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)
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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.
Conclusion
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!
Michael Goodman
Life Insurance Agent, Santa Clarita, California
Thanks for the article. I’ve been researching IUL to see if it is a good fit for me. Here’s the thing I can’t get past: the insurance company is investing my money knowing they will make money even after giving me distributions through loans and paying my death benefit. This simple fact seems to indicate that you will always be better off in a Roth or 401k unless you need early withdrawl (which I have covered through other investments). I’ve run some numbers and it appears that the IUL always loses when comparing historical investment returns with hypothetical IUL returns. It also concerns me that the insurance company can change the cap at will, so there is no gurantee of the 13.25% (which is the rate on the product I’m looking at) continuing to remain that high. All the performance charts of IULs I’ve found are hypothetical because the product has only been around a few years. Bottom line: the insurance company knows it has to make money, which means in the end they are making money that could have been mine. Your thoughts?
Thanks for your comments, Todd. Here are my thoughts –
1. Insurance companies make money in three ways – From the investments they make with the money provided in premiums, from the total premiums they collect over time being greater than the payouts for death benefits, and from abandoned policies. Most people don’t realize that few policies actually pay off because the owner stops making payments on the policy at some point before it pays off. With term insurance, the figure I see most often is that only 2% of term policies ever pay off because they are abandoned or cancelled before the insured dies. Back in the 1980’s, a company called A.L. Williams made money telling people to sell their whole life policies, buy term insurance, and invest the difference in the stock market. What happened is that the premiums for the term policies went up over time and eventually became too expensive and the individual abandoned it; plus they either didn’t actually invest the difference in the market or took a beating (as so many people do) and didn’t have any money there. They didn’t have money for retirement and their families received nothing when they died. Natually, there were lots of lawsuits filed and A.L. Williams is no more. Bottom line – insurance companies make money, which means they will be able to pay off on your policy when you die. I don’t understand how that supports your comment that this fact indicates you’ll be better off in a Roth or 401k. Those products are supported by companies that make money for setting up and administrating those products, not to mention the managers of the mutual funds and the money they make from fees levied against those products.
2. You say you’ve “run some numbers and it appears that the IUL always loses.” I’d like to see your numnbers. Universal life has been around for more than thirty years now, although the indexed products are more recent. I have two problems with the numbers typically used to justify putting money into the stock market. One problem comes from the use of “averages.” If the market goes up 10% one year, then goes down 20% the next year, then goes back up 10% in the third year, Wall Street guys will tell you the average yield was 0%, so they broke even. But they didn’t. If they invested, say, $100, it went up to $110 after year one, went down to $88 after year two, then only got back to $96.80 in year three. They actually LOST 3.2% over the three years, not to mention the costs when they bought and sold. The reality is that the market ALWAYS underperforms the averages over time because the down years mean you have to earn more in the up years just to break even. IUL’s don’t have this problem because the cash value NEVER goes down because of market losses because they have a guaranteed floor. If you earn 10% in year one with an IUL, you’ll NEVER give that back because of market losses. The second problem is that the costs applied to the mutual funds and other stock market products typically found in a 401k are levied against a growing balance (hopefully!), so they go up over time if your portfolio is doing well. If the annual costs in your 401k are, say, 1%, then you’ll pay insreasing fees every year that your 401k balance goes up. Depending on how it’s structured, that won’t happen (at least not to the same degree) with an IUL. As your cash value in an IUL goes up, the cost of insurance will either not go up, or will go up slower than the growth rate. The end result is that 20 years after you start them, the cost of insurance in an IUL is likely to be much smaller than the fees levied against a 401k with the same cash value.
3. None of this means much if you die, say, ten years after you open a 401k or IUL. If you earn $40,000 a year and are putting 10% of your income into the 401k, what will your heirs get if you die? $40,000, plus the growth, and a big tax bill, depending on how the 401k is titled and who gets the money? But what will they get if the same person puts the same amount of money into an IUL with a face value of $250,000? They’re going to get $250,000, tax free. What’s the rate of return on that?
4. Finally, I want to say that if you are investing for the maximum return, you are not going to use an IUL. IUL’s are for people with a need for life insurance that also want to take advantage of the tax-deferred growth, the easy access to the money at zero percent or low rates, or want the extra living benefits provided by policies that offer access to the death benefit to pay for care after developing a chronic or terminal illness, or long term care. When purchased with money that might have gone into a 401k, you’ll get a good rate of return with no risk of loss that builds into a tax-free income at retirement that you can’t outlive. What’s not to like?
