The 401(k) Versus the IUL (Part Two)
Which One Is Better For Building a Retirement Income?
Advantages and Disadvantages of the Indexed Universal Life Policy (IUL)
Advantages of an IUL
An IUL is an indexed universal life insurance policy and this is not the kind of life insurance your parents bought (term or whole life). The first universal life product was created by the life insurance division of a securities firm (E.F. Hutton) around 1980 for one purpose – creating tax-deferred growth. In those days, firms allowed the wealthy to pair a small term life policy ($5,000) with a tax-protected cash growth account (the top marginal tax rates were over 80% in those days). You could put $100,000 in the cash value account and the interest would grow tax-deferred. Sued by the IRS, the Supreme Court ruled that existing policies were legal but the IRS was allowed to force insurance companies to make their future universal life policies look and act more like life insurance products. So universal life policies are only for people with a need for life insurance (most adults do) and cannot be called “investments”, but they still offer wonderful living benefits for those that are aware of them. These benefits include –
1. Part of the money put into an IUL (the “premium) will pay the cost of insurance and part will go into the cash value account. When you die, regardless of age, your family and/or heirs will receive the death benefit free of income taxes. Depending on how your IUL is set up, the death benefit may include just the face value ($100K, $500K, $1,000,000, etc) or it may include the accumulated cash value also.
2. The premiums paid into an IUL are NOT tax deductible, but the growth in the cash value IS tax deferred, the same as a 401(k). There are few limits for the amount of money that can be placed into an IUL, the major limit being that there must be a certain relationship between the premium and the death benefit. If too much money is deposited relative to the face value, the entire account becomes what is called a “modified endowment contract”, or MEC, and the account loses its tax benefits. But, when properly set up, the account will not be a MEC and the insurance company will monitor it to make sure it never becomes a MEC. Beyond this, there is no limit to how much money can be paid into an IUL, making it much more useful for many people, especially high income earners.
3. Indexed universal life policies are famous for the flexibility of the premiums. In any year, you have the option to cut the premiums to the minimum amount needed to keep the policy in force, or to increase the premiums and “overfund” the cash value up to the limit allowed before becoming a MEC. This allows the owner of the policy to tailor the policy to work best for his or her own unique situation, and also allows for changes when emergencies force them. At your annual review, you can also change the index tied to the growth of the cash value and you can also change the crediting method (fixed, annual point-to-point, monthly average, etc).
4. In an “indexed” universal life policy, the growth in the cash value is tied to a common stock index, like the S&P 500 index. When the S&P goes up, the cash value goes up. However, when the S&P goes down, an IUL does not. The cash value either remains the same or goes up by a fixed amount (1-2%), depending on the company and product. This “floor” that protects the cash value from loss is one of the most important aspects of an IUL. It is key for the long term growth of your retirement savings to avoid losses at all times, but especially when nearing retirement age. This is also the reason why securities that do not have a “floor” will ALWAYS underperform the average of the stock market.
If you look at the performance of the S&P from 2000 to 2009, the average return (including dividends) was 1.21% per year (the annual returns were -9.10, -11.89, -22.10, +28.68, +10.88, +4.91, +15.79, +5.49, -37.00, +26.46, according to Wikipedia). Using this average would lead you to believe that a $1,000 investment was worth $1,127.81 at the end of the ten years. But it was not. An investment of $1,000 was only worth $908.83 at the end of these ten years.
Why the difference, and why is this ALWAYS the case with investments that do not have a guaranteed “floor”? Because the annual return results do not apply to the same starting numbers each year. In 2000, you lose 9.1% from $1,000, leaving you with $909. Then, in 2001, you lose 11.89% from $909, leaving you with $800.92. In 2002, you lose 22.10% from 800.92 and have 623.92 left. See how the end of year numbers are changing? So, if the market goes up by 28.68% in year 2003 (as it did), your account only goes up by 28.68% of $623.92, which is $179.94, becoming $802.85. Those annual numbers do not apply to the original investment amount of $1,000, the starting number changes and is often a much smaller number. If the annual return over a given period includes ANY negative numbers, the actual performance of the investment is GUARANTEED to underperform the average.
Here’s another, simpler example – what is the average rate of return if an investment goes up four years, then down four years by the same percentage (let’s use 50%). Four years of plus 50% followed by four years of -50% is an average rate of zero, right? But do the math. $1,000 goes up to $5,062.50 after four years of 50% growth. But after four years of 50% losses, you don’t have the $1,000 that you started with, you have just $316.40!!! So, when some securities guy quotes the average return of some segment of the market over a period of time, don’t expect to get that return unless you know for certain that the market is ONLY going to go up each year and will never go down.
