What if I told you there’s a tax-advantaged investment product that lets you participate in the upside of the stock market with essentially zero chance of losing money? That’s the elevator pitch for indexed universal life insurance.
Sounds great, right?
There’s a problem, though. Actually, there are at least 5 problems and probably more.
This Saturday Selection from Dr. Jim Dahle, telling us why IUL is not all that or a bag of chips, originally appeared on The White Coat Investor.
Indexed universal life insurance (IUL) is an insurance product that seems to promise you can have your cake and eat it, too. Unfortunately, as with most things in life, there are no free lunches. The devil is in the details, and when you really examine them, it becomes clear that these are products designed to be sold, not bought.
What Is Indexed Universal Life Insurance?
Indexed universal life insurance is similar to the more familiar whole life insurance policy in that it is composed of two basic pieces: first, a permanent insurance policy that will pay a death benefit whether you die young or old; and, second, a cash value account from which you can borrow money tax-free (but not interest-free) in order to pay for expensive items, educational expenses, or your retirement.
The difference lies in how the cash value account grows.
IUL vs Whole Life
In a whole life policy, the insurance company determines the dividend rate. Each year, this announced rate is multiplied by your cash value and the product is added to your cash value. The insurance company is the sole determinant of what that rate will be, but it is generally considered to come from a combination of the insurance company’s portfolio returns, surrender fees, and the extra money available when people live longer than actuaries project.
With IUL, the crediting rate for your cash value is determined by a formula, instead of being at the insurance company’s discretion. The specific formula is outlined in the policy documents, but, in general, is related to the performance of the stock market.
Unfortunately, if you don’t listen and read carefully, you’ll misunderstand how the policy works and assume you’re going to get stock market-like returns on your cash value or, worse, on your premiums, not all of which goes to the cash value account due to the costs of insurance.
The basic premise is that when the stock market goes down, you’re guaranteed a crediting rate of zero to 3%. When it goes up, you get to “participate” in that increased return.
5 Problems with Indexed Universal Life Insurance
Your insurance agent is sure to point out all of the benefits of purchasing one of these policies; this article will show you five reasons why buying IUL is generally a bad idea.
#1 You Don’t Need a Permanent Death Benefit
The vast majority of Americans, and especially high-income Americans like physicians, will, at some point, no longer depend on their earnings from work in order to live. This is called financial independence. Once you reach this point, you generally no longer have a need for life insurance.
IULs are, by definition, permanent life insurance policies. Term insurance is very inexpensive: less than $350 per year for a $1 million, 30-year level term policy bought on a healthy 30-year-old. The reason it is so inexpensive is that people are unlikely to die before 60. If everyone died before 60, those policies would be much more expensive.
Since everyone eventually dies, permanent life insurance must be priced so that there is enough money to pay a death benefit to everyone. As such, the insurance component is very expensive.
The portion of your premium that pays for the insurance component cannot go into your cash value account. The more the insurance costs, the less you’ll have in the cash value account. You don’t need a permanent policy to insure against a temporary risk.
#2 Complexity Does Not Favor the Buyer
IULs have many moving parts. The more complex the policy, the less likely you are to really understand how it will work in the future. The less you understand, the more likely you are to be disappointed when you eventually compare the steak to the sizzle you were sold. Also, the more complex the product, the fewer competitors it will have, and competition drives prices down.
Like any insurance/investing hybrid product, you need to hold an IUL for the rest of your life to achieve even a low return, and you are far less likely to do this when it turns out you bought something that isn’t what you thought it was. Those who sell these commissioned products are highly trained, but not in finance. Their training is in sales, and they are generally very good at what they do.
You may have noticed that the best products in life generally sell themselves. If a highly-trained sales force is the only way to sell something, buyers should probably wonder why.
#3 IULs Don’t Count the Dividends
You have probably heard that “the stock market returns 10% in the long run”. While this figure is approximately true—at least on a nominal (non-inflation-adjusted) basis—it includes the stock dividends, not just the change in the index value. IULs, however, only pay you based on the change in the index.
“So what’s the big deal?” you ask.
The big deal is that if you go back to 1870, the average dividend yield of the stock market is over 4%. Even now, at historically low yields of around 2%, the dividend still accounts for one-fifth of the market return. So if an index mutual fund goes up 10% (including a 2% dividend), an IUL may only credit you 8%.
#4 IULs Have Cap Rates
To make matters worse, IULs usually have a cap rate. That means if the stock market has a really great year, such as the 30% index return in 2013, your return is “capped” at some lower figure, often in the 10% to 15% range.
How much does that matter? Well, imagine if your policy had a cap of 12%. Any time the S&P 500 index returned more than 12%, you just get 12%. How often does that happen? Since 1928, the S&P 500 has had an index return over 12% 44 times, or about 52% of the time. It happens more often than not.
Even if you only go back 15 years to 1999, during this supposedly terrible period for equities, it has happened seven times. If that cap wasn’t in place, an IUL purchaser in 1999 would have had 69% more money than he really ended up with.
#5 IULs Have Participation Rates
If that wasn’t bad enough, there is also something called a participation rate. If your participation rate is 80%, that means that if the stock market goes up 10% (not counting dividends) you get 8% credited to your cash value account. After 30 years, a nest egg growing at 8% instead of 10% ends up 42% smaller.
Adding It All Up – Are IULs a Good Investment?
