income planning. Indexed Universal Life has different loan types, including an indexed or participating loan. The discussion of policy taxation and loans are important ones and a web page is not a sufficient resource to explain these loans. A web page is good for reference but to cover this topic in the best interest of policyholders, it should be done person to person.
- Tax-free distributions and death benefits
- Guaranteed principal protection during negative market returns
- Maximum flexibility
- Favorable policy for premium financing
- Unstructured loans
- Stacked gains from indexed growth
- Less risk
- Caps and participation rates are not guaranteed
- Decreasing surrender charges
- Creditor Protection (varies by state law)
- Living benefits
- Financially strong underwriters
Please contact me at 561-869-4500 or email me to arrange a complimentary consultation about anything on your mind concerning life insurance, annuities or retirement planning.
Also published on Medium.