Pros of Indexed Univeral Life Dealing With Growth and Taxes

The Truth about How Indexed Universal Life’s Growth Works

There are a number of either straight-up myths or overblown half-truths about how an Indexed Universal Life insurance policy works and grows cash value. The prevailing tone in many articles criticizing IUL is:

• That Indexed Universal Life insurance for retirement is not good
• That IUL’s crediting strategies are inherently bad for policyholders
• Indexed Universal Life is meant to benefit insurance agents and companies much more than the policyholder.

In the next section, I start with the truth of how growth works with an Indexed Universal Life insurance policy. Along the way, I will also dismantle the most opinionated and inaccurate claims about IUL, and replace them with facts and critical thinking. This will provide more context to the true pros and cons of Indexed Universal Life insurance.

The Top 3 Factors Behind How Indexed Universal Life Crediting Works

The three main factors that make the power of indexed crediting inside an Indexed Universal Life policy so unique and powerful are as follows:

#1: Indexed Universal Life Has a Guaranteed 0% Floor in Bad Market Years.

In other words “zero is your hero”*. What this means is that with IUL you can participate in up to double-digit returns in good market years, yet give back no ground to market losses during bad years. Imagine being able to stay confidently exposed to market volatility at all times without the fear of losing any fraction of your account value to stock market losses? To be fair, critics note that an IUL’s cash value will decrease somewhat during those 0% years because of the policy charges and cost of insurance. However, the fees and charges of Indexed Universal Life insurance (video) can often be greatly reduced by simply funding your policy to the maximum allowable limit within the first 5-7 years (more on this within the section about IUL Cost Criticisms).

#2: IUL’s Powerful Annual Reset Feature.

Wouldn’t it be great if after a bad year in your investment portfolio, you could replace the loss with a zero, hit the reset button, and start over from the next year’s new lower market position? You can do exactly that with Indexed Universal Life Insurance! Let’s just say that the S&P 500 drops from 2,500 to 2,000 in a particular year. Imagine that your IUL’s cash value simply receives no crediting that year rather than seeing a 20% drop in your 401(k) account value.

Here’s where the annual reset feature really matters. Once that losing year passes, your Indexed Universal Life policy starts tracking its growth from that new lower 2,000 level in the S&P 500, despite the fact that your policy cash value incurred no market losses on its way down from 2,500 to 2,000. Since sharp bounce-back market rallies often follow crashes, Indexed Universal Life insurance can be an amazingly powerful financial tool to harness that volatility in a positive way.

Whereas market fluctuations may keep you up at night when thinking about your 401(k) or investment portfolio, you might even start to welcome stock market volatility once you allocate funds to an Indexed Universal Life policy. Unlike with traditional investing, the cumulative gains in the S&P 500 do not matter. What I mean is that the S&P 500 does not need to end up at new all-time highs to get growth on your policy cash value.

In fact, with Indexed Universal Life the S&P 500 can crash and then continue bouncing up and down in a range indefinitely. Whereas your investment portfolio may never recover from those early wounds, your IUL cash value can earn crediting in every year when the index ends up higher than where it was 12 months prior.

#3: Actual Market Fluctuations Work in Indexed Universal Life’s Favor.

With your investment portfolio, major market fluctuations can be a perilous risk factor to your retirement. However, since Indexed Universal Life is suited to harness this upside movement while eliminating any downside free-falls, volatility now becomes your friend. Here are 5 supporting facts about the S&P Index coming from a mutual fund company’s 81-year study on the S&P Index sequence of returns that explains exactly why:

• S&P Index Fact #1:

  The market has experienced annual gains more than three times as often as it sustained annual losses. Put another way, the S&P Index has gone up annually 76% of the time in the last 81 years. I’m referring specifically to the 81-year study period from 1937-2017 where the S&P Index has experienced 62 positive-years and only 19 negative-years.**

• S&P Index Fact #2:

  Of those positive years in the S&P, it was 3-times as likely to have given you double-digit crediting than single-digit crediting. What I’m referring to is that in those 62 distinct positive years referenced above, the market gained more than 10% in 48 of those years and less than 9% (but greater than 0%) in the other 14 years.**

• S&P Index Facts #3-5:

  Fact #3: There were only two instances where the market had three consecutive negative years during that entire 81-year time period. The S&P Index had three losing years in a row from 1939-1941 and not again until 2000-2002.

  Fact #4: There was only one other instance where the S&P Index even had two consecutive negative years from 1973-1974.**

  Fact #5: What’s interesting is that all of these prolonged negative periods were immediately followed up by a rebound year that produced at least a double-digit advance from the new lower starting value. Although your investment portfolio may not have gotten even after this first bounce, there’s a good chance that your IUL’s cash value would have pulled way ahead after that first double-digit rebound (since it only paid policy charges during the consecutive 0% years).**

Our video takes a deeper look at this 81-year study to analyze these historic returns of the S&P Index and how Indexed Universal Life can harness this volatility into positive growth.

Ever heard the term “fail fast?” That’s what the stock market seems to do. When it has a significant correction, it plummets downward quickly. Whereas when the market rallies, it usually has a slow and steady ascent over a prolonged period of time. One of my favorite sayings about the market is that “Stocks tend to take the stairs up, but they take the window down.”

On that note here are two questions for you:

1. Do you believe that the stock market will continue to have corrections and recessions, but still produce more up-years than down-years over the next 30-60 years of your life?
2. Do you believe that the majority of those up-years will continue to produce gains in excess of 10% (even if they were rebound rallies that happen to follow some harsh down-years)?

If you answered yes, then in what universe is the unique crediting methodology of Indexed Universal Life insurance a bad thing? Where else can you confidently channel the volatility of the stock market in this manner much less in a tax-sheltered environment?

With that, here are some questions you should be asking yourself:

• What better way is there to protect my account value, lock-in the lion’s share of my past gains, while still staying confidently invested without worrying about when the next crash will happen?
• Other than hiding money under my bed while waiting for a crash, how can I truly take advantage of the great buying opportunities that market crashes can provide? How else can I do this when other investment strategies available are in some way exposed to major market’s losses?
• What portion of my assets would I be willing to cap my annual growth in the 10%-13% range so that I can completely erase the possibility of downside market risk? (Keep in mind that some Indexed Universal Life insurance policies offer uncapped indexing strategies with a 0% floor.)

