Is IUL a good investment? It sure has a lot of negative press, doesn’t it? But is it warranted? Not at all. I’m going to set the record straight in this article. If you are concerned that IUL is a good investment, keep reading.
First off, I just want you to know that Life Insurance is not an investment per se. But that said, if you are looking for a way to both protect your family and maximize retirement income, an IUL is a great option. An IUL is a great choice for a Life Insurance Retirement Plan (LIRP). I personally think it is even better than other “Traditional” retirement planning asset classes. But are IUL safe? Why all the negativity?
The purpose of this article is to show you that IUL is a good investment and the bad rap is completely unwarranted. The problems is that many agents are just repeating the lies they’ve been told from day one of their training. But they never truly learn how the policies work under the hood. Nor do they properly understand and communicate what exactly the Guarantees mean. It’s important to understand that Whole Life and IUL policies are very much the same.
Maybe its just a coincidence but this approach is usually from agents whose company doesn’t offer an IUL. You should walk away from any agent who makes these types of claims against IUL. They are really communicating that they don’t understand how Life Insurance works.
Indexed Universal Life Insurance vs Whole Life?
It’s important to realize that IUL and Whole Life have a lot in common. In fact they have more in common than they have differences. They look very much the same under the hood. They are built on the same chassis, use the same mortality tables, and have the same cost of insurance. The reserves are held in the same asset classes. If I lay a Whole Life illustration over an IUL illustration and you will see that they perform identically over time.
It’s important to realize that they are the same right up to the point where a Dividend would be credited. A Whole Life allocates the net gains on the Insurance Company investments to each policy as a Dividend. An IUL uses what would have been the Dividend to hedge in the Index Options markets. The goal of this hedging is to safely capture as much movement in the market index as possible. So while IUL interest-crediting rate has more year-to-year volatility, the longer term performance should be superior. The main thing I want you to remember is that these policies function identically up to the point of crediting a Dividend.
An important thing to keep in mind is that a Whole Life and an IUL should only differ in their performance. You should understand that any UL/IUL Policy is really just an unbundled Whole Life. Any two permanent life insurance policies designed with the same premium, same death benefit, and same interest-crediting or dividend-crediting assumptions, will likely perform identically over time.
So if they are so much alike, then why the bad rap for Universal Life?
To answer this question, we need to look back in time and what was going on when Universal Life came about.
History of Universal Life
It’s important to understand the history of Universal Life in order to understand why it has a bad rap.
This Graph helps to illustrate a reason for the birth of Universal Life. Notice the extremely high interest rates around 1980. These high interest rates provided an incentive to create a flexible premium Life Insurance policy. Just imagine if you could:
- Partition off the reserves for a new product so that all new investments had high returns, and
- Run projections for Cash Value growth at 15% as you could in 1982.
Do you see the advantages? It’s important to realize that with much higher growth assumptions, the Premium on the policy could be much lower. This new policy would be much more attractive to the market. As we will see though, this new product led to some new problems.
Life Insurance 101
I want to help you understand why a higher growth projection results in a lower premium. It will help to begin our discussion with a little bit of Life Insurance basics. It is important to understand that the Cash Value in a Life Insurance policy represents the Policy Owner essentially saving up the Death Benefit.
This Graph shows the Cash Value and Death Benefit in a Traditionally-designed policy. The gap between the Death Benefit and the Cash Value is known as the Net Amount at Risk. This is the portion of the total Death Benefit for which the Insurance Company is responsible. It’s important to remember that the Cash Value is part of the Death Benefit. In the early years of the Policy, all of the risk is on the Insurance Company. But over time, the risk to the Insurance Company disappears. For all practical purposes, you could say that the insurance company is “buying term and investing the difference”. If the Insured died at 81, the Beneficiary would receive $1 Million. $500,000 from the Cash Value and another $500,000 from the Risk Pools.
While the mortality costs may rise over time as the Insured ages, the Net Amount at Risk to the Insurance company declines. Note that this is true for both Whole Life and for UL. Yes, even Whole Life faces increasing mortality costs as the insured ages. Be wary of an Agent who tells you this is a risk in an IUL.
