Blog #36: The Magic of Indexed Universal Life

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The more I study the intricacies of Indexed Universal Life (IUL), the more I find it the golden egg of the financial world. This is particularly true when you introduce “Compared to What?” which I’ll present further down in this Blog.

The opportunity to couple valuable policy death benefits with cash values credited with interest rates equivalent to a high percentage of S&P returns is, of course, one of its key lynch pins. The floor of a 0% guarantee to insulate against negative yields is another.

Provided the policy is not a modified endowment contract (MEC), the icing on the cake is the opportunity to access cash values by way of participating loans. Traditionally, the rule has been to use tax free withdrawals up to cost basis (basis being the sum of premiums paid) and then switching to tax free policy loans once cost basis has been exhausted.

The advent of participating policy loans is a real game changer and dictates their use from the get-go as the preferred way of accessing cash values for, say, tax free retirement cash flow. Such loans add a serious level of interest rate arbitrage, often associated with foreign currency transactions but previously unrelated to life insurance transactions.

It only works well if the loan interest rate charged by the issuing insurance companies is guaranteed for the life of the policy. If you can borrow against accruing cash values at a guaranteed rate of say, 5%, and the cash values securing the loan can still participate in a share of S&P returns (guaranteed never to be lower than 0%), you then have the following benefits of 21st century life insurance:

  • checkmarkPolicy cash values accrue free of income tax;
  • checkmarkPolicy loans are free of income tax;
  • checkmarkCash values securing loans participate in the selected index;
  • checkmarkPolicy death benefits are free of income tax.

There is nothing in the financial world quite like this package of benefits.

Caution: You and your clients must manage the amount of policy loans to be sure the policy contains sufficient residual (unborrowed) cash value to prevent a lapse of the policy as that event could trigger taxation of all policy loans in excess of cost basis. Some life insurance companies have sophisticated concierge units whose purpose is to assist policy owners in the management of policy loans.

Case Study #1

Let’s look at “Compared to What” mentioned previously. No financial product is good or bad in the abstract. Real value is determined by comparison to reasonable alternatives. Click the link below to view a recent 8-minute video where I was interviewed by Eric Palmer, Chief Marketing Officer of Brokers Alliance in San Diego, where we discussed comparing IUL to term insurance.

You can contact Eric at (800) 290-7226 (ext. 103) or eric.palmer@brokersalliance.com.

Case Study #2 (The Amazing Impact of Participating Loans)

Elizabeth Rand, age 40, is Board Certified orthopedic surgeon specializing in sports injuries. She is evaluating a $3.6 million IUL illustration at 7.50% compared to buying 30-year level term and investing the difference.

Click here to review the details of her term vs. permanent comparison from the InsMark Illustration System. As you can see on Page 2 of the illustration, even with an extraordinarily low assumption for the term premium and a side investment fund earning 7.50%, the “difference” of term “term and invest the difference” runs out in year 28 (her age 68).

Participating Loans: With Case Study #2, you can really see the impact of participating loans. Notice in Column (9) on Page 2 of the illustration that policy loan activity of $120,000 a year begins in year 21 of Column (4). As you might expect, cash values begin to decline in Column (9). The yearly decline gradually slows until year 34 (age 74) when it turns upward while still supporting ongoing policy loans of $120,000 a year. For example, by year 40 (age 80), the cash value increase exceeds $43,000 from year 39; by year 50 on Page 3 (age 90), the cash value increase exceeds $184,000 from year 49; and by year 60 (age 100), the cash value increase exceeds $642,000 from year 59. This is the power of participating loans.

Note:  In the InsMark Illustration System, you can compare IUL with taxable, tax exempt, tax deferred, and equity accounts. (They all lose — significantly so when participating loans are illustrated.)

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Click here to learn more about the InsMark Illustration System. You can also contact Julie Nayeri at julien@insmark.com or 888-InsMark (467-6275). Institutional inquiries should be directed to David Grant, Senior Vice President – Sales, at dag@insmark.com or 925-543-0513.

Note:  In Blog #37 next week (January 23, 2014), we’ll compare how and why Dr. Rand intends to use the IUL illustration in Case Study #2 in this Blog as the funding instrument for a deferred compensation arrangement.

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7 thoughts on “Blog #36: The Magic of Indexed Universal Life

  • February 25, 2014 at 6:49 pm
    Permalink

    “Hi Bob, I enjoyed reading some of your blogs. To be very brief, I enjoyed everyone’s enthusiasm of EIUL. I share the feeling, but have a hard time understanding why people would not rather utilize a Whole life contract offered by one of the very large mutual’s. When I compare the two side by side, I can’t get past the point that the insurance company can lower caps (and has), raise fee’s and insurance charges. In normal times, competition forces them to be somewhat competitive, but with our uncertain world we live in, what would preclude them from significantly lowering the caps in any given year(s) for starters. Maybe the answer is to diversify into each type. Not sure…

    If there is any information published that address’s the argument, I would be grateful for a copy.

    My Best,

    Patrick R. Davidson, MBA”

    Hi Pat,

    Clearly, Indexed UL has many producer fans; however, there are many producers who do favor high quality whole life policies from a mutual carrier.