Now that you have a basic understanding of how IUL’s growth works, let’s dissect the common crediting criticisms of Indexed Universal Life insurance to unearth the truth. This way you can understand the real pros or cons of IUL’s cost structure and see how you feel about using Indexed Universal Life insurance for your retirement and pre-retirement wealth-building goals.

Cons of Indexed Universal Life Dealing With Growth

#1: “Growth in Indexed Universal Life does not include dividends from the stocks that make up the S&P 500 Index.”

Actually, of the various cons of Indexed Universal Life, this is 100% true that S&P 500 dividends are not a contributor to your growth inside Indexed Universal Life. However, the reason IUL policyholders don’t receive growth from S&P 500 dividends is not for some malicious reason like “Aha, the IUL carriers keeping the dividends for their own profits.” It has nothing to do with greed, manipulation, or some hidden agenda on the part of the insurance companies that offer Indexed Universal Life.

The reason why S&P 500 dividends are not paid in an Indexed Universal Life policy is simply because of the options-hedging strategy that the IUL carriers must use to create this unique crediting strategy. Remember, the S&P 500 index is not an investment itself, but simply a tracking benchmark by which to measure other investments. Insurance companies buy options on the S&P 500 index that profit ONLY if the overall movement of the index is up. Even If you invested directly in S&P 500 index options yourself, you would not earn dividends since index options only track the movement of the index itself and not dividend payouts from the 500 companies that make up the index.

You could instead buy mutual funds that track the S&P 500 index and also receive dividends. But keep in mind that unlike the options strategy used by the companies that offer Indexed Universal Life insurance, mutual funds have no 0% floor so they will also track all the downside movement of the S&P 500 index giving you considerably more exposure to losses.

So, although the objection that “Indexed Universal Life does not pay S&P dividends” is completely true, this fact is often overblown by members of the investment community as well as agents that prefer Whole Life. They use it to vilify Indexed Universal Life insurance and to distract from the true value proposition that makes IUL crediting so unique and powerful.

Whether or not you earn S&P dividends is far less significant than the combination of the following 3 features of Indexed Universal Life insurance when determining your overall growth:

• The 0% guaranteed floor of IUL, which protects your cash value from down-years in the stock market
• Indexed Universal Life’s ability to earn double-digit growth in up-market years (possibly with some uncapped growth strategies)
• IUL’s “Annual Reset” feature (discussed above) that allows you to start from the new lower S&P 500 index value when determining your next year’s index earnings (even though you realized no market losses on the way down to that new lower index tracking point).

The lack of dividends in indexed crediting shouldn’t matter that much since that 81-year S&P Index study between 1937-2017 was comprised solely from the movement of the index itself, NOT including dividend payments. Most of the bullish years with double-digit index gains would have easily hit today’s IUL caps even without including S&P dividend payments.

Here’s what you should be asking yourself…

So because of the cap and floor inherent in Indexed Universal Life insurance, dividend payments would actually have little to no effect on an IUL’s growth during most of the years seen in that 81-year study period.

So if the S&P Index rises by 12% or more without including dividend payments, and the cap on your IUL crediting is 12% that year, does it matter that the 500 companies making up the S&P Index paid an additional 2% dividend? Conversely, if the S&P Index was losing 15-30% in a single year, would receiving an additional 2% dividend payment make you feel anywhere near as good as having a contractual 0% floor against market losses?

For that reason, this argument should hardly be considered when weighing Indexed Universal Life insurance pros and cons.

#2: “The IUL carriers put a cap on my S&P Index crediting probably because they’re keeping the excess profits.”

This supposed con of IUL is another distorted fact that is often overblown by biased sources to suit their own agenda and undermine Indexed Universal Life. The reason behind growth caps in Indexed Universal Life has nothing to do with the IUL carriers keeping all the S&P Index gains over and above the annual cap.

It is again due to the mechanics of how this particular options-hedging strategy works behind Indexed Universal Life. In a nutshell, S&P 500 options that last an entire year can be extremely expensive. In order to keep the cost of these options affordable, IUL carriers must cap the amount of growth that can be earned within a year. By limiting the amount of growth potential in the options strategy, the IUL carriers bring down the net cost of the options backing this growth strategy to the point where it is economically viable for them to offer you.

Some people think that the double-digit cap and zero-percent floor growth methodology in Indexed Universal Life insurance is “too good to be true.”

Let’s take a step back and discuss the economics of how IUL carriers provide this unique growth strategy without the risk of market losses.  It’s actually really simple once dissected. You see, in addition to indexed crediting, all Indexed Universal Life policies also offer you a fixed rate of interest (like the original UL products). This fixed crediting rate fluctuates usually trends with prevailing interest rates. Most IUL carriers currently offer a fixed crediting rate in the 3%-4% range. This fixed crediting rate offered by insurance companies was higher in the recent past and will most likely rise again when prevailing interest rates rise in the future.

As an IUL policyholder, you can choose to take either this 3%-4% fixed crediting rate, or you can forgo the fixed-rate and instead shoot for a higher crediting rate by choosing any of the indexed crediting strategies offered by your Indexed Universal Life insurance policy. By forgoing this fixed 3%-4% interest rate (that you would have been entitled to anyway), the insurance company uses it to pay for this options strategy.

Hence, by forgoing IUL’s fixed crediting rate of 3%-4% allows you to track the annual growth of the S&P 500, usually with a floor of 0% and a cap somewhere in the low double-digit range (10%-12%). The reason why the 0% floor is guaranteed is because the IUL carrier is never risking more on the options strategy than the 3%-4% fixed interest rate that they were prepared to pay you in the first place. The max loss you can experience when buying options is the cost you pay for the options themselves.

Some people ask, “Couldn’t I make this options play myself?”

Of course you could, but because IUL carriers have the law of large numbers on their side, they can hire specialized institutional managers to do it for a fraction of the cost that you can. Also, since life insurance provides a social good in the eyes of federal and state governments, you get special tax treatment on your cash value growth when letting them manage this strategy for you inside your Indexed Universal Life insurance policy.

