How To Compare Indexed Universal Life
“Seeing Through the Smoke and Mirrors”
There’s a well-known saying a former president once famously misquoted. As the saying goes, “Fool me once, shame on you. Fool me twice, shame on me.” No one wants to feel like a fool, especially if it happened before.
In the 1980s and into the early 1990s, there was a torrent of publicity proclaiming the advantages of variable universal life insurance (VUL). It was a classic case of having your cake and eating it, too. Clients secured needed life insurance coverage without giving up access to stock market returns in their cash value accounts.
Unfortunately, many of these VUL plans went unmonitored, and when the market came crashing down with the burst of the dot.com bubble in the late 1990s, many of these plans collapsed along with the market. This left quite a few advisors and clients feeling like they had been fooled by insurance companies that projected 10 to 12 percent returns in their original illustrations.
In the late 1990s, just as the stock market was imploding, a new product—indexed universal life (IUL)—made its appearance. Along with the increasing popularity of indexed funds and exchange traded funds, IUL plans have caught a wave of attention recently.
Unlike VUL plans, indexed plans have some downside “protection” in that the cash value will never be credited with a negative interest rate. It’s this downside protection combined with upside potential that has made IUL the most popular growth product in the universal life marketplace.
According to a LIMRA study, indexed universal life sales were up 35 percent through the first three quarters of 2011. It’s apparent that many advisors and clients are catching onto the IUL story and more carriers than ever are adding IUL plans to their product portfolios.
Even so some advisors remain reluctant to delve into the world of IUL because of their past experience with market-linked insurance in VUL. Those who have taken the plunge into IUL during the past five years have seen a lot of growth; but for others, who still don’t believe in IUL, there is a sense that it’s too good to be true. Many feel as if the cash values in IUL are based on “smoke and mirrors” and the product is too difficult to explain to clients.
Although much has been written about IUL, there’s a paucity of information on how to compare products. Whether you’re an agent who has been selling IUL for years or if you are new to the IUL market, here are five critical issues that should be considered when comparing IUL plans.
IUL Issue One:
Caps and Participation Rates Perhaps the most obvious point of analysis is comparing caps and participation rates of various IUL plans. Essentially, the cap is the maximum amount of upside crediting the cash value account will receive in any given year. For example, if the Standard and Poor’s (S&P) is up 15 percent and there is a 13 percent cap, then the cash value would be credited with 13 percent interest. The participation rate, on the other hand, is the percentage of the positive credit the cash value will receive. If the S&P is up 20 percent in a given year and there is a 50 percent participation rate, then the cash value account will receive a 10 percent credit rate.
The distinction between these two variables is very important. It may seem that the policy with the highest cap would be the best option for a client. However, the participation rate plays a critical role in the analysis, since it ultimately determines the final rate credited to the account.
Some carriers actually have no cap, which sounds great, but their participation rate may be 65 percent. When compared to a plan with a cap of 12 percent and a participation rate of 100 percent, the market return would actually need to be 18.5 percent or higher before the uncapped account is more advantageous. This may seem like a lofty expectation. However, the S&P’s historical returns indicate 35 instances over the last 80 years in which the annual return from January 1 to January 1 was more than 18.5 percent, and many times it was significantly higher. Therefore, an uncapped policy may be better for an aggressive investor, one who likes the possibility of higher returns. The downside of higher caps or participation rates is that the policies typically have lower guaranteed rates or higher policy fees.
Another point to consider when looking at caps and participation rates is the crediting time horizon. The most common is an annual point-to-point method, which takes the index value on the day the money is swept into the indexed account and compares it to the value one year later. However, a more aggressive investor anticipating a steadily increasing market may want to look at a monthly point-to-point method that has a monthly cap of 3 percent, i.e., if the policy “caps out” each month (a highly unlikely outcome), the total return could be as high as 36 percent in any given year.
IUL Issue Two:
Index Options Carriers also try to differentiate IUL products with the index choices they make available. The most common index option is the S&P 500. One carrier did a study of the accounts that clients use most often, and more than 80 percent of their clients funds were invested in the S&P 500 account. Some of this may be explained by the fact that the S&P 500 is the default index on many carriers’ illustrations. Therefore, for an advisor to best emulate the illustrations, they have their clients 100 percent allocated to that account.
The S&P 500 is also very easy for clients to follow, since it’s constantly quoted in the media outlets. Some carriers have gone so far as to offer the S&P 500 index as their only index selection.
There are some distinct advantages to having multiple index accounts. Many clients already have exposure to the S&P through their other investments, such as 401(k)s and IRAs. Providing clients access to European or Asian markets through IUL can provide them some diversification in their cash value accounts without the risk of investing in specific stocks and bonds. Multiple index options can also diversify the returns within the IUL policy and protect from fluctuations in any one index.
The downside of offering too many choices in a client’s indexed account is that it can lead to confusion and a lack of understanding of how interest is ultimately credited to the cash value. A second problem with providing a plethora of index options is that it can increase the carrier’s cost of maintaining the indexed accounts, one that eventually passes to the consumer. In the end, policies with many index options are probably better for the client who is looking for a greater risk/reward payoff and is willing to take a more active role in the management of an IUL policy.
