Some things in life seem straightforward enough that they don’t need explanation, but experience often proves this assumption wrong.
While there are many aspects of indexed universal life (IUL) that consumers, and many of their advisors, don’t understand, I want to focus on one point here: a policy with positive annual returns can still fail.
The Story
The primary marketing story behind IUL is that it’s a life insurance policy with upside potential without the downside risk. Very simplistically, IUL is an insurance contract that’s driven, in part, by an index, often the S&P 500 Index, though index options are expanding. Even though the index drives returns, premium dollars don’t actually go into any securities. An IUL contract is a fixed product with cash value invested in the general account of the life insurance carrier that primarily consists of high-quality bonds.
With an index policy, no premium dollars go into securities. Only a day ago, I was speaking with an accomplished professional who has a client who’s put millions of premium into an IUL policy. Neither of them had any idea of this fact. I’m positive many others don’t either.
Options are purchased to credit the upside of the market in good years. There’s a cap, the maximum crediting the policy can realize, and there’s a floor, the lowest crediting. The floor is guaranteed, doesn’t move and is usually, but not always, 0%. Caps have come down in recent years due to changes in economic markets. Not long ago, many contracts had caps in the 10% to 15% range, or even more, but are in the 7% to 9% range today, some lower and some higher. Many policy owners are unaware that the guaranteed minimum cap is very low, often only 3%.
When 0% Can be a Negative
Let’s focus on the floor. While I’m not going to insinuate that a preponderance of agents are stating this, many policy owners believe that because the floor is 0%, they can’t lose money. This couldn’t be further from the truth. Some are led to believe this, and some simply don’t understand how their life insurance contract really works. A well-advised policy owner understands that even a policy with positive annual returns can fail.
I’ll repeat this because it is the crux of this piece. A policy with a 0% crediting floor can lose money.
How can a policy with a 0%, let alone a positive rate, fail? Expenses. It’s all about expenses. Premium taxes, policy fees, mortality charges, etc. Policy expenses are always coming out of the policy, sometimes higher and sometimes lower. They’re also dictated by how a policy is built and can vary dramatically. Most policy owners don’t understand this, so they must completely trust the agent on the best structure.
While there are intelligent, capable and ethical agents in the market, there are also agents who aren’t. Some agents try to do good work but don’t know any better. I regularly see policy structures built with no reasonable chance of working though it looks like they will on paper.
I pulled out the most recent set of in-force projections for a case currently on my desk. Remember, these two projections are on the same contract. In one, the return on cash value from one given year to the next is negative 99.7% (dropping from $557,879 to $1,414), and on the other, it’s a positive 1.06% (growing from $2,260,005 to $2,284,436). Why? A difference in expenses based on how the policy is being funded, which, by the way, is only a 7% difference in premium. That’s quite a small swing in premium for a dramatic swing in policy performance for the same year for the same policy. Also, at a different point in the policy's life, the increase in cash value from one year to the next is 4.9%. Again, this is the very same policy and even the same projection but a different year. Why? Expenses. At various points in the life cycle of this life insurance contract, the return from one year to the next can be most of the crediting rate. At another point, it can be an effective 100% negative return though no input has changed in the meantime. In both situations, the assumed policy crediting is 5.18%, not even the guaranteed floor of zero.
Caps Have Fallen
Policies issued in the past when projected crediting rates were greater due to higher caps and better general fund returns, this wasn’t as much of an apparent issue because the projections look great. However, when crediting rates come down, as they have across the board, suddenly many projections, to the extent they’re being run and shared with policy owners, are failing, even when current projected crediting rates are 5% to 6% in many cases.
If a policy doesn’t project to pay a death benefit when crediting solid, positive returns, what does the 0% floor really mean? Yes, it means something, but not what very many policy owners believe it to mean. Many projections on IUL policies, even only a few years old and run at the current maximum regulatory allowable rate, don’t project to persist through age 100, and often not even life expectancy.
None of this means the product is definitively bad; it simply means it needs to be better understood and managed. I understand, given common vernacular, when someone is presented with a guaranteed minimum of 0%, they reasonably assume they can’t lose their money. It just isn’t so, and it’s intensely important to understand.
This is part of why I consider IUL the most misunderstood and complicated life insurance ever introduced to the public, even though the marketing story is amazingly simple. As an advisor, please help your clients understand this.
Bill Boersma is a CLU, AEP and LIC. More information can be found at www.OC-LIC.com, www.BillBoersmaOnLifeInsurance.info. Call 616-456-1000 or email at [email protected].