Indexed Universal Life’s crediting methodology is not too good to be true. Nor is it overly complicated to understand when explained properly. It’s not an attempt to rob you of the potentially higher growth of the actual S&P 500 Index, nor is it a scheme to rob you of your dividends. Most importantly, since S&P options are so heavily traded to hedge portfolios by institutional money managers worldwide, these options are extremely liquid. That makes indexed crediting a sustainable strategy that insurance companies can continue to offer regardless of what the stock market and prevailing interest rates do in the future.

This just isn’t true and should not be a factor when looking at the pros and cons of Indexed Universal Life insurance.

#3: “IUL carriers can squash Indexed Universal Life caps at any time.”

This con of Indexed Universal Life is a true statement, but also frequently exaggerated as a manipulative sales technique. This is most often overstated by Whole Life agents using fear-based tactics to steer clients towards their preferred product offering. These agents will highlight the fact that companies that offer Indexed Universal Life retain the right to lower index caps as if it’s an inevitable trap for consumers. They paint the picture that the insurance company can’t wait to sell enough IUL policies to soon spring the trap and rob policyholders of any reasonable opportunity for growth.

Let’s talk about fact vs. fiction.

Insurance companies do in fact reserve the right to lower caps so they can adjust them with steadily falling interest rates like we’ve seen over the last couple decades. It’s really not any different than companies offering Whole Life lowering their dividend interest rates over the same time period. As interest rates fluctuate, Indexed Universal Life caps rates have and will likely continue to trend with prevailing interest rates.

Obviously, Indexed Universal Life growth caps will have to decrease if prevailing interest rates do, since the IUL carriers would have less of an options budget to buy up a higher S&P cap. It’s conceivable that as interest rates rise again in the future, then the corresponding IUL caps should also rise since the insurance companies would then have a larger options budget to work with. That said, the cost of options in the new interest rate environment will also need to be considered.

Here’s what has actually happened with Indexed Universal Life cap rates:

• Most IUL carriers have only lowered caps by relatively small increments over time in an attempt to stay competitive with the rest of the marketplace.
• However, we have seen a few IUL carriers drop their caps more dramatically. Usually, these are lower-rated insurance companies or smaller companies that have been bought out by larger companies. The new controlling company therefore has less loyalty to the old absorbed company’s block of policyholders.
• The other thing we have seen from the top IUL carriers is that they will lower caps and then subsequently raise caps as interest rates have temporarily ticked back upward. That is why we recommend sticking with highly rated, financially solvent companies that have stable histories. Mutual companies may also be more stable since their only obligation is to long-term solvency so it can maintain its promise to policyholders.

Truth be told though, there is no guarantee that says IUL carriers have to raise caps as prevailing interest rates rise. Similarly, there is also no guarantee that Whole Life carriers will ever raise dividend rates in the future or even continue to pay dividends for that matter.

Think about it though…If your Indexed Universal Life was designed properly and funded aggressively, your surrender value will often be equal to or greater than the premiums you paid in a relatively short time. If your IUL carrier makes their product undesirable in any way (by lowering caps or increasing fees), couldn’t you just surrender the policy and walk away?

Also, if an IUL carrier makes this kind of detrimental move, the insurance agent who recommended that company and product to his/her clients also looks bad upon reviews and would be less likely to recommend that company in the future.

For these reasons, IUL carriers are incentivized to remain competitive to sustain long-term business and keep a solid reputation in the industry. Contrary to how they are sometimes portrayed, insurance companies are often trying to do just that, and not trying to rip-off consumers.

#4: “Insurance agents selling Indexed Universal Life often exaggerate the average crediting rate in their illustrations.”

This may have been true in the past with some IUL agents, especially those who naturally have a tendency to over-promise and under-deliver. You know the type.

Regardless, a set of industry-wide regulations called AG-49 (Actuarial Guideline-49) took effect starting September 1^st, 2015. These mandates set forth uniform standards for all IUL carriers and agents to follow when illustrating Indexed Universal Life insurance.

In fact, AG-49 forces IUL carriers to look back and average every single 25-year rolling period the S&P 500 Index experienced within the last 65 years using that particular Indexed Universal Life policy’s current cap and floor. By taking the average of every single one of those individual 25-year slices, the IUL carriers then takes averages all this data to determine the maximum illustrated rate for their Indexed Universal Life policy. This way a carrier can’t simply cherry pick one very favorable look-back period to justify an abnormally high illustrated crediting rate.

Not coincidentally, the push for AG-49 came from a handful of insurance companies that don’t offer any sort of Indexed Universal Life product. They felt that the IUL carriers were getting too much market share and were stealing clients from their preferred product offering, mainly Whole Life Insurance. If you do hear this particular argument about cherry picking averages from any agent, blog post, or video, it just simply cannot be done anymore.

Learn more about Actuarial Guideline XLIX (AG-49) directly from the National Association of Insurance Commissioners (NAIC).

Again, this cannot possibly be true in today’s environment and shouldn’t be considered when deciphering Indexed Universal Life pros and cons.

#5: “Indexed Universal Life agents are afraid to show the actual wild fluctuations of the S&P 500 Index and would rather show you a smooth and steady average to cook the books in IUL’s favor.”

This alleged con of IUL really upsets me because prior to AG-49, this was absolutely an untrue statement. (You can read the clip above to learn more about AG-49).

I used to be able to illustrate an Indexed Universal Life policy’s projected cash value growth through different historical periods in the S&P 500 index. That way clients could see the effects of turbulent market conditions while accumulating cash value as well as seeing the effect of taking tax-free retirement withdrawals and/or policy loans from IUL through different market cycles.

You see, many IUL carriers offered an illustration feature (prior to AG-49) where rather than showing some smooth average like 6% or 7% every year, you could simulate whatever policy design the client wanted through different historical periods. For example, I could show a client putting in $10,000 of annual IUL premium for 7 consecutive years and run those premiums through a policy showing the last 40 years of the S&P 500 performance using that particular company’s cap, floor, and insurance charges. Some IUL carriers even offered these types of back-tested illustration reports for the last 20 years, 30 years, 40 years, 50 years, and even 60 years.

Even if the client was not expected to live that long, It was good for them to see the range of what could happen to their policies through different turbulent periods. The client could also see the effect of using Indexed Universal Life for retirement income as their cash value hit the cap, the floor, and everything in between while taking policy loans.