    I did a Google search on Indexed UL and there are dozens of articles that touch on your question of reducing Caps. Here is a link to one of them: http://www.thewpi.org/pdf/eiul.pdf.

    Here is a link to another one that takes a very pro-Whole Life approach: http://www.infinitebanking.org/the-top-10-reasons-not-to-buy-equity-indexed-universal-life/.

    Here is a neutral analysis I found: http://www.lifesolutionsonline.com/life-insurance/112-life-insurance-index-universal-life-vs-whole-life.html.

    As I don’t have a dog in this hunt, I am not endorsing the content of any of them; I reference them only to give you an example of what you can find on the web.

    Thanks for taking the time to Comment.

    Best regards, Bob

    “Bob, Thanks for taking the time. I will check them out.

    My Best,

    Pat”

    Reply
  • February 14, 2014 at 11:39 am
    Permalink

    “Bob:
    I have concerns about guaranteed participating loans. You and I were around in the 80’s when interest rates skyrocketed and mutual companies with fixed loans, without direct recognition, had serious issues. They eventually offered policy owners a higher dividend scale if they accepted a variable loan rate. What do you think will happen to these indexed products with guaranteed variable loans when interest rates go up? The only thing that can happen is that the caps will drop significantly, which will put a huge damper on cash accumulations. So, guaranteed loans rates may look attractive now, I doubt they will in the long run.
    Dan”

    Dan:
    I hear you, and I think it could be a problem with some of the smaller carriers with fewer portfolio assets. I think the large companies can deal with this. One company I’m familiar with has a 2 trillion portfolio which will tend to stabilize the available cap rates on IUL policies with participating loans.
    Regarding your reference to the Whole Life issue in the 1980s, when clients did a “quick pay”, the premium typically kept being paid by “automatic premium loan”, thus the loan exposure grew much more rapidly on much of the block of business.
    However, a carrier with a fixed charge on a participating loan is exposed to rising interest rates coupled with a higher utilization of participating loans than expected. In the situation where a carrier will have to lower their credited rates or caps, their policyholders will still enjoy the benefits of having a low fixed interest rate, which in my opinion is more pertinent than upside potential during a client’s vulnerable retirement years when loans are likely to be taken on a those IUL policies sold as supplemental sources of retirement cash flow. Below is an example assuming interest rates jump to 8%. I think the numbers are particularly instructive when dealing with a large carrier with substantial portfolio assets.

    Carrier A – fixed rate participating loans Carrier B – variable rate participating loans
    Fixed rate on loans: 5.0% Variable rate on loans: 8.0%
    Usage 20% Usage 20%
    Portfolio yield:
    80% @ 8.0%
    20% @ 5.0%
    Overall = 7.4%

    .

    .

    Portfolio yield:
    100% @ 8.0%

    S&P point-to-point cap – approx. 20% S&P point-to-point cap – approx. 25%


    So we wind up with two different models:

    1. Carrier A offering a guaranteed 5.0% loan interest rate charge with an option budget of 7.4%, translating to roughly a 20% S&P cap; or
    2. Carrier B offering a variable 8.0% loan interest rate charge with an option budget of 8.0%, translating to roughly a 25-28% S&P cap

    In retirement, it is my opinion that the majority of clients will be better served with the lower interest rate charge, as upside potential becomes less important than the certainty of the lower interest rate charge.
    I’m not certain you’ll agree, but thanks, Dan, for taking the time to comment. Let me hear from you.

    Best regards,

    Bob

    Reply
    • February 14, 2014 at 2:05 pm
      Permalink

      “Thanks for responding Bob.
      The attorney you work with also responded. I do understand both of your views. We both were around in the 80’s when interest rates went crazy and I remember all the big strong mutuals having issues when there was a “run” for the money that could be borrowed at 5% without changing their dividends. I was with N.L. of Vermont and they had a 40% loan rate. I don’t think they had to borrow money at 8% and loan it out at 5%, but I heard there were some companies that did.
      Thanks again for responding and I wish you the best.
      Dan”

      Reply
  • February 10, 2014 at 1:17 pm
    Permalink

    “Bob,
    I read every one of your posts – and enjoy them all.
    But your last blog got me to thinking – always dangerous I might add.
    I have always had a lingering question (and one could argue is not really your responsibility, or even the agent’s responsibility).
    But it would be interesting to have the answer come from someone like you, rather than someone in the home office with an obvious bias, and whose job it is to ‘spin’ the answer to a point where you probably forgot the question by the time they were finished enlightening you.
    The question – from the advisor’s perspective –
    How reliable are the illustrations of Index UL?
    In other words, what is the likelihood that the illustration will end up even close to its projections 10 years from now, let alone 20 or 30 or 40?
    We all know that the insurance carriers are masters at illustrations and designing products with the assumptions deeply hidden somewhere behind the curtain.
    And admittedly from the insurance carrier’s perspective, trying to stay competitive has caused part of this by pushing the carriers to stay even or perhaps one step ahead of each other.
    But back to my question – how realistic are the illustrations likely to perform to what they show? Even in its simplest version?
    I know it is a tough question.
    And I know that in some respects some of us, perhaps many of us, might prefer to not know the answer as we are “selling” and things are tough enough without the sales people having to be out there ‘policing’ or even just understanding the true issues behind each and every insurance illustrations.
    I would appreciate your thoughts – and I’m sure I am not the first who has asked you the tough question.
    Thank you
    Reid”

