“People are always looking for the single magic bullet that will totally change everything. There is no single magic bullet.”
After reading this article, if you need more convincing, I perform a second evaluation of an indexed universal life (IUL) policy here.
I am almost universally against life insurance that isn’t term based life insurance. There are a few exceptions where I’m OK with permanent life insurance, but they’re few and far between: if you have a special needs dependent or your net worth is in excess of the amount where you’re going to be exposed to the estate tax and you are planning on passing on a large estate to heirs (although, the advisability of setting up heirs who are waiting on your death is questionable). Otherwise, I’ve yet to find a compelling case to deviate from the standard advice of term and invest the rest.
However, that doesn’t mean that I’ve been closed-minded in my search to find an alternative to the simple formula for life insurance. A few months ago, I had the opportunity to speak to an insurance salesperson who was convinced that he’d found a better mousetrap. He told me that he was selling indexed universal life insurance and that it provided both cash value and life insurance and that it had a guaranteed floor in case the market went down.
I would have loved to have believed him at face value, but I’ve seen my fair share of chart porn, so I was skeptical. I asked the insurance salesperson to provide me with an in-force illustration for a $100,000 policy for a 25 year old male in Texas. The salesperson went one better and sent me a policy illustration for both the $100,000 policy and one that he said “shows the full potential of this product.”
First, though, he sent me a video from the company that provides the insurance. I’m not going to include this video on my website because it’s so full of hand-waving crap that I don’t want any of you to be confused and believe that I endorse this.
Thus, before I even received the in-force illustration, my antennae were up, and I suspected that something was up, since the video didn’t actually provide any actual, specific information, but, instead a pie in the sky analogy of airplanes.
But, first, before I provide my analysis of how an indexed universal life (IUL) insurance policy, let’s look at what it is and how it differentiates from other life insurance plans.
What is indexed universal life (IUL) insurance?
Indexed universal life insurance is a type of permanent, or whole life insurance product with an insurance component and a cash value component. Compared to a standard whole life insurance policy, where there is a given (and usually quite low) rate of return on the cash value, the indexed universal life insurance policy allows you to “invest” your cash value in the stock market, thereby mimicking the performance of the overall stock market. The insurance company doesn’t actually purchase market indices for you; they purchase options and derivatives to simulate performance.
The biggest selling point of an indexed universal life insurance policy is that they set a floor for “protection” – usually at 0%. If the stock market goes down in a year, your cash value won’t.
If you could buy insurance and actually participate in the stock market with no downside, then it would be a perfect product.
Upon reading this, you should be wondering:
What’s the catch?
There are four catches:
- The amount that you contribute over the cost of insurance doesn’t completely go to your cash value. In fact, in the first few years, very little of your money goes into the cash value. The rest of it goes into the insurance salesperson’s pocket.
- There’s an upside cap. Just as there’s a floor, usually at 0% return for the stock market, there’s also a maximum amount that you can gain before you stop getting benefits from a particularly good year in the market. This is usually at 12%. Therefore, if the market goes up 20%, you only get credit for it going up 12%.
- You only get to receive credit for a percentage of the market’s performance. Depending on the policy, this can be anywhere from 25% to 65%. So, if the stock market goes up 10%, your cash value will only go up between 2.5% and 6.5%.
- The guaranteed returns are extremely low. This is a contractual “get out of jail” card that the insurance companies use to minimize the amount that they are legally obligated to pay you. The salespeople may make all sorts of hand-flourishing wild promises like the one that the insurance agent showed me, but the reality is that once you sign the paperwork, the actual terms and conditions of the contract apply.
The insurance agent sent me an in-force illustration from the universal life insurance policy he sells. It was full of fluffy illustrations that showed, in a perfect world, what the insured person would receive. Unsurprisingly, the illustrations were full of asterisks and footnotes.
Once you get beyond the fluffy illustrations and tons of footnotes and weasel clauses, the first thing that you receive in your packet if you’re a potential customer is an illustration. This is the insurance company’s way of showing you what could happen in a close to perfect world.
However, there’s one very important distinction that they put in the verbiage which clearly delineates between the hypothetical and contractual and legally enforceable scenarios:
“The current rates are not guaranteed and are subject to change, but will never be lower than the guaranteed rates.”
To see the vast difference between the two scenarios, let’s look at what happens to this theoretical 25 year old Texas male when he reaches his seventies.
In the illustrated scenario, a 71 year old Texas male had $191,144 in cash surrender value and a $219,816 death benefit, which was based on an 8.09% average interest rate. As we’ve previously seen in “The Cost of Fees in Your Investments,”, the compound average growth rate of the stock market over the past 25 years is 9.7%; however, the constant draining of fees (see catch #3 above), particularly from the first few years, makes this scenario improbable. In the scenario showing the guaranteed rate of 2.5%, the same 71 year old has $0 cash surrender value and death benefit.