So how can IULs offer “market returns” while still guaranteeing you won’t lose money, at least on a nominal basis?
You simply don’t get anywhere near the market returns due to the costs of the insurance, the additional fees, the loss of the dividends, the cap rates, and the participation rates. These products don’t pass the common sense test.
How can an insurance company give you most of the upside of investing in stocks while eliminating the downside? They don’t have any magic investments; they have to invest like anybody else. In addition, they have to generate enough money for profits and to pay hefty commissions to their sales force.
These policies are likely to provide a return very similar to that of whole life insurance (with the possibility of much worse performance), which is easily seen to be in the 2% to 5% range long term for a policy bought today and held for life. While it may have the word “index” in its title, an IUL has much in common with whole life insurance and almost nothing in common with a high-quality index mutual fund.
While guarantees are always nice, you don’t want to overpay for them. With IUL, you are doing so in the form of much lower returns.
Do you own IUL? Are you happy with your purchase? Why or why not? Comment below!
6 thoughts on “5 Reasons Not to Buy Indexed Universal Life Insurance”
As a proponent of the IUL and an investor in the product myself, I’d like to open debate to the points illustrated above.
1. While financial independence is something most, if not all, people pursue there are a limited number who will actually attain it. Currently 1 in 3 people have mentally accepted that they’ll never be at a point financially where they can retire, much less “no longer depend on their earnings from work in order to live.” Also, yes, the premuims for insurance rise as you get older and ultimately closer to death, however to offset this you have not only the tax-free death benefit for life but the ability to withdraw from your cash account tax-free via wash loans.
2. It sounded too good to be true when I was introduced to the idea of a retirement account that never loses its principal value yet still allows exposure to market-like gains. I asked how insurance companies not only maintain but are profitable with such measures, and found that the process is not complicated at all. 95% of premiums are invested in bonds with the knowledge that their return will fund the other 5% which are invested in call/put options. Can anyone do this and make more money than by retirement vehicles such as IUL’s? Yes, but a vast majority of people will not take the time to learn about the fees and risks associated with this strategy. I enjoy the language of the last quote- another question I had was why hadn’t I heard about this before? The answer- if society truly wanted to produce people who made money instead of a workforce, we would have learned about savings vehicles like this in school.
3. I was not aware of this in all honesty. However, what the index mutual fund is not going to tell you is that up front you are more than likely paying a “sales load”. This translates to a maintenance fee, which averages around 5.75%. If you were to compare a $1,000 investment into a mutual fund and an IUL, your returns would be $1,036 in the fund at the 10% gain after adding in the up-front sales load and $1,080 in the IUL given the 2% reduction of dividends. Plus, there are usually other maintenance fees associated with the fund where there are not in an IUL.
4. Yes, there is a cap which is currently averaging 13-15% across the market. However, there is also a guaranteed floor which CAN NOT go below 0% meaning even in years where the market is down you CAN NOT lose your principal, which locks in gains every anniversary of the plan. When comparing a $100,000 investment in 1999 in an IUL with a floor of 0.75% (meaning even during years of market loss you’re still earning positive interest, and this plan is currently available on the market today) and a cap of 15% against the S&P 500 index, in 2019 the accounts would have been valued at $498,545 and $262,801, respectively. By eliminating downside exposure you more than make up the ground for the gap between the cap and the full upside of the market.
5. While some agencies do have limited participation rates, a majority have a full 100%, if not higher, participation rate in the market to remain competitive. It’s important to work with an advisor partnered with a non-captive company to have full access to multiple A-rated insurance groups.
I am employed by an organization that offers indexed universal life insurance plan as part of the benefits package. The plan is marketed by the insurance agent as a capital appreciation plan with death benefits to both employer and employee at a different ratio depends on age of the plan. Employer contributes 15% of premium to offset the cost of insurance with the rest of the premium deducted from employee salary pretax. The promise is that after five year contribution, the policy will pay for itself and money can be borrowed with interest and used for retirement tax free. The entire surrender value can be withdrawn and surrender the policy without paying taxes on the money withdrawn. It sound too good to be true is there a catch I am missing?
Thank you for writing this, great post! A Transamerica advisor is trying to sell me a life insurance policy similar to this.
Just reading this post makes me steam.
Second worst investment of my life was a VUL sold with all the bells and whistles to my wife and I during residency.
This scam artist then had us max fund it at the cost of our retirement accounts AND the “investments” in the VUL were loaded funds.
Luckily we learned our mistake only a few years in and lost only about $10-15,000 (though that doesn’t include the opportunity costs).
I just recently saw a post in a physician forum where a residency actually invited these sharks in to present to their residents!
Physicisns—personal finance isn’t rocket science or even basic physiology!
You CAN learn the basics and do very well even with limited time!
Don’t let these scam artists bamboozle you into thinking, “ Personal Finance is sooo complicated Dr. Gravy Train, you really need to listen to me if you want me…oh I mean you…to get the best return on my…oops I mean your investment.’
I bought a whole life policy years ago and borrowed against its cash value thinking I was paying the usurious interest rate to myself since it was my own money I had “borrowed “. That money actually went to the insurance company.
It was a disaster. I ultimately dissolved the policy and had a nasty tax bill awaiting despite the fact that the cash value was zero and I had paid every bit of the original cash value in interest.
Whole life policies are simply a terrible idea. I learned that the hard way.