Before we get too carried away with this week’s post, we have to admit that we avoid dealing in absolutes. One of us has been humbled (humiliated?) after claiming that an F-15E could never beat an F-16 in basic fighter maneuvers, so we recognize that black swans may be more common than not. With that being said, we’ve found situations where an insurance product was appropriate as an investment vehicle given the scenario.
However, we continue to be surprised to hear sales pitches that go something like this:
I have a product that allows a client to participate in the market’s up moves while offering complete downside protection. You can never lose AND the money grows tax-free for life.
Skeptical? You probably should be. That pitch is one that we hear for an insurance product called Indexed Universal Life (IUL). If you’re only familiar with insurance as a risk management tool and have only run across term life insurance, then let’s lay some groundwork:
- Life insurance is a contract between the insurance company (the insurer) and the insured (perhaps you). The owner of the policy doesn’t necessarily have to be you — you can own the policy that insures your children — and the beneficiary is the person that has the legal claim to the death benefit.
- There are two basic types of life insurance: term and permanent. With a term life policy, the premiums you pay for the insurance are fixed for the duration (or term) of the policy. At the end of the term, the premiums usually become cost prohibitive and the policy lapses; that is, it just goes away and you are no longer insured. Permanent life insurance has a savings mechanism included which allows a cash value to build up and help the policy exist into perpetuity. Part of your premium pays for the life insurance and part of it goes toward the cash value.
- Indexed Universal Life policies are permanent life insurance policies in which the cash value of the account is credited some amount of interest based on the performance of an underlying index. Which is a fancy way of saying that consumers can get an interest payment relative to the performance of the stock market. IULs can be linked to the S&P 500 or NASDAQ 100, for example.
Unlike other permanent insurance products, consumers don’t invest directly into the stock market. As such, insurance companies usually place a cap on the gains that will be credited to the cash value at the end of the year in exchange for mitigating the downside risk. These caps average about 12% a year based on an article in the Wall Street Journal, which means that even if the market rallies 20% in a year, the interest credit you’ll receive is limited to 12%.
Additionally, participation rates may be in force, which limit the amount of the credit. If your policy has a participation rate of 75%, that 12% interest credit has now become 9% (75% x 12%).
What’s worse is that insurance companies can change the policy caps at its discretion.
What happens when the market goes down? Well, nothing is credited to your account. …which is good, right?
Not necessarily. The costs of the IUL — to include the life insurance charges — must be paid from the accumulated cash values or premiums. So when the market goes down, your cash value doesn’t increase, and may decrease to cover the costs of the IUL. These policy expenses can increase as much as specified in the IUL contract (at the discretion of the company). Since the largest expense is the cost of life insurance in the IUL, it’s incumbent on the insurance agent to design the IUL to minimize the death benefit to comply with tax regulations… and absolutely essential that the consumer understand the ins-and-outs of the policy and the contractual rights of the insurance company with regard to expenses, premiums, credit caps, and participation rates.
The IUL sales practices employed by life insurance companies have been the subject of investigations and recent guidelines have tried to limit the overly-optimistic return expectations that are presented to potential consumers.
If someone approaches you with a sales pitch like the one above, remember to do the research, control the costs… and buyer beware.
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