I would say that it was Arthur L. Williams. Back in the 1970 s, he built a multi-billion dollar life incsarnue empire, called A.L. Williams and Associates.Later, he sold the company, which is now called Primerica.
This is fantastic information. However, can you site the actual Supreme Court case in which the IRS sued the Insurance Companies?
That would be of great benefit. Thanks.
Ronnie
That’s a great question, Ronnie. In the Hutton Life rulings in the 1980’s, the Sumpreme Court dealt with the issue of the taxability of life insurance proceeds, affirming the tax-exempt staus in some situations but not in all. This led to the IRS Section 7702 in 1984, which establishes the rules for whether or not the cash accumulation in a universal life insurance policy is exempt from income taxes. Bottom line, the buildup of cash value in an IUL is tax-deferred as long as the rules written into section 7702 of the IRS Code are followed, the death benefit paid is exempt from income taxes, and the proceeds of policy loans are exempt from income taxes, all under federal law,
I know there are some securities guys that think the Sumpreme Court has ruled that life insurance is not an investment, but I don’t believe that’s true and cannot find any evidence of such a ruling. However, all of the insurance companies I work with discourage agents from calling life insurance an investment and I do not. However, “a rose by any other name ….”
i understand that the cost of insurance will go up with age… and other expenses associated with an IUL..if in a certain year the market is down and floor is say 1 or 2 % usually …how can you say that the cash value won’t go down if all other expenses deducted on monthly basis exceed 1% floor ? IUL is a very complex product and even the trivial fact as to when the policy premium is paid and set up date can also make a big impact on the values crediited to the account. A consistent 8.95 % return illustrated does not seem realistic in most cases. Also the fact that company reserves the right to change the cap any time is troublesome to digest. i believe in diversifying …no one financial vehicle is appropriate for funding your retirement.
Hello Nilesh,
Thank you for your comments. There is a lot of baloney circulating about IUL’s, so let’s deal with a couple misconceptions that snuck in with your comments. While it’s true that the cost of insurance rises over time in a term policy (dramatically after age 60, which is why so few policies remain in force), this is not actually true of the IUL’s I write. The cost of insurance does rise for a time, but goes DOWN after the mid-70’s in most cases. Most agents can show you the expected costs in an illustration. Just ask for it. You will also notice that there are almost no other costs after the first ten years. But in an IUL policy that’s been in effect for more than 10 years, the annual costs should not even come close to 1% of the cash value.
2. I never say that the cash value cannot go down. I say that it will never go down because of the market. Can you name ANY stock market-based security that can say the same? There is a rare situation that can cause the cash value to go down a little when the stock index goes down. If you earn zero interest because the market index went down, AND the premiums paid do not cover the total costs, the cash value can go down. I get the impression that you have an inflated understanding of what the costs are in an IUL. If you’re a 45 year old in decent health paying $300 a month into an IUL, your cost of insurance is a couple hundred dollars plus a few hundred dollars more if the policy is less than ten years old. The rest of the money goes into the cash value, plus interest in most years. With a 401k or 403b or an IRA, the costs will almost always be a percentage of the cash value; rising as the cash value increases. If your retirement account has $1,000,000 in it, costs of just 1/2% equals $5,000 a year. 1% would be $10,000 in costs. You’ll probably NEVER approach that kind of dollar cost in an IUL, not even if you have $2,000,000 in cash value, because the costs in the IUL are not related to the amount of cash value. And you’re building TAX-FREE distributions!
3. I never used 8.95% for the illustration. I used 7.6% because, at the time I wrote that article, I was writing policies with a company that had a 13% CAP. Now I write policies that have a CAP of 14.5%, which increases the long-term expectation. Using this strategy with the S&P 500 index over the last 30 years would have produced an average return for the IUL of 8.6% (while the S&P 500 would have actually done just 8.39% in the same years). So I use 8.6% for my top illustration results. Over the last 5 years, this IUL return has been 9.1%, as a great stock market has pretty much floated all boats.
4. Things can change. Look at any list of the top 10 mutual funds over the last 5 years, then check their returns over the last 15 years, if they’ve even been in existence that long. The results will not be pretty. I sell IUL’s as a supplement to any other retirement plans used by my clients. IUL’s offer enhanced safety, tax-free access at any age, plus lower costs over time when compared to any of the “qualified plans.” Unlike the type of insurance most people know, where you pay the premiums for the policy on your life, then somebody else spends the money after you die; I write policies where the client pays into it for 20 years or more, then gets to spent a large chunk of the death benefit on himself, while he or she is still alive. For many people, that’s a better deal.