Indexed UL is not a fad
August 8, 2013 by MICHAEL STAEB
Many advisors are under the mistaken impression that indexed universal life insurance (IUL) is a fad that eventually will founder and go the way of first-to-die and credit life insurance.
What those individuals fail to consider is IUL’s flexibility. Like all universal life products, IUL has flexible premiums as well as death benefits that are not as easily accessible in other products. It is also the only general account product that has interest crediting linked directly to stock market performance without actually being invested in the market. IUL always will be relevant (whether we’re in a bull market or a bear market) and theoretically can be linked to the indexed price of anything.
To quote Bobby Samuelson, an industry expert on IUL, “When times are bad, people just want return of capital and, when times are good, people want return on capital. The great thing is that IUL gets both.”
Indexed life insurance is not for everybody, but it’s not for the elite either. An ideal client for IUL is someone who has a steady income stream and who is looking to maximize tax-preferred retirement savings vehicles. Most important, any client buying IUL needs to understand it is a mid-term to long-term play, generally at least 10 years, and ideally 20 years or longer.
First of all, I don’t claim to be a retirement planning expert. That said, I believe a strong possibility exists that we will experience substantially higher taxes over the next 25-50 years. Today’s top income tax bracket is the lowest it has been since the Great Depression (with the exception of 1988-1992). With an unsustainable national debt, higher taxes should be viewed as inevitable. Between that and the tax treatment of various savings vehicles, the following order of maximizing contributions (where available) is what I recommend to my clients:
[1] 401(k) with employer matching: I tell my clients to contribute only what is needed to maximize the employer matching. This is free money, so don’t pass it up, even if it’s taxable. Employers who match 401(k) contributions most commonly do so dollar-for-dollar up to 3 percent of salary. If matching is not dollar-for-dollar, it may still be worthwhile, but consult a retirement planning professional to maximize the match effectively.
[2] Roth individual retirement account (IRA): Even with a low contribution limit, a Roth IRA offers 100 percent tax-free growth and distributions. For higher income earners, the availability of a Roth phases out above $112,000 for individuals and $178,000 for joint returns (for 2013). However, I tell my clients that if they qualify for a Roth, to max it out while they can! Don’t forget that after five years, Roth IRA holders, regardless of their age, have penalty-free access to principal. For your 1099 contractor and business owner clients, you effectively can create an account with 401(k) level contribution limits and Roth tax treatment. Talk to a retirement planning professional.
[3] Cash value life insurance: This enjoys taxation almost identical to a Roth IRA but with no specific limit on the amount put in each year. It seems common that in the day-to-day activities of helping our clients with their diverse needs, we unintentionally can leave out some of the key benefits of cash value life insurance. The obvious benefits are tax-deferred growth and income tax-free death benefit. Often not explained to clients are the tax-preferred distributions (effectively tax-free with proper planning and an overloan protection rider), no “contribution” limit and creditor protection when individually owned (varies by state).
IULs are still relatively young as far as life insurance products are concerned. It is vital to choose a carrier with a long-standing reputation of doing well by their insureds and policy owners. Obviously, with IULs still the newbies of most carriers’ product offerings, it’s not always easy to compare carriers based solely on how long they’ve been in the IUL market. With IUL being primarily a cash value accumulation product, it is prudent to consider the carriers’ history of cash accumulation products in general, whether that is through whole life, current assumption UL or variable life products. If the carrier has a long history of strength in those types of products, even if the carrier may not be offering them today, that is a good indicator it is diligent in designing an IUL product offering.
Ignore for a moment the difference between one IUL product and another. Think only of the concept of the product. IUL is not a risky product. Downside protection and upside potential is an appealing value proposition. What’s not to like? But with anything that initially sounds attractive, there is a trade-off. Let’s look objectively at how these products work.
One of the most common questions I’ve heard as IULs have grown in sales and popularity is: “How does an insurance company afford the return potential that it offers?” A common misconception is made when answering that question. Explaining the trade-off of earnings above a cap rate is not an accurate answer. Life insurance companies offering these products are actually buying call options from an investment firm or bank that offers options on the index to which the carrier is linking their indexed crediting, most commonly the S&P 500. Call options, put simply, are the insurance company buying the right to purchase the stocks at a given point in the future, but at today’s price and only up to a specific amount of growth (12 percent for example).
