Indexed Universal Life Insurance: Not in Your Best Interest

Indexed Universal Life Insurance.This has become a really bigtime product sold by insurance brokers over the past few years. And even during the first several months of 2022 and beyond, as the economy seems to slip further and further downhill, these policies have become much more popular. It seems that anytime the economy starts to correct/drop/downturn/whatever, insurance salesmen come out of the woodwork to sell something that “you cannot lose with”. However, I’m going to show you why you should be cautious (at a minimum) of indexed universal life insurance policies. Let me explain how they work.

(1) What is an Indexed Universal Life Insurance (IUL) Policy?

An IUL is a type of permanent life insurance contract that combines life insurance (a death benefit) as well as a savings component. It is a lot like whole life insurance (for simplicity’s sake) but with a few major differences. 

IULs have a cash savings component that is tied (indexed) to one of the market indices. It could be the S&P 500, NASDAQ, Russel 2000, or a host of others. Because it is tied to that indici it typically will increase in value when the indici increases in value. 

So if you have an IUL that is indexed to the S&P 500 and that market goes up, then so does the cash value of your life insurance policy. 

However, when that market goes down, your indexed universal life policy will NOT go down. That is the big selling point of these products. They typically have a floor of 0%. Which means that if the market is down 5% in a given year, your IUL will not be down at all. 

Sounds good, right? Hold on just a minute. 

(2) You NEVER Get Something for Free

When I was in my very first finance class in college the professor told us something that has stuck with me for years. 

He told us that there will always be a cost to something that we receive. You will NEVER get something for free.

Want to get good grades? You have to study.

Want to be a better athlete? You have to practice.

Want to have more money? You have to go to work.

Want to have investments that go up in value? You have to take on some risk.

Indexed universal life insurance policies are touted as investments that have no risk because you can never lose money. And while that is (somewhat) true, there is a cost.

If you have an investment, there will always be a chance that that investment can go up or go down in value. That is called investment risk. Some investments have a lot of it. Some just have a little.

So in order to have a policy that will never go down, you will have to pay for it somehow.

Think about it like this:

You give the insurance company money for your IUL each month. With that money, the insurance company:

• Pays it workers
• Pays mortgages, rent, utilities, and other business expenses
• Pays out some death benefits
• Invests the money so that it will grow

When the insurance company invests the money into the market that you gave them, there is a chance that their investment could decrease. That means that they will take a loss but they don’t pass that loss onto you. How is this possible?

It is because you are getting hosed with fees, surrender charges, capped rates of return, high commissions, and participation rates.

So, yes, you pay for it. You don’t get an “investment” with no possibility for loss for free. You pay for it.

Let me show you how.

(3) Problems With Indexed Universal Life Insurance Policies

Here are the major problems with IUL policies that the insurance salesman won’t tell you either because they don’t want you to know them or they simply aren’t aware of them themselves.

Con #1: They Are Not Sold By Fiduciaries

Indexed universal life insurance policies are RARELY sold by financial advisors that are fiduciaries.

(A fiduciary is someone who is legally required to offer you products that are in your best interest, regardless of their commission, pay, or any other factors.)

Insurance agents are not fiduciaries. Yes, financial advisors usually have insurance licenses and can sell you insurance products. But insurance agents are NOT financial advisors and can not sell you financial instruments apart from insurance products. 

So when an insurance agent sells you a policy (any kind of policy) they are not required to sell you something that is in your best interest. But a financial advisor is required to do so because they are fiduciaries.

Con #2: Lower Rates of Return Compared to ETFs, Mutual Funds, or Index Funds

Unless someone is of a super-high income and needs a tax shelter, the rates of returns for IULs are pretty much always lower than that of an ETF, mutual fund, or index fund. 

Intuitively this makes sense because how could the insurance company pay the same rate of return in market as they receive but still offer the downside protection to the policyholders. 

One way that they do this is limiting the returns on the IUL policies. (I’ll get into more depth in a minute.)

Con #3: Surrender Charges

Surrender charges are considered one of the largest drawbacks of IULs.

In order for an investment to make money, you have to leave it alone for a long period of time. Insurance companies know this. So they force people who have IULs to keep their money invested with them. It is common for surrender charges to be 7-15 years. 

That means that if you purchase an IUL, you will HAVE to leave it in the account for that period of time or else you will pay a STEEP penalty.

Oh yeah, you will ALSO have to pay taxes on any gains and an early withdrawal penalty of 10% if you are younger than 59 ½. Ouch.

Surrender changes are usually decreasing in amount over time. Here are some examples of how surrender charges for EIAs look:

This is a really big deal. Surrender charges can really come back to haunt you if you are not careful. They can really cost you a lot of money in the long run.

Con #4: High Commissions

When you think of how high the commissions are for the salespeople to sell IULs, just think of Willie Nelson, Cheech and Chong, or Snoop Dog. They are REALLY high.