The poor person who buys this life insurance policy and gets the contractually guaranteed interest rates will have no cash value and no coverage at age 71. If he complains to his agent (assuming his agent is still alive to complain to at this point), his agent will give him the shoulder shrugging version of “sorry, Charlie…check the terms of the contract.” The pretty pictures and illustrations will have vanished, replaced by the reality of legal contractual obligations.
That, Dear Reader, is why you have to read the contract carefully. The insurance policy is chock full of illustrations and hypothetical examples, but only one contractually obligated return, and it’s very low.
Furthermore, the flow and terminology of the contract is confusing. I have a MBA from a top 10 university and passed the CFP exam, so I’d like to think I’m no dope. I had to reread the contract four times before I fully understood what was going on and where the catches were.
Yes, the hypothetical examples may happen. You may get lucky. Do you want to take that risk?
However, there are contractual guaranteed minimums and thresholds that a purchaser would receive. Based on these contractual minimums, the only amount that I, as a fiduciary to my clients would ever use for evaluating a plan’s suitability, I decided to horse race the purchase of this indexed universal life insurance policy versus purchasing an equivalent term insurance policy and investing the difference in the broad market. I took historical returns of the market and compared the guaranteed growth of the cash value for each of three “strategies” that are available in the indexed universal life insurance policy that the salesperson showed me. I used the cash that was actually contributed each year to the cash value (the amount minus the cost of insurance minus the salesman’s cut) to determine returns and final value. Since the person in the term and invest the rest case was also buying equivalent insurance, the face values canceled each other out, and I calculated the difference between the two policy costs as how much the person would have available to invest in the market.
I examined 35 year periods to see who would be better off.
Strategy 1: Point-to-Point Valuation, S&P 500 Index
This strategy uses the growth between two points in the S&P 500 (e.g. from January 1 of one year to January 1 of the next year) to determine how much your cash value increases.
Guaranteed cap rate: 3.1%
Guaranteed participation rate: 100%
Using this strategy, the term and invest the rest strategy was superior 123 out of 139 35 year periods, for an 88.5% win rate.
Strategy 2: Point-to-Point Valuation, S&P 500 Index, Focus on Participation Rate
This strategy uses the same growth rate, but increases the participation rate at the expense of the cap rate to determine how much your cash value increases.
Guaranteed cap rate: 3%
Guaranteed participation rate: 110%
I expected this strategy to perform a little bit better. It didn’t. The results were exactly the same. The term and invest the rest strategy was superior 123 out of 139 35 year periods, for an 88.5% win rate.
Strategy 3: Point-to-Point Valuation, S&P 500 Index, No Cap
This strategy has no upper cap, but gets back at you by slashing the participation rate.
Guaranteed cap rate: None
Guaranteed participation rate: 25%
Eliminating the cap helped just a bit, but the low participation rate decimated performance. Term and invest the rest was a superior strategy in 122 out of 139 35 year periods, for an 87.8% win rate.
Even if you used the illustrated scenarios at the 8.09% average interest rate rather than the contractually guaranteed rates, in most instances, you were still better off using term and invest the rest. The only time where the illustrated rates were superior was in Strategy 2:
Illustrated cap rate: 11.5%
Illustrated participation rate: 140%
In that illustration, Strategy 2 was superior to term and invest the rest for 87 out of 139 35 year periods, for a 62.6% success rate.
I have an extremely high amount of skepticism that the insurance companies will hold the rates in the future. I suspect that they will lower them. Ask holders of variable universal life insurance (VUL) policies in the 1980s what happened to their illustrated returns.
My analysis shows that if you purchase the indexed universal life insurance policy that this salesman showed me, you’re running an extremely high risk of losing money compared to buying an equivalent term life insurance policy and investing the difference between the two policy premiums. Certainly, there are no guarantees in life, and I have no idea what the market is going to do tomorrow, much less in the next 35 years, but the low contractual guarantees in an indexed universal life insurance policy means that I will never recommend one for my clients. If someone tries to sell you one of these policies, please, please, please talk to a competent financial planner who has a fiduciary duty to you so that he or she can review the policy and determine its appropriateness (or lack thereof) in your situation.
I wish I could say the same for the salesperson with whom I discussed these results. He was surprised that it was possible to get a return other than the illustrated return until I showed him the contractual language. He could find no errors in my data and agreed with my conclusions, yet, still told me that he thought that it was a good plan and that he was going to sell it to people.
It’s a shame when your wallet gets in the way of everything else.
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.
According to the cited Wall Street Journal article,
Investigators are trying to discern whether the projections in the illustrations are unduly optimistic or misleading…