Another Evaluation of an Indexed Universal Life Insurance Policy

Several months ago, I provided an evaluation of an indexed universal life insurance (IUL) policy. In the comments, I said that if any insurance agent could come up with a policy that met the standard of beating term + invest the rest when aftcast using the guaranteed levels provided in the policy, I’d change my mind.

Mr. Michael Goodman of M. C. Goodman Insurance out of California stepped up to the plate.

Before we get into the dialogue and the analysis, I’ll explain the basics of an indexed universal life insurance (IUL) plan for those who did not read my first analysis of an IUL.

An indexed universal life insurance plan is a form of whole life insurance, meaning that as long as you pay premiums through age 100 (in the case of the IULs that I have seen), you will receive a death benefit. Pay the premiums, and the policy can never expire, compared to term life insurance, where you’re insured for a given period of time and then the policy, if you’re still alive, expires.

In an IUL, you pay more than the insurance premiums require in the beginning, and the excess that you pay goes into an accrual account. Over time, the accrual account is meant to grow, and once you either a) stop paying the premiums, or b) the premiums are insufficient to cover the cost of the insurance, the accrued amount can pay for the insurance costs. It’s important to note that, according to the guaranteed terms (more on that later),

If you pay the premiums that are shown on the Tabular Detail pages of this illustration, then based on the guaranteed interest rates and guaranteed charges, the insurance coverage of $391,078.00 would cease at age 68.

Once you hit age 68, you’ll have to pony up more cash to keep that universal life insurance policy at the guaranteed rates and charges.

In the interim, in an IUL, the accrued amount that you have not used is allowed to increase based on the performance of whatever index you choose it to mirror. You could also choose to allow it to be tied to a fixed amount. In the case of the illustration Mr. Goodman sent me, the index he chose was the S&P 500 index; he allocated 100% of the accrual to the index, leaving 0% to the 3% fixed rate that was also on offer.

There are three components to how much your accrual amount actually goes up:

• Participation rate: This is the percentage of the change in the index that your account receives. It’s tied to the other factors as well, which we’ll explain with an example afterwards.
• Index cap rate: This is the cap on the upside of the performance. Simply put, if the index gains more than the cap rate, then you only get the increase of the cap rate. If the cap rate is 13.5% and the index – the S&P 500 in this case – earns 20% in a year, then your accrual account increases by 13.5%, since the performance of the index hit the cap.
• Minimum index floor: This is the guaranteed minimum growth of your accrual account. It’s the opposite of the cap rate. If index performance is lower than the minimum index floor, then your accrual account will receive the minimum index floor amount instead. For example, if the minimum index floor is 0% and the S&P 500 loses 10% in a year, then your accrual account will receive a 0% return.

Let’s give three examples to illustrate the different concepts:

1. Cap rate of 13.5%, participation rate of 75%, minimum index floor of 0%, S&P 500 earns 10%. In this case, your accrual account was above the floor and below the cap. Since the participation rate is 75%, that means your accrual account gets a 7.5% gain.
2. Cap rate of 13.5%, participation rate of 100%, minimum index floor of 0%, S&P 500 earns 15%. In this case, the index gain is above both the minimum index floor and the index cap rate, meaning that your accrual account gets a 13.5% gain.
3. Cap rate of 13.5%, participation rate of 100%, minimum index floor of 0%, S&P 500 loses 10%. In this case, the index gain is below the minimum index floor of 0%; therefore, your accrual account gets a 0% return for the year.

In the policy illustration that Mr. Goodman sent me, there is also a bonus after 10 years of holding the policy – adding 0.75% to whatever you receive in the accrual account.

There are two more exceptionally critical concepts to an IUL that you need to understand:

• Illustrated: In the policy that Mr. Goodman sent me, the term “illustrated” or “illustration” appears 139 times. Therefore, it’s very important. The very first page of the packet explains:
  