But first let me say, I believe there is nothing wrong with paying someone a commission. The last few cars that I have purchased, there were commissions paid to the salesmen/saleswomen. When I have sold or purchased a home, the realtor(s) have earned commissions. I have no problem with paying commissions when necessary.

But the commissions on indexed universal life insurance policies can be ridiculous.

On average, an IUL commission is 75-90% of the first year’s deposited amount. And a lot of agents will try to get you to transfer your 401k, IRA, etc. into the policy. 

This means that the insurance salesmen would earn on average, $7,500-9,000 on a $10,000 EIA account. (Do you see why they are marketed so aggressively now?)

However, that is generally the only commission that would be made by the insurance salesman. 

In comparison, if you were to invest your same $10,000 into an ETF, the commission earned would be somewhere around 0.1%.

It is important to note that generally you will not have to pay that commission out of the money that you put into the IUL. The commission is generally paid by the insurance company.

A good rule of thumb is that the more complicated the product, the more expensive it will be and the higher the commission will be needed to sell it.

Con #5: High Expenses

Typically, an equity IUL will charge several different fees. They will usually include:

• An annual expense charge
• A mortality charge
• A premium load charge
• Monthly expense charge

It is hard to pinpoint how much these charges are because the different insurance companies all have different amounts that they charge consumers.

However, the important part is that these charges are usually 3x-5x the charges of a mutual fund and 30x-50x the charges of an ETF! 

Fees for a mutual fund are usually around 1%, and fees for an ETF are usually around 0.1%. 

Con #6: Capped Returns

Mathematically, this is the #1 reason that you should avoid putting money into an indexed universal life policy: your returns will always be capped.

This means that you will NEVER make more than a stated percentage, even if the market does way better. On average, this amount is 7%.

So if the market has a good year and makes 12%, an IUL will only get 7%. 

Insurance companies know that the market averages greater than 7% each year. That means that if they have to pay out a MAXIMUM of 7%, they will almost always make money.

This is the largest cost of an IUL. When the market does well, you don’t get to participate. You have to sit on the sidelines.

This is also the ying to the yang of the 0% floor. Yes, you won’t lose money. But you also won’t gain very much either. When the market is bad and makes a negative return, you win and the insurance company loses. But when the market does well and makes more than 7%, you lose and the insurance company wins. 

Con #7: Participation Rate

Another big drawback of indexed universal life is that they have participation rates. These rates usually average 80-90%.

This means that if you have an IUL with a 90% participation rate and the market goes up 10% in a given year, then your account would only go up 9%. Eeek.

In other words, you only get to participate in part of the gain.

It’s also important to note that the capped returns and participation rates are not exclusive of each other. They are almost always STACKED! That means that you will have a participation rate of 80-90% AND a maximum return cap of 7% on average. Holy cow that sucks!

And yes, some IULs have participation rates that are more than 100%. But they come with even lower caps on them. 

For example, you might have an IUL with a 90% participation rate and a cap of 8% earnings. But someone else might have an IUL with a 140% participation rate but their cap will be 6%. 

Once again, there is always a cost.

(4) IUL and ETF Comparison

So I have shown you that an IUL is not a very good place to put your money. The best thing that you could do is purchase term insurance and invest the difference into a low cost investment (usually an ETF) instead of purchasing an IUL.

But how does that look side by side?

Let’s put all of this together. Let’s compare two people: Jack and Dianne.

The year is 1990 and they both have $100,000 to invest that they will not need until 2020 (30 years).

Jack is okay with investing all of his money in the S&P 500 and riding the ups and downs of the market for the next 30 years. 

But Dianne does not like the prospect of losing any money at all. She elects to put all of her money into an indexed universal life policy. Her IUL is perfectly average. She has:

• A 10 year surrender period.
• A floor rate of 0%.
• A cap rate of 7%.
• A 90% participation rate.
• For simplicity, we will ignore fees.

Here’s what both of their investments look like each year for 30 years:

Because Dianne took the road of “less risk” she made nearly $660,000 LESS than Jack!

Yes, Jack did have some losses along the way but he more than made up for them over time.

Another way to look at it is with this graph:

This graph shows the returns each year for both Jack and Dianne. As you can see, Dianne misses out on the drops in the market from the Dot Com recession and the Great Recession. But she doesn’t get to have the big gains of several of the other years.

Final Thoughts

As you can probably tell from this article, I am not a big fan of equity indexed universal life insurance policies. Yes, they offer you the protection of a down market. But the cost is simply too high. 

Remember, whenever you see an overly complex financial tool. It is not overly complex for your benefit. It is for the benefit of the company selling it. 

Also remember, that if you ever want a guarantee, it will cost you. Nothing in life is guaranteed. And likewise, nothing in the financial world is guaranteed either. You will have to pay for it in the form of surrender charges, earnings caps, high commissions, and overall less earnings.

I am here to help you avoid the pitfalls and traps of the financial world!

Please let me know how I can help you!

Until next time!