The uniform standards of AG-49 outlawed this practice with IUL because almost every back-tested time period produced a better long-term result than the maximum illustration rate allowed by the new formulaic constraints. This is because when you earn that double-digit crediting on your balance that experiences no losses in the 0% years, it has a much more profound effect on your cash value than even a linear 7% average even when zeroes are peppered in between.

It’s unfortunate because having the client observe IUL’s cash value being stress-tested through different time periods was invaluable to framing expectations for the type of volatility they may experience inside an indexed universal life insurance policy. There is no period in the S&P 500’s history that went up every year by 6% or 7% for 25 straight years. In my mind, showing multiple back-tested time periods is much more compliant than picking some average, even if that average is regulated.

Ironically, the call for these new AG-49 standards originated from a handful of insurance companies that primarily sell Whole Life Insurance. They claimed that Indexed Universal Life growth rates being misrepresented by agents, which was certainly true in some cases. Unfortunately, these new regulations subsequently outlawed one of the most powerful tools available for illustrating potential turbulence in an IUL policy.

Click here to learn more about Actuarial Guideline XLIX (AG-49) for Indexed Universal Life insurance directly from the National Association of Insurance Commissioners (NAIC).

#6: “If you have a 0% year or multiple consecutive 0% years with Indexed Universal Life insurance, then the average crediting rates being shown are unrealistic.”

Of the various pros and cons of IUL, this one is simply not true. Some argue that if your Indexed Universal Life policy has a 0% year, then it will have a very hard time earning long-term average crediting rates in the 6%-7% range, which are commonly being shown in today’s relatively low cap environment. Let’s reference the facts again by citing that 81-year year study of the S&P Index we looked at in the last section. Past performance is no indication of future returns, but isn’t 81 years of the S&P a large enough sample size to inject some factual basis into this assertion?

Since the inception of stock investing, when the market goes down it eventually bounces back to those previous highs and at some point makes new highs. As far as multiple 0% years, didn’t we see in the 81-year S&P Index study above that there were only two instances where the market lost for three consecutive years and only one more instance where it lost for two consecutive years? All three of these extended losing periods were immediately followed by at least one double-digit year that would have easily hit today’s Indexed Universal Life cap rates. This strong rebound year would have bolstered your IUL’s average crediting rate and helped to make up for the prior two or three years that translated to 0% crediting.

Keep in mind too that there were at least two and a half decades between each one of these multi-year losing periods. During the entire 81-year study there were 3 times as many up years than down years. When we isolate the 61 up years during the 81-year study, there were 3 times as many double-digit up market years than single-digit up market years. For the last 81 years, this is how the market has moved through good times, bad times, recessions, corrections, world wars, inflation, deflation, and so on. Why then is it conceivable to think that a long-term average Indexed Universal Life crediting rate of 6%-7% is unrealistic, even if consecutive 0% years are experienced at some point?

Now if for some reason the market doesn’t bounce back from a multi-year bear market in the future, don’t we all have bigger problems than the type of insurance policy or investments we own? If some kind of ongoing global systemic economic meltdown hit, how could Whole Life carriers somehow be immune to these problems?

I mention this because this argument is often brought by operations favoring Whole Life insurance vs Indexed Universal Life Insurance. Don’t get me wrong, I own several Whole Life policies, and I recommend Whole Life insurance vs. Indexed Universal Life for clients wanting rock-steady guaranteed growth every year rather than the potential for greater upside growth in any given year.

Keep in mind though that although Whole Life offers very modest guaranteed growth provisions, dividends are not guaranteed to be paid to policyholders every year. If dividends are not paid, then Whole Life will not perform very well as a growth vehicle nor can it even function as an income vehicle. All of the cash value would be needed to support the guaranteed death benefit, and there would be little or no dividends to distribute as income.

Cons of Indexed Universal Life Dealing With Cost

#1: “IUL’s cost of insurance is expensive”

This is one of the most common cons of Indexed Universal Life, which often comes from investment community or worse yet random bloggers who are unlicensed and uninformed on how IUL’s fee structure works. In fact, the next time you hear this kind of blanket statement from someone, ask them to explain exactly how IUL fees are assessed. What’s ironic is that most members of the investment community don’t even understand all the utility of Indexed Universal Life for retirement, much less exactly what is IUL’s cost of insurance.

For eons, the investment industry has been competing with the insurance industry for the same dollars. So the investment community leans heavily on the common opinion “Indexed Universal Life is too expensive” without providing any factual grounding.

What’s interesting is that our best clients will buy expensive cars, houses, electronics, etc., all of which obviously provide more benefits than a multitude of cheaper alternatives. So why then should our clients disregard the unique benefits which Indexed Universal Life insurance can provide and base this one particular buying decision solely on what is cheapest? A more intelligent approach would be to discuss if IUL’s unique combination of benefits are indeed valuable to them. If the clients feel they would be valuable, then why not do an in-depth analysis to see if the cost for the benefits with Indexed Universal Life insurance would, in fact, be “too expensive” for them?

However, since most investment advisors were trained by companies that don’t directly profit from life insurance products, they will often lack the expertise to perform this kind of examination of an Indexed Universal Life insurance policy. In fact, most would be hard-pressed to list even half of the benefits that can be provided by IUL. Rather than have their comfortable business model be threatened and be forced into an intensive new learning curve, it’s much easier to throw around the common opinion that “IUL’s cost of insurance is expensive.” This justifies their one-dimensional insurance analysis and also frees up more dollars for the financial products they actually can speak intelligently about.

So are IUL fees expensive? Compared to what exactly… term insurance? Of course, Indexed Universal Life will cost more than a comparable term policy. IUL provides a unique combination of benefits that you can’t get in term insurance or any other investment product for that matter. These benefits include:

• Tax-deferred growth
• A unique way to capture growth from stock market volatility without stock market risk
• Tax-exempt access to both your principal and growth even before age 59.5
• A tax-free death benefit that doesn’t automatically expire after 20 years
• Potential lifetime access to the death benefit in cases of chronic illness, critical injury, terminal illness, or other situations requiring long term care
• Protection from lawsuits and creditors in certain states

We have found that the higher the client’s income is, the more valuable these benefits become to that client when properly explained.

