Recently a prospective client sent me an email referencing various anti-EIUL articles from the internet. I took the liberty of posting these objections along with my responses to them below.
Pros and Cons of Indexed Universal Life Insurance
Taxation of EIUL – EIUL policies are life insurance policies, which have generally received favorable tax treatment from Congress. There is no tax deduction on premiums paid. But the cash value of the policy grows tax free, and the policy owner can generally access the cash value of the policy tax free at any time, provided the policy remains in force. Since there is no income tax or capital gains tax on the proceeds of withdrawals or loans against in force policies, and since there is no 10 percent penalty on proceeds received prior to age 59 1/2, EIUL policies have become popular savings vehicles for some individuals, especially those who earn too much to qualify for retirement accounts, such as IRAs or 401ks, or who have maximized allowable contributions.
Dave’s Response: There is a prevailing line of reasoning among some online “gurus” that we should only be contributing to tax-free accounts once we have maxed out all our other tax-deferred accounts. This, of course, runs counter to everything we believe (and that math suggests) if tax rates in the future are likely to be higher than they are today. See my article here for more insight.
EIUL Advantages – Equity indexed universal life policies have favorable tax treatment, no restrictions on what the cash value can be used for, and provide a tax-free cash death benefit for the policy beneficiary in the event of the death of the insured. Additionally, the cash value in an EIUL policy generally receives some creditor protection, depending on the state, and does not count against the family for the purposes of determining need-based financial aid for college. Finally, EIUL policies do provide some safety of capital, because the policy owner is guaranteed a minimum crediting rating. However, policy premiums are frequently higher than the guaranteed rate, especially on low-balance cash values.
Dave’s Response: Many EIUL’s provide a guaranteed rate of return of around 3%. This means that if your account value doesn’t grow at least 3% per year over a period of time (in some cases 8 years), the company will go back and retroactively credit 3% for each of those years. I can’t conceive of a scenario where a company would ever have to actually honor this guarantee. With certain companies, there has never been any 8 year period over a 30 year history that has averaged less than 6%. So, I think this comment may be a case of “let’s be sure to disclose every possible thing that could go wrong.”
EIUL Disadvantages – EIUL policies can have a relatively high fee structure compared with competing savings vehicles. Commissions are front-loaded, so it can take years before the cash surrender value of the policy catches up with the accumulated premiums paid into the policy. Unless the policy is aggressively funded, the cash value is frequently insufficient to keep the policy in force later in life, and many times retirees are faced with the unpleasant choice of letting a policy lapse or paying amounts of premium to keep the policy alive. Finally, the crediting methods the companies use to calculate the policy owner’s share of stock market returns frequently lead to disappointing results. Caps on returns are generally lower than the historic performance of the stock market. The company keeps the rest.
Dave’s Response: Certainly the policy needs to be aggressively funded and this is what we have done in your case. The key is to always buy as little insurance as the IRS requires of us while stuffing as much money into it as the IRS allows. We’re attempting to re-engineer a life insurance policy to mimic a Roth IRA, only without the contribution limits and income limitations. In order to do so, expenses need to be as low if not lower than what you might find in a typical Roth IRA. The math suggests that we have done so in your case. If you can get LTC, life insurance and a guarantee you’ll never lose money in exchange for those expenses, then you’re already ahead of where the Roth gets you. Please see my article here for a robust discussion on the expenses of an EIUL.
Cost of Insurance – The cost of insurance is separate from the cash values. This allows the insurance company to raise the cost of insurance and make the policy more expensive to own. This is problematic with all universal life insurance. However, indexed life insurance has a particular kind of risk associated with it that could make it extremely susceptible to higher cost of insurance charges in the future. Since interest is credited using index call options, the insurance company needs to make sure it is fully hedged (that it has enough call options to pay the promised interest rate in the contract). However, insurance companies are not mandated to be fully hedged. If an insurance company does not purchase enough call options to cover its liabilities, it may need to raise the cost of insurance to raise money to pay future claims.
Dave’s Response: Most companies handle the fluctuating cost of options by raising and lowering caps. The cost of the option to cover the index usually goes up when the market is volatile, i.e., 2008. In 2008, when the world was coming apart at the seems, the company I use lowered their cap from 15% to just 14.5% and it has stayed steady ever since.
History – There is simply not a long history with index life insurance. Modern index life policy design began in the early to mid-1990s. As such, it is simply unknown as to how well these products will perform over very long periods of time through repeated bull and bear market cycles (i.e., 50+ years).
Dave’s Response: They do have back-tested historicals that go as far back 30 years. These demonstrate how the program would have performed had it been in place over longer periods of time.
Dave’s Conclusion: You can find good and bad on everything on the internet if you look hard enough. In an attempt to cut through all the static, we put an enormous emphasis on the math behind our recommendations. If the math suggests that these types of programs will push you further ahead of where you might otherwise be, help diversify your assets for tax purposes, protect your estate from premature death and LTC, then it could be a welcome compliment to what you’ve already done. I welcome any other questions that may arise as you further research our recommendations. Thanks!