How a Life Insurance Policy is Priced
You can see that the Insurance Company needs to make sure that the Cash Value grows and reaches the Death Benefit. Two factors impact that growth: the amount of Premium and the Growth Rate on the “Reserves”. But what Growth Rate should they use? A Life Insurance policy is a long term commitment. As the interest-rate graph showed, rates can fluctuate tremendously. Realize that if they commit to too high of a growth rate and rates fall, they may not be able to perform on the policy obligations. Their best bet is to use a nice low, conservative rate that they KNOW they can achieve.
It’s important to point out that Insurance companies are very risk averse. They will never risk defaulting on a Death Benefit payment. That would destroy the reputation of the Company as well as the entire industry.
As a result, Insurance Companies use a very low, conservative growth assumption. This is also known as the “Actuarial” growth rate or the “Guaranteed” rate. They simply use a worst case rate to make sure they don’t over estimate.In a Whole Life policy, the insurance company is responsible for maintaining adequate reserves to meet the guaranteed obligations of the policy.
The insurance company can easily calculate how much Premium they need to collect if they know the rate at which it will grow.
Over-funding
It’s important to remember that two factors impact the growth of the reserves (Cash Value): Premium and Growth Rate. That means that if you think that the growth rate will be very high, then the policy doesn’t need as much Premium in order to cover its costs.
If the Cash Value grows faster than expected, then the Cash Value intersects with the Death Benefit sooner. This is shown in this next Graph.. In this example, the client could have paid even less premium into the policy. Understand that as the Cash Value accumulates, it generates more in interest-crediting or dividend-crediting and is more able to meet the rising mortality costs. This is exactly what happened with UL. Policy owners believed that interest rates would remain high and make up for the lower Premiums they were paying.
Under-funding
This next graph shows a Policy where the Cash Value growth rate is lower than projected. In this example, the Policy will not accumulate enough Cash Value by the time the insured reaches their life expectancy. Notice the much larger gap between the Death Benefit and the Cash Value. It’s important to consider that the cost of insurance may be a burden on an under-funded policy.
The Birth of UL
So why is this important for our discussion? It is important to understand that a Universal Life policy has a flexible Death Benefit and a Flexible Premium. That means that when interest rates are high, as in 1982, a Policy could achieve the necessary growth rate with LESS premium. Universal Life was presented to the market as an inexpensive alternative to traditional Whole Life. Since a Whole Life was required to price the Policy using the 4% Actuarial (Guaranteed) growth rate, a Universal Life was a much more inexpensive option. The Dividends were much higher in 1982, but the Policy was still more expensive.
With Great Power Comes Great Responsibility
Sales of Universal Life exploded. Because of the Flexible Premium and the high Interest Rates at the time, UL was much less expensive than Whole Life.
It’s important to realize, however, that a Whole Life Policy requires no Policy Owner management. That means the only thing they need to do is keep their Premiums current.
A UL DOES require the Policy Owner to manage the policy. It’s is absolutely crucial to understand that if you are intentionally paying less Premium because the Growth Rate is enough to offset it, then you NEED TO INCREASE the Premium if Rates drop. Prior to 1982, as interest rates were rising, Policy Owners could get away with less Premium. But it’s important to understand that starting in 1982, as interest rates started dropping, these policies required more Premium. It’s important to realize that the Policies are in danger of lapsing if the Cash Value doesn’t grow at the necessary rate.
By giving the Policy Owner some control over the funding of the policy the Insurance company is absolved of the responsibility of maintaining the reserves. Since the policy owner makes investment decisions regarding the Cash Value, they assume responsibility for maintaining adequate growth over time.[2]
THIS is the fundamental difference between Whole Life and UL. In the right hands, a UL Insurance policy is a very powerful financial tool. But in the wrong hands, it can be risky because it introduces the opportunity for speculation into a life insurance product.
This is not a problem with Universal life, it is the advantage of Universal Life!
