Indexed Universal Life Comes Of Age
In addition, IUL (indexed universal life) and fixed indexed universal life (FIUL) have become the number one selling life insurance products for cash accumulation in the United States. The number of companies offering the product has grown exponentially, too. According to Todd Petit, ASA, MAAA, senior actuary at Allianz Life, five companies added the product to their portfolios in the past year, including some of the best known and most respected in the industry. According to another industry consultant, there are as many as 15 additional carriers that are in various stages of IUL development with about one-third of them being household names of significant size.
Only a few years ago, many agents, GAs, BGAs, IMOs, FMOs and even life insurance companies were barely aware of the product, and only now are beginning to understand it. Why did this happen?
There are a number of reasons for this phenomenal growth. Some are simple and some are more complex. The simple answer is that during its relatively brief existence, IUL has proven to be a competitive cash accumulation vehicle—even with declining interest rates and a flat stock market, which has been the “norm” since its inception (including no market losses in the 2008 and 2009 financial crisis).
Now, for the more complex reasons.
The death benefit of permanent life insurance has long been viewed as the most efficient way to transfer accumulated wealth, income tax-free, to future generations. The after-tax rate of return at life expectancy of the death benefit of a permanent life insurance policy is very competitive. In other words, the premiums, if accumulated in other financial instruments, would have to be invested at much higher risk levels to achieve the same after-tax rate of return. At the same time, if there is a premature death, permanent life insurance leaves a legacy that otherwise would not be accumulated.
By all previous standards, the cash value of legal reserve life insurance policies is safe. Furthermore, once accumulated, the cash values of IUL, like fixed interest rate UL, are absolutely guaranteed against market loss. Also, there is no market exposure or risk to the accumulated cash values. And finally, like universal life, the account value is completely transparent and charges are completely disclosed.
Unlike fixed interest rate UL, interest credited to IUL policy values is based on the published stock market or bond index. Generally, if the index goes up, interest is credited to the account value of an IUL policy as determined by that growth. If the index goes down there is no loss to the account and a policyowner participates in the next period’s growth without having to gain the loss back. Some people call this gain when the market gains but no loss when the market loses—or the ratchet effect.
In the highly unlikely event that the index goes down every year for 10 consecutive years, an IUL account would not be penalized one dime due to market losses and patiently be ready for growth whenever the market starts moving up again. Theoretically this could happen, but it has never happened in the history of the indexed products currently used. As a matter of fact, during the so-called “lost decade” of 2001 to 2010, the commonly used indexes went up and down year by year but ended the decade at virtually the same level they were 10 years before. In the meantime, policies using the indexed crediting method had interest credited as high as 12 to 17 percent (and more in some years), while experiencing no losses in the years that the market was down.
Another advantage of IUL is that the cash values accumulated in an account can be used as collateral for a loan from the general account of an insurance company at any time and for whatever a policyowner wants (e.g., purchase of a car, college expenses for a child or grandchild, a wedding, etc.). Some carriers will even allow a policyowner to keep the loaned money in his account using the index crediting method, while charging a fixed interest rate for the loan. Since a policyowner is not borrowing “his own money,” tax-free compounding of his cash values is allowed while paying simple interest on the loan. When he pays the loan off, he has no further interest charges. If he dies with an outstanding loan, it is simply paid off from proceeds of his income-tax-free death benefit.
For many decades the only cash accumulation product was whole life. As we all know, whole life is based on a formula that adds up all the mortality charges for a lifetime and then uses a discount rate stated in the policy (often confused as a guaranteed interest rate) to determine a net level premium. An elaborate formula is then used to determine the nonforfeiture values each year, one of which is a guaranteed cash surrender value option. When considering a whole life policy, something that is often overlooked is that the cash vale is guaranteed only if every premium is paid. If any premiums are skipped, the guaranteed cash values are dependent on the dividends paying the skipped premiums and, of course, dividends are not guaranteed.
In addition to the net level premium, an additional charge is levied on the premium that is not separately disclosed. This charge is for an additional margin of safety and a source of profit for the company. The total of the net level premium and the additional charge is the premium for the policy. The concept is that if the additional charge is not needed for company claims and operations, then it is returned to policyholders in the form of a dividend.