What if we said that Indexed Universal Life was no more expensive than decades of compounding managed money, would you believe it?

For starters, most clients don’t even understand how much in aggregate they’ll actually pay for decades of professionally managed money on an increasing balance. It obviously depends on the exact facts and circumstances, but we have run multiple studies with IUL vs a 401k or any kind of AUM (assets under management) where we even give AUM a better long-term rate of return. In many instances, especially where the client is in a higher tax bracket, we found that they will often pay considerably more in fees for AUM and yet still end up with less after-tax income during retirement and less money left behind for heirs by life-expectancy. This is because of the special tax perks offered to permanent life insurance.

Again, the relevant facts and circumstances will change with every fact pattern, but it is definitely not as cut and dry as the investment community would have you think. So, next time you hear that Indexed Universal Life is expensive, ask “compared to what?” Ask them to explain their research or admit if it is just an ungrounded opinion. Ask your investment advisor how much they would charge to provide a cheaper investment alternative that can offer the exact same combination of benefits offered by Indexed Universal Life insurance.

Guess what…they can’t without using some sort of life insurance product.

#2: “IUL cost of insurance will increase dramatically.”

This is probably the most misunderstood of Indexed Universal Life insurance’s pros and cons. It is over-sensationalized and touted like IUL fees are a ticking time bomb by agents who primarily sell Whole Life Insurance. As an independent, who takes an educational approach with clients to discover which type of insurance product suits them best, I’m incredibly disturbed by this kind of hype. It’s really unfortunate because agents using fear-based half-truths to further their own sales process are in fact damaging the insurance industry as a whole.

The Truth Regarding the Increasing IUL cost of insurance:

It is absolutely true that the IUL fees do indeed increase every year with age. As the insured gets older, he/she is more likely to die, and therefore the cost of insurance with an IUL will go up. However, this next little factoid of information is something that the critics conveniently omit in their attacks on Indexed Universal Life insurance. That ever-escalating cost per unit of insurance is only levied upon the “net death benefit” or “net amount at risk” (the total death benefit minus how much you have in cash value).

Here is an example of what the insurance company calls “the net amount at risk.” If you have $600,000 of death benefit and $50,000 of cash value, your IUL cost of insurance will be based on $550,000 of death benefit since the $50,000 of cash value is already your equity in the policy.

Let’s say four years later that your cash value has grown to $300,000 after paying more premiums and getting index crediting. Even though the IUL cost of insurance per unit has increased because you’re now 4 years older, you are will now only be charged IUL fees for $300,000 of death benefit. This is because the insurance company is only risking $300,000 if you die ($600,000 total death benefit minus the $300,000 of cash value that is technically yours to take at any moment).

What sounded like one of IUL’s cons may actually be a pro.

The advantage to you with the aged-based increasing IUL fees is that you often will actually have a lower total cost of insurance during the early years even when the IUL carriers have more at risk in the way of death benefit. In fact, these initial IUL fees can be significantly lower at the onset of the policy compared to the same-sized Whole Life Insurance policy.

Since you have more money working for you early on, and Index Universal Life can provide double-digit growth opportunities, you can rack up substantial cash value during these early years. This early compounding may propel your cash value toward the death benefit, which in turn may reduce the total amount of death benefit you’re actually paying for when the IUL fees per unit of death benefit increase.

So if funded properly, your IUL’s cost per unit of insurance will certainly increase because of age, BUT you may be paying for substantially fewer units of insurance as you get older.

Most informed agents will tell you (even if they have a strong preference for Whole Life) that Indexed Universal Life insurance for retirement can work very well through life expectancy as long as it has been funded properly. Remember that this article is discussing Indexed Universal Life insurance in the context where cash accumulation is the main goal, and the policyholder’s intention is to fully fund a policy within 10 years or less (preferably 4-7 years for optimal performance). 

To view more information on this subject, check out this YouTube video examining IUL Fees.

Your escape hatch if your IUL fees are set to start increasing aggressively

If for whatever reason you can’t fund your Indexed Universal Life insurance policy as expected, or it doesn’t get the cash value growth inside the policy as projected, you may find the your IUL’s cost of insurance will get out of control unless you do something.

If you are trying to use your IUL for retirement and cash value accumulation, one option is to simply just call your IUL carrier and have them manually reduce your Indexed Universal Life insurance policy death benefit to minimum allowable level before the increasing cost per unit of insurance really starts to get prohibitively high. This often doesn’t happen until deep into retirement age.

However, if you fund your Indexed Universal Life policy early and get reasonable crediting along the way, you likely will not have to reduce the death benefit because the amount of cash value should already be getting much closer to the total death benefit number come retirement age. However, you always retain your right to lower your Indexed Universal Life insurance policy’s death benefit to the minimum allowable level, if this is your goal.

Maintaining a minimal amount of death benefit over and above your cash value will often create a situation where the amount of IUL crediting you get from your compounding cash value should overshadow whatever charge the insurance company levies upon the much smaller amount of “net death benefit” remaining in your Indexed Universal Life insurance policy.

Keep in mind that whatever IUL fees you are paying for that nominal amount of net death benefit will often be worth maintaining for the ongoing tax sanctuary afforded to Indexed Universal Life insurance. I’m sure you’d be happy to pay for a nominal amount of life insurance to ensure that your cash value continues growing tax-deferred and you maintain your ability to take tax-exempt distributions from your IUL policy while you are still alive.

Dirty little secret: How agents will improve a Whole Life policy’s performance by making it more like IUL’s cost of insurance

Often the same agents who insist that “increasing IUL fees are too risky and should be avoided,” are not practicing what they preach.

If one of their Whole Life clients demands maximum early cash value or has a need for some premium flexibility, these same agents will quickly recommend blending a pure Whole Life Policy with a supplemental term rider. This term rider allows for much more premium flexibility than Whole Life typically offers, and at the same time, the term rider permits the client to over-fund a Whole Life policy with double, triple, or quadruple the mandatory premium. This can increase early cash value buildup far beyond what is possible inside a pure Whole Life policy.

