Oct 10, 2020 | 09:15 am
In a recent teaching session offered to Johns Hopkins residents the following question came up: Is an Indexed Universal Life (IUL) policy a good idea as an investment?
The short answer for almost everyone is, NO.
First, let's review IUL policies (to help explain IUL I compare it to Whole Life insurance. This is not an endorsement of Whole Life. I'm merely using it to illuminate the features of IUL).
Indexed universal life (IUL) are permanent life insurance policies with a cash value account. Unlike Whole Life policies, which require fixed premium payments, IUL allows flexibility in the size of premium payments. Similar to Whole Life, a fraction of each premium paid by the policyholder is assigned to the cash account, however, unlike the guaranteed interest payments offered in Whole Life policies, cash accumulation for an IUL is pegged to the performance of an underlying stock index. Instead of directly purchasing units of the index, the insurer typically purchases or sells options (derivatives).
If you invest directly in indexed funds, you stand to receive dividends paid out by those funds. Since IUL does not actually buy the underlying indexed funds, you don't receive any dividends, reducing your potential gain by several percentage points.
Even setting aside the dividend issue, the policyholder does not receive the exact return of the underlying index. Instead, a non-transparent calculation determines the amount of interest actually credited to her account, where the allocation is further subject to a cap and floor. The cap sets an upward limit on policyholder cash accumulation while the floor sets a lower limit.
For example, a floor of 2% means that the policyholder will receive interest credit of 2% whenever the actual index return is below 2%. This means that if the index suffers a heavy loss, e.g., -10%, the policyholder will be insulated from that loss and will instead receive a positive (yet low) return. Insurance agents tend to highlight the floor as an amazing feature, making IUL sound favorable. But along with the floor there is also a cap. A cap of 12% means the policyholder will receive at most 12% for a given period, even if the underlying index experiences a higher return. In some years index returns may be 20% or 30%, but with the cap in place the policyholder won't benefit from those higher upward movements.
Common floors range from 0% to 4%. Caps are typically 10% to 12%.
Most importantly, IUL is characterized by very high fees. As noted here, high fees severely undermine long-term returns, and turn promising "deals" into traps.
While insurance agents will play up the "safety" of the floor feature, history shows that most of the time, indexes exhibit gains. A rough perusal of annual S&P 500 gains since 1928 shows that a 12% cap (reducing gains) would have applied 42 times, while a 0% floor (reducing losses) would have applied 30 times. The average returns (1928 to 2020) with the cap and floor in place would have been 6.84% vs. 7.67% without them. The latter is the number you'd have realized through a direct investment in the index. And we haven't even begun to take into account the fee differences. Investing on your own through low fee indexed funds means you'd have realized almost the entire 7.67%. Fees for IUL are much higher (on the order of several percent), which means you'd have gained much less than the 6.84%, probably around 5% or less.
Another crucial IUL feature is that unlike Whole Life premiums which are fixed over time, in IUL the premiums may increase as you age. Death benefit can be compromized or even lost entirely if the index performs poorly over an extended period of time, or your required premium payment exceeds cash accumulation.
Insurance salespeople also throw around the words "tax-free" to describe IUL. In fact, the tax benefits are no different from those of other permanent policies. Yes, death benefit from life insurance is income-tax free for beneficiaries (but not estate-tax free). If your direct investment in indexed funds is undertaken in an IRA or 401(k) account your gains would be tax-deferred. If instead your direct investments were in a Roth IRA, you would get to keep all the gains, i.e., they would effectively be tax-free and much higher than you'd have realized after paying high fees through an IUL.
Every few years the insurance industry comes up with a new flavor of permanent insurance, and they always pitch it as an amazing opportunity with tax benefits. But the small print and high fee structures generally makes all of these inferior investments to those investments you can access on your own, and they force you to bear investment risk.
The bottom line is that IUL net returns are constrained by the maximum available on indexed (or market) returns, and are significantly lowered by high fees. IUL cannot do better than the market average investment return which you can obtain yourself by directly purchasing indexed fund ETFs with near-zero fees.
What is insurance for?
A more fundamental question here is: what is insurance for?
Is it for removing existential risk exposures your household may be subjected to, or is it for increasing risk exposure through speculative investments?
It must be the former! Once we realize that, it becomes clear that investing through a high-fee insurance policy is fundamentally an inefficient way to approach investing, and the wrong way to view insurance.
Should anyone consider IUL?
The only people who should even consider IUL are those with very high income (think greater than $300,000 or $400,000) who have already maxed out all other tax-deferral vehicles (such as IRA and 401(k) accounts).
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