    Hi Reid,

    Much of the decision involving what policy form to use in a given case comes down to the risk tolerance of a client.
    I am personally more comfortable with Indexed UL than I am with Variable UL. I am particularly OK with Indexed UL illustrations done at reasonable interest assumptions (7.00% to 8.00%). The crediting of an S&P index – even with a Cap – is an attractive option (particularly with a downside of 0.00%).
    One thing I vastly prefer with IUL is the availability of participating loans (with guaranteed loan interest rates at 5.00% to 6.00%) where cash values securing policy loans continue to participate in the S&P index selected. Not all companies offer participating loans and very few offer them at such guaranteed loan interest rates, but they are both an important consideration.
    As to the reliability of projected values, one thing we all know is that IUL, VUL, or WL will never perform as illustrated. I think the only sure way to handle volatility of values with IUL (and VUL for that matter) is to keep in close contact with your insureds with these policies and try to keep the actual values close to the original illustrated values by paying in more, if needed, than originally scheduled. If you don’t do this, by the time danger surfaces, it may be too late to do anything about it as we all found out about with UL several years ago.
    You should also direct your concerns to the actuaries of Indexed UL companies with whom you do – or intend to do – business. If you go through an IMO, brokerage, or career agency, your questions should also be directed to them.
    Thanks for commenting to my Blog, and be sure to let me hear back from you.

    Bob

    Reply
  • February 7, 2014 at 12:59 pm
    Permalink

    “Bob,
    I have enjoyed your succession of blog entries but I think you have missed it big time on this one. I am at The Forum 400 right now and member Robert Stuchiner gave a very thoughtful main platform talk this morning analyzing IUL and pointing out some very dangerous issues surrounding this product. I hope David Grant was at this session and can share the recording and slides of this talk with you when he gets home.
    Respectfully,
    Howard Edelstein, Cleveland Ohio”

    Howard,
    It’s difficult to respond to your “missed it big time” comment without knowing what Robert Stuchiner actually said. (Our David Grant did not attend his presentation.) This is just a guess, but I suspect Mr. Stuchiner prefers Whole Life, and I have no quarrel with that.
    There are many quality producers who prefer Indexed UL, just as there are many that favor Whole Life, and InsMark has no dog in the hunt for a preferred product. We are currently featuring Indexed UL in a series of Blogs. We will undoubtedly feature both Whole Life, UL, and Variable UL in other series.
    The purpose of the Case Study of Dr. Rand is to point out that Indexed UL has some marvelous features, particularly from those carriers that offer participating loans with guaranteed loan interest rates.
    Thanks for taking the time to comment. I really appreciate it.
    Bob

    “Bob,
    Thanks for your note. Bob Stuchiner may have a preference for whole life, but his presentation was a very technical analysis of the features of IUL which he felt were being overstated by the carriers selling it, and what he feels are hidden risks in the product which are not being properly disclosed to the buyers. When the Forum releases the audio of his talk, I’ll try to dub a CD and send it to you with the slides. As an old timer in this business (44 years) I am initially wary of products being introduced which claim they can “name that tune in no notes.” Most of the exhibitors in the Forum exhibit hall we’re promoting that product very aggressively, and since it is a very complex product with many moving parts, I would prefer to see it exhibited in a cautious way so anyone who buys it can really understand its complexity. My main concern is that our industry has invented new products which have so much risk on the buyer side of the ledger, and if/when they fail to perform in the way the buyer “thinks they should” , in come the plaintiff lawyers and our industry is on the defensive. Its hard enough to sell in the advanced markets that we don’t need that potential problem hanging over our heads.
    Sincerely,
    Howard”

    Thanks, Howard,
    I’ll look forward to the material.
    Bob

    Reply
  • January 19, 2014 at 10:04 am
    Permalink

    Could you run through the math in year one. How do you come up with the side fund value?
    Thank you, Bruce

    Reply
    • January 21, 2014 at 5:50 pm
      Permalink

      Hi Bruce,

      Year 1: Here are the calculations that turn $97,000 in Column (3) into $100,219 in Column (5) at the end of year 1:

      $97,000 x 7.50% = interest of $7,275

      $97,000 + $7,275 = gross year-end balance of $104,275

      $104,275 x 0.75% = management fee of $782.06 (0.75% management fee is reflected in a footnote)

      $104,275 – $782.06 = net year-end balance of $103,492.94 (after deducting the management fee)

      $7,275 (interest) x 45% (tax bracket) = $3,273.75 income tax

      Assuming the income tax is taken from the account:

      $103,492.94 – $3,273.75 = $100,219.19 rounded to $100,219 (as shown in Column (5), Year 1)

      Thanks for taking time to comment, Bruce. I hope you are enjoying the Blog.

      Best regards, Bob

      Reply

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