However, if you put any of these supplemental term riders under an actuarial microscope, what you will see is that they are all Annual Renewable Term riders that function almost identically to the cost structure to Indexed Universal Life insurance. It starts with a very low initial cost of insurance but increases every year with age. Sound familiar? Many Whole Life Insurance policies designed for maximum early cash value growth are blended so heavily with this kind of term rider, that the base Whole Life policy (which they insist is so much safer than Indexed Universal Life) will make up only one-third or one-quarter of the entire policy structure.

So why is a heavily blended Whole Life policy OK and a max-funded Indexed Universal Life insurance policy not?

Whole Life agents will tell you not to worry because your cash value will grow and reduce the amount of the term rider you will be paying for on an ongoing basis. This is basically the same for IUL fees. With both Whole Life’s term rider and IUL cost of insurance, as the cash value approaches the death benefit, you are paying for fewer units of insurance, so even if the cost per unit of insurance increases, the total cost should be manageable and eventually even minuscule compared to your cash value growth.

I agree that blending this type of Supplemental Term Rider can be a very effective way to accumulate cash value for a Whole Life Policy. Thankfully the underlying structure of a pure Indexed Universal Life is already designed the same way. With lower IUL fees in the early years, you actually have a better opportunity for early growth, so there’s a good chance that the converging of the cash value upon the death benefit (which lowers cost of insurance with each may happen even sooner with Indexed Universal Life vs. Whole Life with a term rider. But if you want the certainty of having steady crediting every year, Whole Life may be the way to go. I let my clients’ preferences dictate the recommendation, rather than some rigid stance or preference of my own.

If for whatever reason your Whole Life policy with a supplemental term rider doesn’t grow as expected, Whole Life agents will tell you that you can simply drop the rider and be left with a much smaller base Whole Life policy that is sustainable. With IUL you essentially have the same option of reducing the overall death benefit to the point where the remaining amount of death benefit is easily sustainable. Although would not be guaranteed, the costs for this nominal amount of death benefit in a properly-funded Indexed Universal Life policy would be so minuscule to the amount of cash value you have in indexed crediting strategies, that it would be nearly impossible for the fees to overshadow the growth, much less your principal balance.

So why then are the same agents selling Whole Life with a Supplemental Term Rider simultaneously condemning Index Universal Life insurance like it’s the devil incarnate? Often it is ignorance. They simply don’t know what they don’t know and are parroting the same fear-based propaganda that they have been fed by their preferred companies that only offer Whole Life. Many Whole Life agents have not bothered to investigate the facts beyond the harsh negative hype since they already have a product and sales process that they are very comfortable with.

Ironically, more and more of the old stalwart mutual companies that primarily sell Whole Life are starting to develop and release IUL products of their own lately.

#3: “The dreaded guaranteed column in Indexed Universal Life is something to legitimately fear.”

I’ll be the first to admit that the guaranteed column of Indexed Universal Life does look pretty scary. What you’ll see is steadily declining cash value shortly after you stop paying premiums. Eventually, you’ll see either the word “Lapse” or “End” followed by a big blank area on the page where your IUL’s future cash value and death benefit are supposed to be.

Keep in mind that for the guaranteed IUL cost of insurance to actually occur, not one, but two horrible and extreme factors need to take effect:

• Your Indexed Universal Life policy must get very little or no interest crediting at all…ever
• Your IUL carrier must raise their internal mortality charges to the absolute maximum allowable level (often more than triple the illustrated charges)

Let’s discuss what it would take for each leg of this horrible double-whammy to come true.

For most Indexed Universal Life insurance policies the guaranteed column means 0% growth…in any year ever. When I bring up how the “guaranteed column” of a 401k account would actually be a -100% return leaving you with $0, people will commonly reply, “Well that’s ridiculous because I have conservative and diversified mutual funds. Even if my investments dip temporarily, they will eventually bounce back.”

I agree that in all likelihood this will be a true statement. If that’s the case then you certainly shouldn’t need to worry about tracking the S&P 500 index with a 0%-1% crediting floor like you have built into IUL crediting strategies.

In fact, I did a little experiment using the worst period I could find with the Dow Jones Industrial Average from 1929-1953 (since the S&P 500 doesn’t have data that far back). This awful 25 year period in the stock market had 11 years with 0% growth or worse, and it wasn’t until the 26th year (1954) until that index finally broke above the pre-1929 highs. So if I isolate this atrocious period, and use a 0% floor and a paltry 11% cap, it produces an average crediting rate of 5.3%.

This is the worst period anyone can find in the stock market. But because the market still moved up and down on the way to breaking even over a period of more than two decades, this environment can still produce fairly decent average crediting rate inside an Indexed Universal Life insurance policy.

Regarding the maximum mortality charges, no company out there selling any kind of Universal Life has ever inflicted the maximum guaranteed mortality assumptions on any block of policyholders. The maximum charges are often more than triple what the illustrated charges are. The only reason that IUL carriers maintain their right to raise their charges that high is just in case some epidemic like the modern equivalent of the Bubonic Plague strikes America and modern medicine simply can’t handle it.

Most of the higher-rated companies that offer IUL have never even raised their mortality charges above what was originally illustrated for the client. Even if you isolated the companies that have raised their mortality charges above what they originally illustrated, they didn’t even come close to charging the maximum possible charges that must be on display in the guaranteed column. In order to raise their charges even a fraction above what they illustrated, these companies have faced regulatory hurdles as well as a slew of class-action lawsuits. So raising mortality charges is not some willy-nilly tactic that an IUL carrier employs whenever they simply want a bit more profit.

If you haven’t even bought an Indexed Universal Life insurance policy yet, and are simply looking at an IUL illustration, then all of this perfect storm of a continuously plummeting S&P 500 and a disturbing mortality rates in America would have to commence directly after you write your first premium check for the guaranteed column to come true. As soon as one year goes by where you either earn crediting, or the carrier doesn’t triple their charges, then the guaranteed column you see on that sales illustration suddenly becomes utter nonsense. Scary as it may have looked, it was as mythical as a fire-breathing dragon.

Let’s just say for a moment that you fully fund your Indexed Universal Life insurance policy with the maximum allowable premiums in the first 5-7 years like you should do to maximize your IUL’s crediting strategies and potential future retirement income. Let’s also say that you, in fact, earn an average of 5%-7% crediting over that period. Then after 5-7 years your particular insurance company suddenly decides that it must drastically raise their cost structure and/or lower their caps.