IUL Issue Three:
Guaranteed Minimum Crediting A third factor when comparing IUL plans is the guaranteed minimum crediting rate. This is important because it will support the policy for a given number of years, taking into account a zero percent credit to the indexed account, as well as maximum insurance charges.
For a 35-year-old male, the typical policy is guaranteed to last from 35 to 50 years, depending on the carrier. This is significant, since some IUL plans will carry out to life expectancy on a minimum guaranteed basis, which gives a conservative client some assurance that the policy will not lapse until at least age 85.
The other important facet of the guaranteed minimum crediting rate is that it can provide some protection against those years when the index return is zero or negative. It’s said that with IUL, “zero is your hero,” meaning that the client can never do worse than zero. However, regardless of what the crediting rate is in any given year, policy fees are still taken out of the cash value account. Consequently, a 1 to 2 percent guarantee can be important in terms of maintaining value in the cash value account.
Another key point to consider when looking at a company’s minimum guaranteed rate is how the rate is credited. Some carriers will credit the given rate to the cash value account on an annual basis, while others will use a five-year look-back period. If the average crediting rate is below the guaranteed rate for that period, then they will credit the higher guaranteed rate. Additionally, some carriers will only allow access to the guaranteed account upon surrender of the policy, so the guaranteed account value is not available for loans or withdrawals.
For a more conservative client a guarantee can be an important consideration in making a decision. On the other hand, a more aggressive client may be willing to forego the guarantee for the opportunity to make up for it with higher caps or participation rates which can lead to more cash accumulation.
IUL Issue Four:
Loan Rates This leads to the next consideration in comparing IUL plans: loan rates charged to the policy. Since a majority of IUL is purchased for the purpose of cash accumulation, it’s important to understand the policy’s terms for access to the cash. There are two types of loans that carriers will allow from the cash value account: fixed and variable. Again, the distinction is worth noting, since it can have an enormous impact on the amount of cash available for withdrawal.
Fixed loans are easy to understand: They are charged a fixed interest rate every year after the loan is taken. The client can either pay the interest or have it added to the loan amount each year. The loan rates are typically higher than the current variable rates because they’re guaranteed. As a result of the higher current cost of the loans, when showing an illustration of loans coming from the policy, there is less income available in a fixed loan scenario. However, fixed loans are contractually guaranteed so the interest will never increase.
Variable loans, on the other hand, can change from year to year. Typically, a variable loan rate is based on a published rate such as the Moody’s corporate bond rate plus 2 percent. The possibility of the rate rising and falling adds some risk for the client, but it can also lead to positive arbitrage if the loan rate is lower than the actual index credit in a given year. For example, if the variable rate is 4 percent and the index credits 8 percent, the loaned money actually earns 4 percent. In times of low interest rates and a bullish stock market, the positive arbitrage can be significant.
IUL Issue Five:
Policy Fees and Expenses The four prior points all have a significant impact on the policy fees and expenses. Although it may be an automatic assumption that policies with the lowest fees and expenses are the most advantageous for the consumer, it’s not always the case. If higher expenses can be justified due to a better minimum guaranteed rate or a more diverse selection of index accounts, then it might be worthwhile for a client to opt for the higher fees.
Another consideration when evaluating policy fees is the length of time that the fees are applied. In most policies, a majority of the expenses and fees, aside from the cost of insurance, are paid in the first 10 to 15 years of the policy. However, some carriers reduce the number of years the fees are applied to the first seven or eight years of the contract, which creates higher charges initially. This can be extremely important for the year when and if the account has a credited rate of zero percent; then, the expenses that aren’t paid from the premium will come out of the cash value.
Generally speaking, there’s a reason for higher fees. A more conservative client might value a policy with higher fees that offers the added protection of a better guarantee, while a more aggressive client may opt for a policy with higher fees that result from a higher cap or participation rate. If it’s found that a similar type of policy can be obtained for a lower expense structure in either scenario, then that’s the time to go with the lower cost alternative.
As more clients and advisors become familiar with IUL and as additional carriers introduce IUL policies, it is becoming both a much larger and more confusing space in the insurance market. These plans have more “moving parts” compared to whole life or guaranteed universal life; however, these additional features allow an advisor to more appropriately address clients’ needs in terms of cash value accumulation and insurance protection.
IUL fits nicely between variable and guaranteed universal life policies on the risk/reward spectrum and can have many applications in a client’s insurance portfolio. However, along with the additional IUL benefits comes a need for advisors to have a greater understanding so they don’t become victims of the second part of that old saying and are able to see through the “smoke and mirrors.”
by Josh O’Gara for the April 2012 issue of Broker World Magazine. Author’s Bio Josh O’Gara, CLU CLU, is a brokerage manager at First American Insurance Underwriters, Inc., a brokerage firm that specializes in coaching life insurance producers wanting to grow their practices