  AN ILLUSTRATION IS NOT INTENDED TO PREDICT ACTUAL PERFORMANCE. INTEREST RATES, DIVIDENDS AND VALUES SET FORTH IN THE ILLUSTRATION ARE NOT GUARANTEED, EXCEPT FOR THOSE ITEMS CLEARLY LABELED GUARANTEED.
  Furthermore,
  We also show you how your policy would work if the cost of insurance and policy expenses were the same as today’s rates (which are lower than the maximum amount we could charge you in some or all years), and the interest rates for the Fixed Account and/or Index Selections to which you chose to allocate your premium payments remain the same in all years. The interest rate(s) used is based on your premium allocation selection(s).
  and
  The rates, costs and expenses assumed in computing the non-guaranteed values are subject to change by North American. This illustration assumes that the currently illustrated elements for both Non-Guaranteed Alternate and Non-Guaranteed scenarios will continue unchanged for all years shown. This is not likely to occur, and actual results may be more or less favorable.
• Guaranteed: In the policy that Mr. Goodman sent me, the term “guarantee” or “guaranteed” appears 94 times. 46 of those times, that word is preceded by “non,” meaning that what is described is not promised by the insurance company. It’s another very important term. Guaranteed means the terms that the insurance company is legally obligated to actually abide by. If the terms of an IUL change and still exceed the minimum guaranteed terms, then you have zero standing in a court of law to argue against the change. Again, let me reiterate a quotation from the actual illustration:
  
  The rates, costs and expenses assumed in computing the non-guaranteed values are subject to change by North American.

How does an insurance company actually fund these policies? Obviously, in times when the index’s performance exceeds the floor, then it wouldn’t seem to be a problem, but what about when the index’s performance is below the floor, and the insurance company has to cover the difference?

The insurance company doesn’t actually invest your accrual account in the S&P 500 or whatever underlying index you choose in the policy. It will buy bonds in the amount necessary to guarantee the minimum index floor payment and then uses the remainder of the funds to buy index options. This has a key outcome that we’ll see momentarily.

The price of bonds is inversely proportional to interest rates. In times of low interest rates, the cost of bonds increases. When interest rates rise, bond prices decrease.

The price of index options is affected by volatility – how much the index goes up or down in a given period. An option is the right, but not the obligation, to buy or sell the underlying security at a given price at some time in the future. Therefore, the amount of time left before the option expires affects the price, but so, too, does how much the index swings. The more the index changes, the higher the probability that the index will exceed (or fall below, depending on the type of option you’re buying) that price at some point between the time of purchase and the time of expiration. The higher the volatility, the higher the price. Therefore, in times of high volatility, the insurance company cannot buy as many options as it can in times of low volatility.

Thus, the insurance company is subjected to two risk factors: low interest rates and high volatility. That is why, in a typical IUL policy, you will see a guaranteed cap rate much lower than the illustrated rate and why the terms “illustrated” and “non-guaranteed” appear so frequently in the policy illustration. The insurance company needs to be able to change the cap rates in times when it is either expensive to buy bonds or expensive to buy index options (or both).

There is a second, knock-on effect from how the insurance company invests the accrual account. Your accrual account tracks the performance of the index, but it does not receive dividends. Between 1872 and 2012, dividends accounted for 43.8% of the total overall return of the S&P 500. In an IUL, you do not get to participate in that dividend growth.

There are two main selling points of the IUL.

1. Protection against the downside: this plays on loss aversion, meaning that, psychologically, you feel more pain from losing than you feel happiness in gaining the same amount. Losing $100 causes more pain than gaining $100 causes happiness. Therefore, even though from 1872 to 2012, the S&P 500 index only had losses 37.9% of the time, that will be the focus of your attention because of the psychology of loss aversion.
2. Policy loans: As long as there is enough money in the accrual account to pay for the interest on the loans and the insurance premiums, then a policyholder can take out loans against the accrued amount tax free. The catch is that if the underlying index performs below the interest rate of the loan, then the difference comes out of the accrual account. If there is not enough in the accrual account to cover the interest, then you either have to pay the amount or surrender the policy. If you surrender the policy, then, if you have more cash value than what you have paid in premiums, you will pay income taxes on the difference.

Insurance agents will also often pitch a tax angle on IULs.

For example, here is the claim that Mr. Goodman made to me:

At death, the DB [death benefit], after deducting any outstanding policy loans or money used in number 4, is also income tax-free to the beneficiary under federal law.

This is the exact same death benefit as a term universal life insurance policy. Death benefits are not taxable to beneficiaries unless the beneficiary is the estate of the insured and the amount of the estate exceeds the estate tax threshold. That’s a wash.

The death benefit in an IUL is defined as the insurance amount (for the policy that Mr. Goodman sent me, $391,078) plus the accrued cash value.