In the majority of cases, we find that most to all of the premiums you put into your IUL policy would be available for you to withdraw (sometimes even more). It’s highly unlikely that you would be confronted with this kind of decision, but even if you were, all would not be lost as the fear-based propaganda would have you think about the Indexed Universal Life insurance pros and cons.

The Biggest Myths of Indexed Universal Life

Myth 1 – “Late Premiums kill guarantees in an Indexed Universal Life insurance policy.”

This statement is actually completely false regardless of how you interpret it. I say this because there are a couple different ways you can this take comment.

One way is to acknowledge the fact that most of the best performing IUL policies on the market don’t even offer a guaranteed death benefit option. Most people aren’t buying Indexed Universal Life for a guaranteed death benefit. So late premiums don’t matter with IUL unlike with say a Guaranteed Universal Life product or even Whole Life, both of which have some sort of rigid mandatory premium structure to support such guarantees.

People are often buying Indexed Universal Life insurance for retirement and cash value growth as their main goals as opposed to the highest guaranteed payout to heirs at death. It is the policyholder’s responsibility to make sure that their Indexed Universal Life insurance policy is funded with enough premium and earning enough crediting to sustain the ongoing IUL fees. As discussed previously, the policyholder can always manually reduce their total benefit inside Indexed Universal Life to reduce these charges and optimize cash value growth.

The benefit to the policyholder for bearing the full responsibility of maintaining however much death benefit they want is that IUL is a very flexible policy without any rigid premium structure. So looking at the “late premiums kill guarantees” comment through this particular lens, it is clearly false.

It’s worth mentioning that there are a few select companies that do offer an optional “No-Lapse Guarantee” rider that you can attach to your Indexed Universal Life insurance policy.

As stated, most people don’t buy Indexed Universal Life insurance for guaranteed death benefit, but if you do buy one of the IUL products or riders that does offer some sort of guaranteed death benefit, any late or missed premiums will not immediately kill the guaranteed death benefit. This is unlike a Guaranteed Universal Life product or even a Whole Life policy, where the policy can lapse or the guarantees be removed after a single missed or late premium.

If you make a late premium payment on an Indexed Universal Life insurance policy with a “No-Lapse Guarantee” rider, you actually have the option of restoring the guarantees by paying back that premium at interest. Even if you choose not to do so, your guaranteed death benefit will often still be in place, only it may not last as long as when you originally started it. For example, the death benefit may only be guaranteed to age 88 after missing a premium rather than say age 95 or whatever age it was originally guaranteed to when you started the policy.

Again, any way you slice it, the statement about how “Late premiums kill guarantees in an IUL” is clearly not true and should not be considered when weighing Indexed Universal Life insurance pros and cons.

Myth 2 – “Many UL Policies sold in the 1980’s imploded like IUL will going forward

Oftentimes agents who sell mostly Whole Life Insurance will bring up the early history of Universal Life as evidence not to buy an Indexed Universal Life insurance policy today. Let’s discuss the historical background and why it actually may not be a con of Indexed Universal Life, but rather a pro for IUL’s validity in this current economic environment.

Many remember the rampant inflation during the 1980s and as a result, the double-digit mortgage interest rates and even savings account rates. Because of the prospect of rapidly increasing interest rates, E.F. Hutton got a private letter ruling from the IRS to create a new type of permanent insurance product called Universal Life (UL). Inside this revolutionary new UL product, the cost of insurance was separate and completely unbundled from the growth of the cash value. That way consumers could more nimbly benefit from the rapidly rising interest rates.

Apparently, it was very popular, because droves of Whole Life policyholders quickly adopted this new type of life insurance and rolled their Whole Life cash values into Universal Life Insurance.

I was but a young lad during that era, but I heard first hand from multiple veteran agents who remember this disruptive shift in the insurance industry. What they reported to me was that the Whole Life Policies at the time were indeed performing better than how they were originally illustrated (since dividend rates were now higher). However, the cash value growth inside Whole Life Insurance paled in comparison to what was possible with the newly unbundled Universal Life product.

Let’s discuss why below.

From a Crediting Standpoint: Why Whole Life underperformed Universal Life during the 1980’s

The three factors that affect Whole Life cash value growth other than the annually declared dividend interest rate are:

• Credits for favorable mortality experience by the insurance company (fewer people dying than originally expected during underwriting)
• Credits for the mutual company managing the company more efficiently than expected in terms of the overall cost to run the business
• A contractually guaranteed internal policy growth rate (usually declared at 4%) that is predetermined at the onset of the policy and therefore unaffected by higher interest rates in the future

Isn’t it interesting that a feature that sounds so good like “a guaranteed growth rate,” can actually turn out to be a bad thing if interest rates rise dramatically? So even if the dividend interest rate for a Whole Life policy reaches double-digits, the base growth rate of a Whole Life policy is GUARANTEED NOT to increase.

Also, as stated above, the dividend interest rate was simply one factor that determining how big the annual dividend increases were in the 1980s. The other two factors that make up a Whole Life dividend (credits for favorable mortality experience and managing overall company expenses) did not increase anywhere near how the rapidly rising interest rates did in the 1980’s. So even though prevailing interest rates had more than doubled, there wasn’t twice as much efficiency running the insurance company’s operations, nor were twice as many policyholders living longer than expected, thereby paying premiums longer than expected or at least delaying the carrier having to pay out death claims sooner.

In contrast to these diverse factors that make up Whole Life crediting, the increasing interest rate environment of the 1980s was the sole crediting component of these recently invented Universal Life policies. (Note: Keep in mind that all Indexed Universal Life insurance policies have some sort of fixed account like the old UL policies that participated in rising interest rates).

Now, this doesn’t mean that Whole Life is a bad product vs. Indexed Universal Life. There are many times that a client’s preferences and risk tolerance dictate that they will be much more comfortable building cash value inside Whole Life vs. Indexed Universal Life. However, in an extremely high-interest rate environment, it’s probable that a Whole Life policy’s cash value won’t benefit as much from the increased rates as a comparable UL or IUL policy can because of the factors listed above.