Each year the executives of an insurance company determine their company’s “divisible surplus” and distribute it as a dividend to the individual policyholders. They use an actuarial formula based on the size of each policy and how long it has been in force. In many cases the dividends fluctuate from the original projections but because of the complexity and lack of transparency in the way they are calculated, it is impossible for policyholders to account for the changes.
Another life insurance product that clients used as a safe parking place for cash was fixed interest universal life, the grandfather of IUL. The product appeared in the early 1980s and was anointed with the tax benefits of life insurance under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). These tax benefits are found in IRC Sec. 101(a) and 7702, referring to income-tax-free death benefits, tax-free inside buildup, and tax-free loans.
Unlike whole life, all universal life policies disclose the actual cost of insurance charged each year, based on actual current mortality experience (as opposed to the total charge allowed in the mortality table published in the policy). This information is published in each company’s annual statement, which also discloses any other charges or fees and exactly how much interest is credited for the year. The statement also declares the interest rate the company will pay on account values of the policies during the coming year, which is guaranteed not to change for that year. Each policy carries a minimum guaranteed rate, generally between 2 and 4.5 percent, depending on when the policy was issued.
The products that were purchased in the early 1980s were based on interest rates that were current at the time, which were then well more than 10 percent for years (8 percent was conservative). As rates fell in the ensuing years, the cash values were still protected against market loss, but were not growing as they would have at higher interest rates. As a result, the projected values were unattainable using the planned premium outlays, because the projections were based on what turned out to be higher than sustainable rates. Policies that were designed assuming those higher rates began to be underfunded.
The next variation was universal life that used stock market accounts, called sub-accounts, for tax-deferred growth. These policies are registered securities and are called variable universal life (VUL). They soared in popularity during the falling interest rate environment. However, many policyholders and registered representatives have become disenchanted with the concept.
When indexed universal life policies appeared in the mid to late 1990s, they were first viewed as a specialty product offered by small niche market companies. Also, because indexed interest crediting was relatively new in the insurance world, only a few advisors understood how it worked and, because of that, very few felt comfortable selling the product. After the tech bubble crash in 2001, the product began to gain momentum with more sophisticated advisors who specialized in supplemental retirement, non-qualified deferred compensation, and in executive bonus cases.
Also in the early 2000s, the concept of maximum funding of the contracts gained momentum. Simply put, “max funding” in life insurance refers to the practice of funding the policy at the highest level permitted by the tax laws that would still allow the cash values to be taxed as life insurance, and not similar to annuities.
As clients began to seek a safe haven for their savings dollars that would provide income-tax-free death benefits with no market risk, advisors began designing cases with minimum allowable death benefit and maximum TAMRA premiums funded (to avoid creating a modified endowment contract (MEC) or annuity like taxation). When funded like this, the target was only around 25 to 35 percent of first year total premium, yet the performance was amazing.
The rising popularity of these concepts led to the widespread use of indexed universal life for what cash value life insurance had always been about. IUL is a complete financial vehicle that allows people to build their wealth, maintain cash reserves, accumulate retirement dollars and leave unused dollars income-tax-free to their heirs…and, all the while, protect their families, businesses and wealth by providing an income-tax-free life insurance benefit should they die prematurely.
The life insurance industry has searched for hundreds of years for the perfect product that includes a combination of safety, reliability and value. The industry has survived countless economic upheavals, including the Great Depression and the recent liquidity crisis that severely affected banks, the stock market, interest rates and the economy.
After hundreds of years, with the lessons of the past, and arguably some of the smartest financial people in the world working to build the ideal product, indexed universal life was born. It has all the features and benefits that draw people to modern permanent life insurance, including: full disclosure, guarantees, a floor for the values, plus interest crediting that takes advantage of the modern financial acumen and unique cash position of life insurance companies to provide competitive after-tax returns.
It is 2012, and the whole world has changed. Indexed universal life has taken the cash accumulation life insurance market by storm. You owe it to yourself to learn all about the structure and nuances of IUL. It can solve a myriad of financial challenges for your clients, possibly better than any other financial vehicle available.
IUL has definitely come of age!
By Bill Zimmerman for September 2012 Issue of Brokerworld Magazine. Author’s Bio Bill Zimmerman is founder, president and CEO of LifePro Financial Services, Inc., a premier distributor of life, annuity, long term care, and securities-based insurance products.
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