Is IUL a Good Investment?
Yes, but…
It’s important to realize that UL, IUL, and Whole Life all work nearly the same. There is no functional difference other than the Premium and Death Benefit flexibility. You should understand that the flexibility is more a a marketing difference than a technical difference.
However, it is super imperative that the funding requirement be adequately explained to Policy Owners. Unfortunately, that didn’t happen in the case of Universal Life. There were multiple reasons that policies became under-funded:
- Agents failed to fully and properly explain the nuances and risks to their prospective clients.
- Policy owners may not have completely understood that UL put the responsibility upon themselves.
I think the real problem is that the neither the Agents nor the prospective clients understood the nuances of a Universal Life.
Agent Failures
Did Agents who were only familiar with Whole Life Insurance truly understand the risk of using a very high growth assumption? Permanent Life Insurance is a pretty complicated product. Even today, many Agents do not understand how it truly works under the hood.
The Agent should definitely stressed the need to keep the Policy adequately-funded. Moreover, as Interest rates began dropping after 1982, Clients should have been informed of the need to keep the Policy funded. If a Policy was barely affordable with the high growth assumption, could the Client handle a Premium increase?
This is an issue of Suitability and Education.
Client Failures
In any case, responsibility for maintaining the growth on the Cash Value ultimately falls upon the Policy Owner. When the Policy Owner’s policy became underfunded, it was the Policy owner who needed to add premium in order to make up for poor performance.
The Problem With “Illustrations”
A Life Insurance illustration is just that: an illustration of how the Policy will perform. It’s not a part of the Policy and its definitely not a contract. It’s simply a projection of the Policy values over time. The projection relies on assumptions of the Cash Value earning rate. As I discussed above and in Do Life Insurance Guarantees Matter?, a Whole Life guarantee is only the actuarial minimum growth rate necessary to ensure that the reserves are adequate to cover all expected liabilities. It is not the rate at which the Cash Value actually grows.
The insurance company is investing their reserves in US Treasuries, bonds, mortgage-backed securities, preferred stocks, etc. And, as was the case during the late 1970s, the actual rate of growth may far exceed the minimum required rate of growth.
As a result, the insurance company typically shows the client both the Guaranteed projections as well as some “reasonable” projections. No one knows what rates will really do in the future. Most agents and insurance companies simply show the projections based on rates in place at the time.
The Bad Rap
This is exactly what happened. Insurance companies introduced UL policies just as inflation and interest rates peaked. Over the next 40 years, interest rates dropped substantially.
Policy owners need to understand that if the Growth Rate falls, they must increase the Premium to keep the policy adequately funded. Clients who bought under-funded policies expecting double-digit growth had to add Premium.
Many policy owners surrendered their policies or let them lapse when they realized they needed to pay more to keep them active. Whole Life Agents used this as a reason to discourage purchasing UL policies. However, we should remember that the Policies actually worked exactly as designed.
Agents, Insurance companies, and Policy Owners all believed interest rates would remain high. When rates fell, the Policies required more Premium to maintain adequate reserves and Cash Value.
Policy owners can also save their policies by reducing the Death Benefit. This lowers costs and reduces the need for additional Premium, highlighting the flexibility of UL policies.
Is The Bad Rap Warranted?
It’s important to remember that Interest Rates and Inflation had peaked in 1982. Interest rates today are just above near-historic lows. This is just the opposite of what happened 40-years ago. Actual performance of the Cash Value could in fact greatly exceed the low interest rate projections used in illustrations today.
IUL is a good investment and we need to understand that these policies worked exactly like they were supposed to. The policies performed exactly as we would expect during a period of declining interest rates. There is no problem with UL Life Insurance. A policy will not spontaneously lapse. The rising cost of mortality has nothing to do with it. As the graphs above show, when the Policy is properly-designed and funded, the Cash Value keeps up with the increasing cost of insurance. You should also realize that the Cost of Insurance increases every year in a Whole Life too. They work the same way.