From a Cost Standpoint: Why Whole Life Underperformed Universal Life During the 1980’s

(Note: I apologize in advance to any actuaries reading this for my oversimplified explanation below.)

For a whole life policy, the lifetime’s worth of mortality charges are essentially averaged throughout the life of the policy. This means that although you do not need to worry about exponentially increasing insurance charges inside a Whole Life policy as you get older, you essentially have pre-paid for these would-be charges by having less cash value at work for you during the early years of a Whole Life policy.

Let’s think critically for a moment. Do the Whole Life carriers have such vastly different mortality data or underwriting skills that allows them to offer some discount on permanent death benefit that a Universal Life carrier can’t? The famous musician Neil Young put it best, “They give you this, but you pay for that.” One of the things I always tell my clients is “There are no deals in insurance. Everything is priced perfectly. If for a moment some product is mispriced, jump on it, because it won’t last long.”

This is why you often see little or no cash value during the first two policy years of a pure Whole Life policy. As you learned earlier in this article, Universal Life on the other hand, has lower mortality costs in the early years, allowing more of your cash value to compound in your favor from the get-go. It’s true that in the later years of a Universal Life Policy that the policy charges can increase dramatically if:

• Your policy’s cash value hasn’t performed well
• You haven’t funded the policy properly
• Or you haven’t made adjustments to lower the death benefit

However, there is obviously a benefit to having more money working for you sooner. As discussed earlier in this article, you can combat the future rising cost per unit of insurance inside any UL or IUL policy in many different ways throughout the life of the policy.

So, going back to the debacle of the 1980s. What happened is that agents started selling this new UL product as if interest rates would remain that high for perpetuity. The declared interest rate at the time, often a double-digit number, was projected forward each and every year throughout the policy illustrations. Using those assumptions, it appeared as if premiums only needed to be paid for a handful of years to support a lifetime’s worth of charges. Well, we all know now that interest rates have declined steadily ever since.

Many of the consumers, who weren’t regularly reviewing their policies were under the impression that their policies would be fully paid-up until death since that was what they originally saw. However, since the cash value performance was substantially lower than originally projected due to steadily declining interest rates, the policyholder would need to either:

1. Pay more premium
2. Or they would have to manually drop the death benefit to reduce the ongoing charges.

Since a large block of policyholders failed to do either of those things, it left a stain on Universal Life and the life insurance industry in general, which still reflects negatively on IUL today. Had the agent reviewed the policy or the consumer had been proactive enough to reach out to the company for a policy review, they could have rectified the situation before it was too late. Unfortunately though, droves of agents who sold these policies left our high-turnover industry, and many policyholders took the “set it and forget it approach,” allowing the train wreck to unfold.

Does this mean that train travel is no longer safe for anyone? Does it mean that both Universal Life and Indexed Universal Life are inherently bad products? I think not. There are certain considerations and responsibilities that the policyholder must take on when buying any type of universal life product, including Indexed Universal Life. If they do, then they stand to receive a unique combination of policy features and benefits as a result.

If Universal Life turned out to be a bad choice during a declining interest rate environment, what does that mean now for Indexed Universal Life that interest rates are near historic lows?

Let’s discuss how this same set of circumstances MAY play out with Indexed Universal Life in the current economic environment and into the future. I say MAY because my hypothesis below is by no means a certain outcome or backed by any contractual guarantees. But if you think critically when approaching the facts, you may find that this could be the ideal economic environment to start a universal life policy, especially an Indexed Universal Life insurance policy.

Recall that the main reason Universal Life products from the 1980s didn’t perform as planned was that they were illustrated during an exceptionally high-interest rate environment. From that point interest rates started a steady decline to the historic lows we find ourselves in today, right?

Let’s just say for a moment that you started just a basic Universal Life policy in today’s low-interest environment, a policy with no S&P Index crediting option and only a fixed crediting rate that fluctuates with prevailing interest rates. If you see an illustration that works in today’s low-interest-rate environment, isn’t it probable that the actual results could be much more favorable if interest rates rise in the future? If interest rates increase over the next decade or two, shouldn’t actual results be much better than what you’re seeing illustrated today?

If you believe that interest rates can’t go much lower or can’t stay low indefinitely, then what we have today is the exact opposite of the UL train-wreck situation after the 1980s, correct? In fact, if the critics citing the 1980’s UL debacle followed their own logic, they would see that this may be the ideal entry point for a universal life policy.

To take it a step further, it could be even better for an Indexed Universal Life policy, where you have the option to toggle every year between a fixed interest rate or any of the indexed crediting strategies offered. So as the economic climate changes, you can choose every year how much of your cash value you want allocated to one of the IUL crediting strategies with a 0% floor and a double-digit cap, and how much of your cash value you want to earn a steady declared fixed-interest rate.

Of course, with every year that passes, you can revisit your options and reallocate your Indexed Universal Life’s cash value account as you see fit.

Little Known Sweet-Spot with IUL Loans:

A handful of insurance companies that offer Indexed Universal Life policies will actually lock in your policy’s loan rate FOR LIFE while still letting you fully participate in some or all of their policy’s indexed crediting strategies (even on loaned money).

Wait, what?!?

That’s right, many IUL carriers currently have a 5% or 6% loan option that would be locked-in for life as soon as you initiate one of these policies. This gives you a great opportunity to earn positive arbitrage because you can currently earn up to 12.5%-13.5% tracking the S&P 500 index, even on the amount of money you borrowed at 5%-6% to use for other things.

Many people plan on borrowing against their policy value someday to:

• Acquire real estate
• Lend money to their own business ventures
• Buy vehicles
• Send kids to college
• Take tax-exempt loans as supplemental retirement income

If that’s the case, then locking in a rate now using today’s low 5%-6% policy loan rates is an amazing advantage. No Whole Life policy allows you to lock in your loan rate and still realize maximize growth potential on loaned money. No bank or brokerage account will let you lock in your margin loan rate today for the entire life of your account. Right now though, you can lock in a low lifetime rate on your IUL policy with a handful of highly-rated companies.

Indexed Universal Life is most often the premium financed life insurance product of choice when clients choose to take loans from third-party loans from outside lenders. You can all about how premium financing works as well as the pros and cons of premium financed life insurance here.