An IUL pays for its important protective “floor” by using a cap on upward performance in good years. The cap will vary by company and product, but is often in the 12-16% range. So, if the S&P 500 goes up 10% in a year, you get 10% added to the cash value in the IUL. But if the S&P 500 goes up 20%, you will get the cap of, say, 12%. This is why we say that, when the market goes up, the cash value of our clients goes up. But when the market goes down, our clients are protected.
If you apply this strategy to those same years of 2000-2009 and use the exact same index, the average rate of return in an IUL with a cap of 12% and a floor of zero was 0, 0, 0, +12, +10.88, +4.91, +12, +5.49, 0, +12 = 5.78%. Keeping in mind that, for many people, the costs of insurance in an IUL are typically LESS than the fees and expenses in a 401(k), would you rather have the 401(k) that went down from $1,000 to $909 from 2000-2009, or the IUL that goes up from $1,000 to $1,745.42 while using the same index during the same period? Note that the IUL NEVER goes down because of market performance and does not suffer from the same “average rate” accuracy problem of securities that have no guaranteed floors.
5. If you thought the indexed growth and guaranteed floor were great, listen to this – most of the cash value in an IUL can be accessed at any time by simply asking for a policy loan. There are no qualifications for a policy loan, as long as there is sufficient cash value to provide the money. The effective interest rate will be zero, or very close to it, because insurance companies use “wash loans.” This means that the interest charged on the money borrowed will be the same or close to the money earned by the same amount of cash value.
When you get a policy loan from an IUL, you are not removing the money from the account as you do in a 401(k). With most companies, the loan amount won’t earn the full indexed growth rate (it’s normally a fixed rate), but it will continue to earn money, which will offset the interest for the policy loan. In addition, the money never needs to be repaid by the borrower. If you don’t repay it, the money will come out of the death benefit when you die. Policy loans can be used for anything you want, like emergencies, college tuition, a new car, the down-payment on a house, a vacation, to invest in a business. The possibilities are nearly endless. You just need to keep in mind that any money not repaid will lower the income that you can draw later and/or the death benefit. Keep in mind that policy loans from life insurance are not subject to income taxes. Borrowed money never is.
6. Since borrowed money is not subject to income taxes, this means that you can build a retirement income with an IUL that is free of income taxes by using policy loans. This LIVING BENEFIT simply swamps the 401(k)! I recently presented an
illustration to a 24 year old male (an illustration is a document that shows the possibilities and describes all the options and rules of an IUL) that is starting his first full time job after doing a year in an MBA program. He’s starting at $65,000 a year, with an annual bonus of 5-10%, so I assumed he could put $4,000 a year into his policy for ten years, then increase that to $10,000 a year after that. The face amount of his policy would start at $389,000 and would go up each year as his cash value increases.
When he dies, his heirs will get the face amount AND the cash value. Because he’s young, a non-smoker, in good health, and his face amount starts low, his cost of insurance is very low and the cash value builds very quickly. In the illustration,
which uses a growth rate of 7.62% (the average growth rate of this indexed strategy over the last 25 years), at the end of ten years, he has paid $40,000 in premiums but his cash value is already over $44,000 (all insurance costs and expenses have been deducted). From there, it gets very exciting. At the age of 65, he can stop making premium payments and has $1,853,111 in cash value. If he waits three years and starts taking loans at age 68, he can borrow $245,745 per year, TAX-FREE FOR LIFE!
Since this is technically borrowed money, it will not make his Social Security income taxable. Isn’t that a pretty good return on total premiums of $350,000? If he were to die at 65, his family and heirs would get a TAX-FREE death benefit of $2,260,794. If this same money had been put into a 401(k) and earned the same net rate of return after expenses, the income would be fully taxed, 85% of his Social Security income would be taxable, and when he dies, his heirs would get the cash value and a massive tax bill!
I told you at the start that I am not an unbiased judge of these two financial tools, but I have tried to keep this analysis factual. But, I hope you can see why I am such a fan of IUL’s.
The Disadvantages of an IUL
This is the shortest section of this post because there are very few disadvantages to putting money into an IUL. Here they are –
1. The premiums paid into an IUL policy are not tax deductible in the year paid and not all of the money deposited in an IUL will be credited toward the cash value since part of the money must be used to pay the cost of insurance and other fees.
2. The upside growth potential of the cash value when the stock market is climbing may be limited by the cap.
3. If the stock market index tied to the policy does not grow for an extended period of time, or if the average growth rate is less than the percentage used in the illustration, the projections made in the illustration will prove to be overly optimistic and the performance of the cash value will be lower.
4. Access to the money paid into an IUL will be limited during the first 5-10 years.
I know this post (and the post before it) was long and I want to congratulate you for making it to the end. Please, tell me what you think. Which tool is better for building a retirement income? Is it a 401(k)? Or an IUL? Thank you!
Life Insurance Agent, Santa Clarita, California