A large portion of the insurance and investment industry has perpetuated a dangerous narrative, a … [+]
Photo by Loic Leray on Unsplash
A large portion of the insurance and investment industry has perpetuated a dangerous narrative, a false belief.
One where if you want a return you must take higher risks.
As people have lost money, they have also lost faith in this erroneous philosophy. People value protecting their money, but would still love the possibility of more growth than a CD, savings account, or other fixed income instruments that have had a long track record of low interest rates.
Enter: Index Universal Life
These policies have become the popular choice for cash value insurance. Looking at the illustrations and listening to the sales pitch, I can see why. It has a minimum guarantee. It has upside potential as the market performs. You can overfund beyond the target premium by adding cash, shielding the growth from taxes. If you are healthy enough to get a standard or preferred rating, the cost of insurance is seemingly small, well… up front and with current conditions at least.
If it sounds like there may be a catch, well there is.
Actually a few that you may want to be aware of before making allocations to this type of vehicle: Current costs are not guaranteed, late payments could eliminate guarantees, there are several limits on the upside potential, you give up certain control of your money to the company and can take on unnecessary risk.
Let’s begin with how your costs are calculated. There are multiple death benefit options and the one you choose can impact the cost/drag on your policy.
The more cash you have in relation to your death benefit, if you choose option 1 (yes there are several options on how your death benefit grows and costs are calculated), the lower the cost. This is called your net amount at risk, which is the difference between the death benefit minus the cash value. You are only being charged insurance costs on the net amount at risk. Great news.
What happens if you take money from the policy though?
Can that increase your cost of insurance?
Will it impact you if you borrow instead of withdrawal?
These are critical questions to ask in order to design the policy in your favor. If that isn’t possible, avoid this vehicle altogether.
You may choose option 2 and this can increase your death benefit as your cash value grows and even allow you to put more money into the plan without triggering the MEC (modified endowment contract) provision that can eliminate some of your tax benefits. On the other hand, this will change the nature of your insurance expenses.
One of the costs is M&E (mortality and expense). The cost of insurance works in 2 ways. As we get older, Universal Life is built really similar to a term insurance chassis- the older you get, the cost of that insurance goes up like an Annual Renewable Term. Because it is an Index Universal Life, they actually charge a bit more for the cost of insurance than most term policies, but people are allocating more dollars to create cash value. As you age, Annual Renewable Term becomes more expensive.
Only 1.1% of term insurance actually pays out according to an executive at Ameritas Life, because they are only issuing it to healthy people and if you live the life expectancy, then they phase/price you out.
Another thing about these Universal Life type policies is the companies implement something called “bundling”. They look at all like-people who buy their policies at a similar time, age and health status. Then they say “how many people are dying per 1,000 in that bundle?”. Not many early on- but as you get older more people start to die and people abandon the policies because maybe they found something better or they couldn’t afford it. This will change the deaths per 1,000 ratio and is likely to increase your future insurance costs.
To see the worst case scenario you can look at the columns of your Index Universal Life illustrations. Note: the right side lists what is currently happening and is the best case scenario as far as expenses are concerned. The left column, circled in red, shows the guaranteed cost.
IUL Example (con’t)
It is highly unlikely, nearly impossible, that the guaranteed cost will go right to the maximum in the beginning. That happens over a longer period of time. But because most insurance agents generally haven’t been selling this for 20 years, they haven’t watched these things implode and explode. They haven’t watched policies from the early 80’s that went to the guaranteed cost. And on the guaranteed cost side you’ll see that those costs went up so high that they destroyed the cash value. As it eats away the cash value then there is even more cost, because now there is more net amount at risk. Hence the worst case scenario and problem.
I recently sat down with the creator of Truth Concepts software (truthconcepts.com), Todd Langford, to further illustrate what problems may arise with Indexed Universal LIfe.
So buyer beware.
These may not be what you think and Todd brilliantly unveils the problems lurking for policyholders that can be detrimental and erode your wealth.
Garrett: Todd, can you give me an overview of why people aren’t informed of the issues and potential problems with Equity Indexed Universal Life?
Todd: Insurance companies have put numerous pages on the front of Equity Indexed Universal Life (EIUL) illustrations that show the main issues, but most people (by design) will not take the time to read and understand what these pages are saying. I would encourage everyone to read those pages thoroughly before depending on an EIUL policy to increase your assets or protect your family. Similarly, Universal Life (UL) and its cousin Variable Universal Life (VUL) have some of the same problems.
Garrett: What are the top things people should look for or the main problems you see with this product?