The death benefit can be accessed to pay expenses related to a chronic illness, long term care, or a terminal illness. This money is also income tax-free because it is an advance of the DB. The carriers I represent offer these benefits at no extra charge.

Again, this is a standard rider on most term life insurance policies as well. If you have a documented terminal illness (usually 24 months or less of life expectancy) or chronic illness, you’re allowed to accelerate the death benefit – normally at a cost, just like the IUL. A good example is the Columbus Life’s Nautical Term product.

Here’s the cost of the accelerated death benefit from the IUL:

The minimum benefit is the smaller of 10% of the death benefit on the election date or $100,000. The maximum benefit is the smaller of 75% of the death benefit on the election date or $750,000. Only one election can be made for terminal illness.

So, Mr. Goodman is claiming that you can use after-tax proceeds to buy something that provides tax-free growth in the future. What does that sound like?

A Roth IRA.

In the illustration that Mr. Goodman provided, his client, a 24 year old non-smoker in excellent health, would buy $4,000 worth of an IUL policy for the first 10 years and then increase the amount to $10,000. He would stop funding the policy after 41 years.

So, for the first 10 years, his client could put the same amount of money, minus the cost of a term universal life insurance policy, into a Roth IRA. After 10 years, assuming that the Roth IRA limits do not change (unlikely given the history of limit increases), he could put $5,500 into a Roth and the remainder pre-tax into a 401k. That means that he could put in more money to mirror the equivalent after-tax money needed to put into the IUL, though he will have to pay income taxes later when he withdraws the money.

This is the most favorable scenario for buying term life insurance and investing the rest, but also the most likely one, as about 90% of single filers are eligible for Roth IRAs and slightly over 80% of families are eligible for Roth IRAs.

So, to balance out the comparison, I also evaluated a scenario where the person who buys term life insurance and invests the rest is not eligible for any tax-favored retirement account whatsoever (highly unlikely in the case of a 24 year old, which is the proposed client for Mr. Goodman). In this case, the person would pay income tax on dividends and then, when calculating the total value, would pay a long-term capital gains tax on the gains in the investments. This is the most favorable scenario for the IUL, as it maximizes the tax advantages of the IUL compared to the taxable accounts.

The actual policy illustration provides three scenarios:

1. Guaranteed: This is the minimum guaranteed amount that the universal life insurance policy will pay out based on using either a fixed account (3%) or a 0% index floor, 100% participation rate, and a 4% cap rate.
2. Mid-point: This is the average of the non-guaranteed and guaranteed charges, as defined:
   
   The midpoint values are based on an interest rate which is midway between the guaranteed and non-guaranteed rates used in this illustration, and an average of nonguaranteed
   and guaranteed charges.
   In this case, the midpoint is a cap of 8.725%.
3. Illustrated: This is the best-case scenario for the policy. In this case, it is a 0% floor, 100% participation rate, and 13.5% cap rate.

To evaluate the two strategies, I looked at six scenarios. In each, I compared purchasing an IUL with purchasing a $400,000 30 year term universal life insurance policy using the same rating factors provided by Mr. Goodman, and investing the rest.

I then looked at 40 year scenarios using the historical performance of the S&P 500 to see which approach would leave the person better off after 40 years. It is impossible to project into the future, so in this case, aftcasting is an appropriate measure and readily accepted in financial planning and analysis. I could also build a Monte Carlo simulation using historical averages and standard deviations, which would lead to similar results.

Remember, barring estate tax thresholds (which were never reached in any of the scenarios), if the person dies during this period, most tax benefits are nullified, as all proceeds pass to the beneficiaries tax free, except in inherited tax-deferred retirement accounts, which will require tax payments on distributions based on life expectancy; therefore, to give the IUL the best scenario, I assumed that this person was living at the end of the evaluation period, as where applicable, the person was paying either income or capital gains taxes. Here are the six scenarios:

