Today's post is the second of two parts. I will go through the pros and cons of the Indexed Universal Life Insurance (IUL), share with you my general opinion on using life insurance as an investment, and give you some questions to ask yourself to help you decide whether you should invest through an insurance product. If you haven't read the Part 1 yet, you could easily find it here.
3. Fixed Indexed Universal Life Insurance
Fixed Indexed Universal Life Insurance (FIUL) or Indexed Universal Life (IUL) policy is getting more and more popular and probably even oversold in recent years. It has two unique selling points.
The first one is that your investment in an IUL will be based on the return of a specific market index you choose (the most common one is the S&P 500 index) with zero downside risk. For example, if you pick the S&P 500 index with an annual credit method and the index goes down 20% excluding dividends, you will earn 0% on your money rather than losing 20%. It sounds great, isn't it? The main reason people don't want to invest in the stock market is the downside volatility which I covered in a previous post here. So, what's the catch? The limit is not only on the downside but also on the upside. It is called the cap. Back to the same example above, if the cap is 12% and the S&P 500 goes up 20% excluding dividends, you will only earn 12% rather than 20%. There are many nuances between different index options, credit methods, and insurance companies which I will not cover in this post. The one thing you need to know is that who controls the upside and who will never lose before you? The answer is the insurance company.
For those of you who would like to dig into details, here is how it works. Similar to a current assumption universal life policy, your money in an IUL will be invested in the same conservative fixed income portfolio. But instead of giving you the interest generated from the portfolio directly, the insurance company uses it to buy option contracts, a complicated type of financial instrument. The combination of the interest amount and the price of the options determine the downside and upside limit of each index. If you understand how the option pricing mechanism works, you would realize that you are still subject to the market risk indirectly. Then the insurance company declares a conservative number to you to make sure they won't lose money which adds a layer of control risk.
The second unique feature that most IULs have is something called participating/indexed loans. For a regular loan, when you borrow money from your insurance policy, only the money left in the policy will continue earning the credit interests. However, for an indexed loan, the money you have already taken out will keep earning interests together with all the money left in your policy. For example, assuming you have $10,000 cash value in your policy, if you take out a regular loan of $1,000 and leaves $9,000 in the policy, only $9,000 will continue earning the interests from the indexes. On the other hand, if you take out a participating/indexed loan of $1,000, even your cash value will go down to $9,000, you will still earn interests from $10,000 rather than $9,000. It also sounds fantastic, isn't it? If the index could earn interests more than the loan interest you need to pay, you will be getting money out of your policy for free. It is what we called an arbitrage. That is also the reason why you usually find a much better projected loan payment and rate of returns from an illustration using indexed loans than regular loans. There are two caveats here. The first one is that the loan interest on an indexed loan is a lot higher and usually not guaranteed. It is currently about 4% - 6% depending on the insurance company. On the other hand, for a regular loan, at the end of your policy year, the insurance company will usually reimburse you most of the interest payment you made at the beginning of the policy year if you meet certain criteria. The second caveat is that no one could predict the future return from those indexes. If the index you choose doesn't perform well for a few consecutive years as you accumulate loan balance, the high-interest payment plus the new loan amount may deplete your cash value very quickly.
In my opinion, an Indexed Universal Life policy is more transparent than a whole life policy, and it could potentially provide a higher return than a regular universal life policy. However, there are still many factors you cannot control including the policy charges, the cap on the indexes, and the loan interest, etc. You are more like investing in your trust in an insurance company. Furthermore, this type of policy requires not only extensive knowledge and understandings of this complicated product to find the best one but also ongoing policy review and monitoring to make it work in the long run. Designing and managing an indexed universal life policy is not easier than a globally diversified investment portfolio. Based on all the illustrations from our clients, different insurance agents, and other financial planners, I have never seen a policy been optimized in the best interest of the clients. In other words, I concern more about the insurance company and the agents who are selling the insurance product rather than the product itself.
In general, I am not a big fan of using life insurance as an investment. However, it may be beneficial to certain people in certain cases. If your put yes to all the four questions below, you may consider adding life insurance as part of your overall investment strategy.
1. Do you need more life insurance for your families or want more life insurance for estate planning purposes?
2. Are you investing for a goal more than 20 years down the road?
3. Do you expect to be at a higher and at least the top three tax brackets when you take out the money?
4. Have you maxed out your 401(k), IRAs, and other tax-advantaged accounts?
But before being sold to a specific policy, please ask yourself the final and probably the most important question below.
Do you believe that your insurance agent is independent? Does he/she know the differences between insurance companies? Does he/she have the expertise of different types of insurance products? And more importantly, is he/she willing to give up their commissions as much as possible for your benefits?
If your answer is no or not sure, I highly recommend you to consult an independent fee-only financial planner who knows the ins and outs of the dark side of the insurance industry. And let the planner help you figure out if it's a good idea of investing through life insurance, choose a type of life insurance that is best for you, and design the policy in an optimized way based on your specific situation