#10 Internal costs are not guaranteed
#9 Mortality charges are not guaranteed
#8 Market drops cause double pain
#7 Late premiums kill any guarantees
#6 Dividends from the index don’t get credited
#5 Participation ratios are often less than 100%
#4 Returns are usually capped at various interest rates
#3 Guarantees are not calculated annually
#2 All of the above can be changed by the company
#1 The risk is shifted back to the insured
Garrett: Can we look at each of these individually and give more details of what this means, how it impacts the policy and most importantly impacts those that own these policies?
#10 Internal costs are not guaranteed: Internal administration fees charged against cash value on any type of Universal Life policy and shown on illustrations are run under current expense levels, but those can change at the discretion of the company. Since the insurance company uses this money to run its operations, as the prices of office supplies and real estate go up, they may choose to adjust these internal costs after you have bought the policy.
#9 Mortality charges are not guaranteed: Mortality changes, what the insurance company charges for the death benefit are removed from the cash value or paid by premiums. In UL, these pay for annually increasing term insurance costs. This is true for any type of UL, no matter what the side fund is invested in. The cost for this one year term insurance can be changed at any time.
#8 Market drops cause double pain: With VUL, market drops affect the side fund negatively no matter what the side fund is invested in. Since the death benefit is comprised of the One Year (or annually increasing) Term Insurance, plus the side fund, any market drop causes double pain. Markets can drop regardless of whether they are supported by stocks or money markets. When the side fund is reduced by a drop in the market or current interest rates, it now has less value so more Term Insurance must be bought to make up the difference which further reduces the side fund. Consequently you have double pain; less cash value and higher costs.
#7 Late premiums kill any guarantees: Any late premiums remove any guarantees in the policy. In most UL policies, even if the premium is finally paid, once it is late, the insurance company is off the hook for supporting any guaranteed premiums, cash value amounts or death benefits. In many cases, the insured may not even know that a premium was late and that the guarantees have been forfeited. Thinking about the time frame of a 50 year policy paid monthly (600 payments) ask yourself what the likelihood is of a mistake being made by the premium payer, their bank, the post office, the insurance company clerks or anyone else along the way.
#6 Dividends from the index don’t get credited: Equity Indexed Universal Life policies provide the policy holder no credit for any dividends from the stocks making up the index. The side fund of an EIUL isn’t actually invested in the index; instead the index is used to determine the gross crediting rate for the side fund. If money were actually invested in the index, the investor would get both the change in Net Asset Value (whether up or down) AND the dividend income. However, in the case of EIUL, only the change in value of the index is the determining factor and the dividend is left out of the calculation entirely.
#5 Participation ratios are often less than 100%: Participation ratios are often less than 100%. As mentioned directly above, the side fund is not invested directly in the index and many insurance companies only credit a certain percentage of the increase in the market. Known as the participation ratio, this is often reported at 80% or less meaning you are getting only 80% of the increase in the market.
#4 Returns are usually capped at various interest rates: Capping returns in order to keep high returns in the market from crediting too much to the side fund is a strategy many insurance companies use. The maximum return they’ll give credit for may be at a certain percentage rate even though the index may have generated a higher percentage rate.
#3 Guarantees are not calculated annually: Guaranteed minimum returns are not always calculated annually. Most EIUL policies have a guaranteed minimum return so that if the index drops below this rate, the insurance company will still credit at the guaranteed minimum rate. However, with some policies this guarantee is not applied annually but instead over an “indexing period” which could be 5-10 years. So you could have negative years in the index (below the guaranteed minimum rate) which would be applied to the side fund. This would cause a further reduction of value in excess of the guaranteed minimum rate in one particular year and as long as the overall average rate for the entire indexing period is not less than the guaranteed minimum rate, this would still count as meeting the minimum.
For example, if the minimum guaranteed rate is 2% inside a 5 year indexing period, you could have crediting rates of +13, -10, +10, -8 and +9% which would validate the promised guarantee because it would average more than 2% per year over the 5 years. The implication is that you cannot have a negative return, but as shown in the example below, you can have a negative return as long as the guarantee is not calculated annually.
You’ll notice another example below of the same interest rates, but with $100,000 of existing value instead of $10,000 per year of cash flow into the account.
#2 All of the above can be changed by the company: At the discretion of the company any of the above factors can be changed at any time for the benefit of the company even after the policy has started. This is really one of the scariest aspects of all types of UL. There is no way to calculate what the outcome might be. Even if you analyzed the policy under the current structure and found it to be a viable tool, future changes could cause future problems.
#1 The risk is shifted back to the insured: Where as typically the point of all insurance purchased is to shift the risk from the insured to the company, all types of UL shift the risk backwards or from the insurance company to the insured.
Garrett: Todd, thank you providing the rest of the story and sharing the pitfalls of a popular, yet misunderstood product.