1. Illustrated IUL conditions compared to a person who invests in a Roth IRA and a 401k (or equivalent) tax-deferred retirement account. This would pit the best-case IUL scenario against the best-case term and invest the rest scenario.
2. Illustrated IUL conditions compared to a person who only invested in taxable accounts. This would pit the best-case IUL scenario against the worst-case term and invest the rest scenario.
3. Midpoint IUL conditions compared to a person who invests in a Roth IRA and a 401k (or equivalent) tax-deferred retirement account. This would pit the middle-of-the-road IUL scenario against the best-case term and invest the rest scenario.
4. Midpoint IUL conditions compared to a person who only invested in taxable accounts. This would pit the middle-of-the-road IUL scenario against the worst-case term and invest the rest scenario.
5. Guaranteed IUL conditions compared to a person who invests in a Roth IRA and a 401k (or equivalent) tax-deferred retirement account. This would pit the worst-case IUL scenario against the best-case term and invest the rest scenario.
6. Guaranteed IUL conditions compared to a person who only invested in taxable accounts. This would pit the best-case IUL scenario against the worst-case term and invest the rest scenario.

Scenario 1

In this scenario, term and invest the rest led to a higher total value (after-tax account value) in 67 40 year scenarios, or 66.3% of the time. The IUL led to a higher total value (accrued value plus death benefit) in 34 40 year scenarios, or 33.7% of the time. The average total number of years during the 40 year periods in which the IUL balance exceeded the term and invest the rest balance was 6.48 years. The average term and invest the rest balance over the 101 scenarios was $582k better than the average IUL balance over the 101 scenarios. In the 67 scenarios where term and invest the rest was superior, it had an average balance 50.9% higher than the IUL balance. In the 35 scenarios where the IUL was superior, it had an average balance 30.0% higher than the term and invest the rest balance.

Scenario 2

In this scenario, term and invest the rest led to a higher total value (after-tax account value) in 53 40 year scenarios, or 52.5% of the time. The IUL led to a higher total value (accrued value plus death benefit) in 48 40 year scenarios, or 47.5% of the time. The average total number of years during the 40 year periods in which the IUL balance exceeded the term and invest the rest balance was 12.27 years. The average term and invest the rest balance over the 101 scenarios was $181k better than the average IUL balance over the 101 scenarios. In the 53 scenarios where term and invest the rest was superior, it had an average balance 34.2% higher than the IUL balance. In the 48 scenarios where the IUL was superior, it had an average balance 42.1% higher than the term and invest the rest balance.

Scenario 3

In this scenario, term and invest the rest led to a higher total value (after-tax account value) in 86 40 year scenarios, or 85.1% of the time. The IUL led to a higher total value (accrued value plus death benefit) in 15 40 year scenarios, or 14.9% of the time. The average total number of years during the 40 year periods in which the IUL balance exceeded the term and invest the rest balance was 3.65 years. The average term and invest the rest balance over the 101 scenarios was $1.08 million better than the average IUL balance over the 101 scenarios. In the 86 scenarios where term and invest the rest was superior, it had an average balance 91.8% higher than the IUL balance. In the 15 scenarios where the IUL was superior, it had an average balance 14.0% higher than the term and invest the rest balance.

Scenario 4

In this scenario, term and invest the rest led to a higher total value (after-tax account value) in 70 40 year scenarios, or 69.3% of the time. The IUL led to a higher total value (accrued value plus death benefit) in 31 40 year scenarios, or 30.7% of the time. The average total number of years during the 40 year periods in which the IUL balance exceeded the term and invest the rest balance was 6.28 years. The average term and invest the rest balance over the 101 scenarios was $675k better than the average IUL balance over the 101 scenarios. In the 70 scenarios where term and invest the rest was superior, it had an average balance 75.3% higher than the IUL balance. In the 31 scenarios where the IUL was superior, it had an average balance 23.7% higher than the term and invest the rest balance.

Scenario 5

In this scenario, term and invest the rest led to a higher total value (after-tax account value) in 99 40 year scenarios, or 98.0% of the time. The IUL led to a higher total value (accrued value plus death benefit) in 2 40 year scenarios, or 2.0% of the time. The average total number of years during the 40 year periods in which the IUL balance exceeded the term and invest the rest balance was 1.69 years. The average term and invest the rest balance over the 101 scenarios was $1.44 million better than the average IUL balance over the 101 scenarios. In the 99 scenarios where term and invest the rest was superior, it had an average balance 153.2% higher than the IUL balance. In the 2 scenarios where the IUL was superior, it had an average balance 5.3% higher than the term and invest the rest balance.

