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Let’s explore why Universal Life Insurance gets such a bad rap and also why Indexed Universal Life (IUL) since it rides on a Universal Life chassis, why it often gets lumped in with these criticisms.
We’re going to take a look at the biggest egg on the face of Universal Life and we’re gonna think critically about today’s environment, and explore how Indexed Universal Life Insurance could perform in not only a rising interest rate environment but also flat interest rate environment.
So cutting to the chase if we go back in time to when Indexed Universal Life was invented around this era – interest rates were spiking and people wanted a product where they could get nearly pure participation of these interest rates and.
They were abandoning other insurance products and UL was all the rage. Now probably the biggest flaw in our industry is the reliance on illustration as if it’s fact or if that’s what you’re buying. So illustrations that were showing this as the crediting rate projected forward as if that’s going to happen each and every year.
And obviously you can see by the trend below that did not continue and interest rates spiraled downwards for the next 30 plus years. Now you can see even today so this the last tick on this chart was May 25th, 2018. Interest rates are starting to tick back up but there are several challenges keeping them from really skyrocketing like they were before.
That being said even in today’s low-interest rate environments where the 10 year treasury is in the two and a half to three range you can often get fixed interest rates on an IUL policy similar to what a universal life policy had in the past, and they didn’t have index crediting they only had the fixed interest rate so the fixed interest rates on an IUL you can often get today between 3 to 4 percent (sometimes a little bit lower, sometimes a little bit higher depending on the product and carrier).
So if that’s the case, what happened in the past is these interest rates were being shown to double-digit returns and obviously the consumers didn’t get the return that they expected.
Now I’m not sure why they didn’t follow up with the company or why their agent didn’t check back in with them. But something’s got to give, if what you saw in the illustration was “this” and you’re not getting “that” performance, then if you want the comparable results since you’re not getting the performance from index earnings you’re going to have to pay more premium to make the policy behave like “that“.
Needless to say, people didn’t do that, they often waited several years or before right before the policy was about to lapse. And by then there was no runway to make things right.
And so a lot of these policies blew up. So just thinking critically and playing the tape out in the future, if you bought an Indexed Universal Life policy in today’s low-interest environment (the lowest it’s been since the inception of any sort of Universal Life product) whether interest rates meandered up in the future or whether they spiked up dramatically, arguably shouldn’t the actual returns you experience be better than the illustration you’re seeing now?
Just thinking critically, isn’t this really a photo negative of the debacle situation that occurred after the inception of universal life in the early 80s? Let’s just explore, because I know some of you’re thinking “Well wait, I’m not getting a fixed interest rate on my universal life policy I’m participating in the index”.
So let’s discuss how that works – as we shared before, commonly you’re seeing 3 to 4 percent as a fixed rate in today’s IUL policy. So you don’t have to participate in the index. Each and every year, you can choose how much of your cash you want to take this steady 3 to 4 percent and how much you actually want to try and put into the index to earn 0 to 12, 0 to 13, 0 to 11.
Whatever it is and all these numbers used to be higher. So when Indexed Universal Life was being sold here sometimes this was 14. I’ve even seen 15 in some of the early policies were in the high teens, so arguably again when interest rates go up in the future shouldn’t caps also go up?
There are other factors involved but the answer is “Yes they probably should” because caps are really a function of these fixed interest rates you can get in your IUL policy, so whatever interest rate you can get for not being in the index. Essentially, what the insurance company is doing for you is they’re taking this, they’re not giving it to you, and they’re spending it in the options market to buy S&P options.
And arguably the more interest they would have given you, the more S&P options they can buy and therefore the higher the cap. That’s theoretically how things should work.
Even in today’s low-interest rate environment, we’re seeing average crediting rates with today’s caps in, call it the 6 to 7 percent yield or 6 or 7 percent range, when interest rates are here. So as they go up, there is a good chance that the average crediting rate that’s being illustrated on your IUL policy could go up.
Does it have to? Absolutely not. And that actually helps us go back to one of the other major criticisms of Indexed Universal Life – the guarantees.
There’s no guarantee that insurance companies have to do this. However, your cash value will be accumulating so much in the policy that you can surrender or 1035 exchange your policy.
Much like people did when UL was born, they were getting out of other policies to go into this and so they are incented incentivized to be somewhat competitive with other product offerings. There is a good chance you’ll find that as interest rates go up Indexed universal life companies will also raise their caps in tandem since they have a bigger options budget to play with.
The other major criticism of Indexed Universal Life or any Universal Life is that the underlying cost structure inside a policy goes up each and every year.
So going back to the 1980s, it was really a double whammy negative. Interest rates were trending down so they weren’t getting the performance they were used to. And meanwhile, the cost of the net amount of risk (or the costs of the death benefit over and above the cash value) was going up since they weren’t getting the performance.
And this caused, again, there’s just this great debacle in the industry.
There are some safeguards that are available in Indexed Universal Life and really that were available to these policies. They just weren’t really touted as loudly as they should be.
Going back to the rising cost structure, if you took out a policy here and this was supposed to be your cost structure, this is really talking about the cost per unit of death benefit. So let’s just say your total death benefit is here and you have cash value that’s going up by any degree.
The actual amount of death benefit you’re going to get charged for is going to be based on the difference between how much cash value you have and how much net amount of risk or how much actual death benefit over and above your cash value would have to be paid out to the consumer.
Even though this underlying rising cost of insurance per your age is going up inside the policy, you’re actually paying for less and less units of this death benefit as your cash value converges upon the death benefit.
And since people are mainly buying Indexed Universal Life, not so much for the permanent death benefit, but more so about the cash then they can control these costs either by getting decent performance or if they don’t, you actually have the ability to manually ratchet down the death benefit so long as it doesn’t violate the mech limits at any time during the policy.
So anytime after year 7, you can run a calculation and see how much you can reduce the death benefit by so that you’re paying for less and less units of actual net amount of risk or the amount of death benefit you’re paying for.
Well if that’s the case, if you’re paying for very little net amount at risk and you’re merely keeping the death benefit alive for the tax sanctuary of IUL, then does it really matter how much the cost per unit of that insurance is? It pales in comparison to how much interest you’d be earning or how much compounding you’d be getting off of the cash value inside your Universal Life policy.
The moral of the story is two-fold here. I think the main one is responsibility and the other one is thinking critically.
As far as responsibility goes, I happen to know people that are agents who bought Universal Life in this environment. And even though it performed much worse than illustrated, their policies are doing just fine. Their cash is growing nicely because either they chose to fund it heavier, put in more premium early to support the death benefit, or to manually reduce the death benefits so that the rising costs did not cannibalize and eclipse their cash value.
If you’re going to look at an Indexed Universal Life policy today, talk to an agent that is going to help you service it or has a team that can help you service it.
And even if for whatever reason they leave the business you have a falling out with them, ultimately it’s your product. You have the responsibility. You can always just call the carrier and you can request a new servicing agent or you can deal with the carrier directly to run these projections and see if you’re on track to make the necessary adjustments with your own policy.
The last is to think critically.
Don’t just believe the hype that because “this” happened (and it was bad, I admit). Think about the fact that, well wait a second. If that was bad then shouldn’t this be great? Isn’t there a better chance that this should be great?
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John “Hutch” Hutchinson
ChFC®, CLU®, EA, AEP®, CExPs®