This is a win/win situation for all parties because of three potential outcomes. For example, let’s say:
- Index gains more than call option (+15 percent) Insurance company gets 12 percent, credits the client 12 percent and the investment bank keeps the extra 3 percent stock earnings and the option fee.
- Index gains less than call option (+5 percent) Insurance company gets 5 percent, credits the client 5 percent, and investment bank breaks even on the stock and keeps the option fee.
- Index loses value (-10 percent) Insurance company has no earnings, credits the client 0 percent and is only out the option cost. Investment bank keeps the option fee, but doesn’t recognize any loss on the stock because the bank retains ownership to sell it sometime in the future when it may be more profitable.
Who pays for call options? Ultimately, it’s the client, through the internal policy charges and fees assessed by the insurance company. The price of call options, which does fluctuate, can affect a carrier’s cap rate or other indexing strategies. For example, the investment bank has a higher earnings potential on a 9 percent call option compared with a 12 percent call option. Naturally, an insurance company buying a 9 percent option will pay less than one buying a 12 percent option. This means they can have lower internal charges and expenses to cover the cost of their call options.
Any advisor who has been in the business for at least a while has heard of the “Wild West days” of illustrated rates. During the late 1980s and early 1990s, current assumption UL illustrations were paying interest rates as high as 16-18 percent, and advisors would illustrate these rates indefinitely. Even conservative advisors of the day were illustrating 8-10 percent. Many of these contracts had minimum guaranteed rates of 4 percent, which are virtually non-existent today. Many of those over-illustrated and underfunded contracts are now failing at or very close to their guarantees.
When it comes to today’s IULs, the illustrated rate can, in many cases, be quoted up to 8 percent or even 10 percent. Aside from the guarantees of minimum interest and maximum charges of an IUL contract, the only certainty that an advisor can give their clients is that the illustrated rate will be wrong. Inevitably, it will be higher or lower in the long run and will most certainly not be level. Taking a historical view of the S&P 500 (the most commonly used index in IUL crediting methods) can have some eye-opening results for advisors and clients alike. By the numbers:
Most carriers include at least one page of their illustration that is dedicated to a historical look at how their indexed crediting method would have performed had the product been available 10, 20 or 30 years ago. A carrier who has been in the IUL business for most of the product’s history is Indianapolis Life (purchased by AmerUs Group in 2000, Aviva USA in 2006, and Global Atlantic in May). When I first discovered IULs, I learned that Indianapolis Life based their default illustrated rates on how each of their six index crediting methods would have performed over the entire history of the S&P 500. Prior to the Great Recession and using the most common indexed crediting strategy (one-year point-to-point) returned an annual average of 7.65 percent. The average client isn’t investing money in a life insurance contract over that long a duration, but this illustrates the power of a long-term play with an IUL.
The past 10-15 years have seen dramatic swings in the S&P 500 and other indices. For example, the S&P 500’s relative high during the dot com bubble exceeded 1400. During both the dot com and real estate bear markets, the S&P fell below 800. And, just in the past couple of months, the S&P has continued to set all-time closing highs north of 1500 and 1600.
Taking all these factors into account, it would behoove those of us actively marketing IULs to illustrate a rate below the historical averages, thereby managing client expectations. I generally recommend 6 percent, down from what I would show prior to the 2008 crash when 7 percent was commonplace. I have colleagues who sometimes show less than 6 percent. There is nothing wrong with conservative assumptions. It is better to exceed expectations than to have to explain why your assumptions were incorrect. Educate your clients and prepare them for multiple outcomes and it won’t come back to haunt you.
Don’t Forget Why You Do This
Product specifics aside, don’t forget why you are selling life insurance in the first place: protection. Life insurance in retirement planning (LIRP) is a great tool when designed properly. The life insurance death benefit can make the plan self-completing through face amount leverage. Inclusion of a Waiver of Specified Premium rider can make it self-completing in the event of a total disability. Protect your client’s family, business, estate, retirement, etc. Be a hero and be there when your clients need you the most. Providing financial security for the client now and in the future is and always will be a noble profession. Don’t let anyone tell you otherwise.
Michael C. Staeb is an independent insurance wholesaler based in Seattle, Wash. In addition to his brokerage general agency, 5 Brokerage, he also does consulting for insurance and financial advisors identifying missed client opportunities and helping advisors both inside and outside the insurance industry expand or improve their practices. Contact him at Michael.Staeb@innfeedback.com.