Scenario 6

In this scenario, term and invest the rest led to a higher total value (after-tax account value) in 90 40 year scenarios, or 89.1% of the time. The IUL led to a higher total value (accrued value plus death benefit) in 11 40 year scenarios, or 10.9% of the time. The average total number of years during the 40 year periods in which the IUL balance exceeded the term and invest the rest balance was 3.16 years. The average term and invest the rest balance over the 101 scenarios was $1.04 million better than the average IUL balance over the 101 scenarios. In the 90 scenarios where term and invest the rest was superior, it had an average balance 122.3% higher than the IUL balance. In the 11 scenarios where the IUL was superior, it had an average balance 11.6% higher than the term and invest the rest balance.

Summary

Even in conditions most favorable for the IUL – where the person who purchased term life insurance and invested the rest in a taxable account compared to the illustrated conditions for the IUL – term and invest the rest was a superior historical strategy. Placing money in an IUL drastically reduced the overall amount of money available to the person after 40 years.

IULs have, as of this writing, been around for 17 years. I evaluated 140 years of S&P 500 performance. Insurance salesmen will point repeatedly to the illustrations which a) are likely to change, and b) do not account for sequence of returns risk.

If an insurance agent tries to sell you an IUL, ask why the illustrated returns are not guaranteed. He’ll probably try to answer, like Mr. Goodman did, that neither is the S&P 500. That is true, but 140 years of historical performance give me more confidence than 17 years of performance where the presented best-case scenario of IULs versus the worst case scenario of term and invest the rest still cannot, historically, beat term and invest the rest – before any potential changes to the IUL policy, which, as we have seen, are quite possible.

Emotions

The IUL insurance agents who have contacted me have had one thing in common: emotions. By the way, none have been happy to find this analysis; yet every CFP who has contacted me has agreed with my conclusions. I do not know if it because the IUL insurance agents feel threatened by my analysis or have other reasons for being so emotional, but I have yet to find one who has taken what I would consider a professional approach to the discussion. Were I an agent who disagreed, I’d probably contact me and initiate the discussion along the following lines:

Mr. Hull,

I saw your article regarding IULs, and respectfully disagree. Here are the following reasons that I disagree with your approach:

1. Reason 1
2. Reason 2

Etc.

I have run an analysis using your conditions and have the following findings…

Instead, I’ll use Mr. Goodman’s correspondence with me as an example:

I happened on your post at https://www.hullfinancialplanning.com/an-evaluation-of-an-indexed-universal-life-plan/ and was amazed that you would print such seriously biased and factually deficient advice. Does CFP mean something different in Texas than in California? There’s an old saying that it’s usually “better to keep your mouth closed and be thought a fool than open it and remove all doubt.” I guess you’ve never heard that one.

I don’t want to overwhelm you by discussing how policy loans do not remove the amount of the loan from the cash value, allowing the security for the loan to continue earning interest. Your head would probably explode!

I’m not questioning your intelligence. I’m questioning your integrity!

MY mother would be proud and my clients will eventually see our exchanges on my website…

So get off your horse…

There’s a psychological term called willful blindness, wherein you only focus on facts or opinions that are favorable to your side. This is what I believe happens to these passionate IUL representatives. They so want to believe the illustrations that they either fail to do the requisite analysis required to be responsible in a fiduciary manner – meaning they put their client’s best interests first, or they have willful blindness to the analysis and facts which would require them to try to sell a product that is analytically inferior to another method. Yet, as we have seen, even the illustrated caps fail to beat term and invest the rest.

IUL commissions are higher than term life insurance commissions.

I’ll let you draw the conclusions.

In this case, Mr. Goodman, I appreciate the opportunity to evaluate another indexed universal life insurance policy. Even in the scenario most favorable to your product, and, statistically, historically, and demographically speaking, the least likely to occur, it still underperformed versus purchasing an equivalent amount of term life insurance and investing the difference in the S&P 500 index. I certainly hope you show your clients and potential future clients this analysis before offering them an IUL product.

Yes, I am biased because the facts and analysis lead me to such a bias.

The Bishop Company has an excellent analysis of IULs, here, written by two CFPs, who, in order to maintain their CFP credentials, are required to abide by fiduciary duty.

On September 21, 2014, New York Financial Services Superintendent Benjamin Lawsky sent 134 letters to New York insurers asking whether or not the illustrations used in IULs are misleading consumers. Given what I’ve seen with those projections, I will not be surprised if some of the insurers are found liable and forced to change their illustrations. It is my opinion that they are misleading.