Agents need to educate their clients properly. Agents need to understand the products they sell. I want to emphasize the importance of Suitability. If a UL Insurance Policy is too complicated, the Agent should recommend a simpler product, such as Whole Life.
IUL for The Double Play
It’s important to remember that The Double Play and any “banking” strategy uses a Maximum Over-funded Policy. Everything I’ve discussed thus far relates to minimally-funded life insurance designs. None of what you just read has anything to do with Maximum Over-funded Policies. Why? Because they are “MAXIMUM OVER-FUNDED”. A Max-funded IUL is a good investment. A Max-funded Policy purchased in 1982 would have earned much less than illustrated, but it would have been in no danger of lapsing.
UL policies should ideally be used only in Max-funded policies where the death benefit is held to an absolute minimum. There is virtually no risk of a Policy lapsing when it is properly designed and maximum over-funded.
This graph shows a Maximum Over-funded Policy design. Notice the huge difference between this and the Traditionally-funded Policy. You can see that the Death Benefit is as low as possible for the entire life of the Insured. The Net Amount at Risk is minimized for life as well.
The arrow indicates that the Growth of the Cash Value with an increase in the Growth Rate. The opposite is also true. the growth will simply be slower if rates decline.
Never listen to Agents who tell you to avoid IUL/UL because it is risky. This shows a lack of understanding of the true nature of UL and Whole Life, for that matter!
IUL/UL for Death Benefit Protection
Never fund an IUL or UL insurance policy with a minimum premium based on prevailing rates. I require my clients to sign a disclosure stating they understand the risks. When funded similarly, UL/IUL policies perform just as well as Whole Life policies. Remember that both types of policies operate the same way internally, given the interest rate risk. They use the same mortality tables, charge the same cost of insurance, and invest in the same reserve assets.
How To Fix A Universal Life That Is Failing
Policy owners need to understand that if the Growth Rate falls, they must increase the Premium to keep the policy adequately funded. Clients who bought under-funded policies expecting double-digit growth had to add Premium.
Many policy owners surrendered their policies or let them lapse when they realized they needed to pay more to keep them active. Whole Life Agents used this as a reason to discourage purchasing UL policies. However, we should remember that the Policies actually worked exactly as designed.
Agents, Insurance companies, and Policy Owners all believed interest rates would remain high. When rates fell, the Policies required more Premium to maintain adequate reserves and Cash Value.
Policy owners can also save their policies by reducing the Death Benefit. This lowers costs and reduces the need for additional Premium, highlighting the flexibility of UL policies.
Conclusion
IUL is a good investment. We just need to make sure:
- That a UL is Suitable for the Client.
- The Client understands the risks and benefits
- To properly fund the Policy.
Hopefully I made it abundantly clear that all of the hype over UL is just that. A properly designed and funded UL is going to perform the same as a Whole Life funded exactly the same way. IUL is a good investment. Just make sure to properly design and fund the Policy. The user of a UL will only get in trouble if they rely on interest-crediting growth that doesn’t occur. And since a Maximum Over-funded life insurance policy has as much Premium/Cash Value as legally possible, concerns about UL do not apply to Maximum Over-funded policies.
Notes
[1] See Should I Buy Term and Invest the Difference? and Myth Exposed! Buy Term and Invest the Difference for more information on the advantage of Life Insurance over the “Buy Term and Invest the Difference” approach.
[2] See Life Insurance 101 for more detail on the inner workings of Universal and Whole Life as well as an explanation of the piece parts of a policy such as the cash value and mortality risks.
[3] Even the insurance companies did not expect the prolonged streak of extremely low interest rates currently observed (March, 2021). As a result, new regulations are loosening the guarantees that a Life Insurance company must offer. I’ll address these new rules in an future blog post that I’ll link here.
[4] See Minimum and Maximum Over-funded Life Insurance Policies for an explanation of the differences in policy design. But basically, the goal of minimum funded policies is to get as much death benefit for as low a price as possible. The goal of a maximum over-funded policy is to maximize cash value accumulation.
