Foundational Asset: Indexed Universal Life (IUL)

It is a given that everyone wants to grow and protect their money.  That said, there are two different mindsets as it relates to managing money.  An "investor" prefers growth over safety while a "saver" prefers safety over growth.  Since indexed universal life (IUL) insurance offers safety guarantees AND historical returns higher than the stock market, it appeals to both investors and savers.  Although Aspen Creek Asset Wealth Strategies helps coordinate many different asset classes, IUL is the foundational asset of most of our clients' portfolios, especially since it complements many of their other favorite assets, like real estate.

So what exactly is IUL?

  • IUL is also known as equity indexed universal life (EIUL)
  • IUL is a type of permanent life insurance policy that provides both a death benefit to named beneficiaries and living benefits to the policy owner in the form of policy account values
  • What is unique to IUL is that the account value grows with the upside performance of stocks, bonds and real estate, while protecting against the downside risks of these markets
  • IUL is in the Guaranteed Indexed Account (GIA) asset class
    • Though indexed CDs and indexed annuities are in the same asset class, they differ significantly from IUL.  A good analogy might be that though chess and checkers are played on the same board, they are different games played with different pieces and strategies.

Many people who “drink Wall Street Kool-Aid” are surprised that life-insurance-company-based products are a significant part of the net worth of some of the savviest and wealthiest institutions and individuals in the world:

  • According to a New York Times (Charles Duhigg) article published in 2006, “Hedge funds, financial institutions like Credit Suisse and Deutsche Bank, and investors like Warren Buffett are spending billions to buy life insurance policies” on the secondary market
  • According to government disclosures, Federal Reserve Chairman, Ben Bernanke, has the majority of his liquid net worth on deposit with life insurance companies (not deposited in banks or invested on Wall Street) – Medical Economics 6/19/2009
  • The nation’s large banks invest immense sums of their Tier 1 capital reserves (a bank’s most important asset and a key measure of its strength) into permanent life insurance underwritten by major life insurance companies – Medical Economics 6/19/2009
    • As of the date of the article, Bank of America, JP Morgan, Wells Fargo, US Bancorp and Bank of New York Mellon had more of their Tier 1 capital reserves in permanent life insurance than they did in bank premises fixed assets and real estate COMBINED
    • During the economic downturn of 2008-2009, Wells Fargo (owned by Warren Buffet) almost tripled its holdings in permanent life insurance

 So a good question might be: Why do they do that?

Well, after a brief analysis of the five key elements of any prudent asset, the answer should be clear.  These five LiSERT elements are:

  1. Liquidity
  2. Safety
  3. Expense
  4. Return Potential
  5. Tax Efficiency

Since no asset is perfect in each of these areas, it is important to know the pros and cons of each asset using these five elements as a guide.

The following bullet points are only meant to highlight some of the pros and cons and are not a comprehensive discussion.  In addition, any reference to specific financial products is not a recommendation to buy or sell these products.

Liquidity

  • Though IUL is designed to be held long term it offers significant liquidity
    • Of all other long-term, tax-favored assets (i.e. IRAs, 401(k) plans, annuities) it provides the most liquidity without a tax penalty
    • IUL is the only long-term, tax-favored asset used as collateral for a bank loan
      • Using an annuity or retirement plan as loan collateral, even if allowed by the bank, will trigger a taxable event
      • Due to IUL liquidity, banks will even lend money for the purpose of purchasing IUL, using the policy values as primary collateral
    • Some policies offer access to 100% of your money immediately after funding the policy
    • IUL liquidity provisions include either withdrawals from the policy values or loans from the insurance company using the policy values as collateral
    • According to a Medical Economics article on 6/19/2009:
      • John McCain used the liquidity of his large life insurance policy to initially finance his campaign
      • Doris Christopher used the liquidity of her life insurance policy to launch Pampered Chef—that she eventually sold to Warren Buffet for $900 million
      • J.C. Penney used the liquidity of his large life insurance policy to begin resuscitating his retail stores after the crash of 1929

Safety

  • An IUL policy that is properly structured and funded with a highly-rated insurance company should be one of the safest assets to hold in a portfolio
    • IUL is sold by some of the largest and highest-rated insurance companies in the world
      • Unlike banks, life insurance companies do not use excessive leverage
      • According to the Medical Economics article, during the Great Depression, when more than 10,000 banks failed, 99.9% of consumers’ savings in life insurance remained safe with legal reserve life insurance companies
    • IUL contractually guarantees that though the policies values are linked to various markets, there is a guaranteed minimum return in case of negative markets
      • In addition, all positive interest that is credited to policy values is protected from future market losses
    • In many states, life insurance policy values are protected from creditors (lawsuit, bankruptcy) by state law
    • There are two main risks of losing money in an IUL:
      • Not properly funding the policy
      • This risk can be mitigated with proper structuring (i.e. minimum death benefit per $ of premium) and source funding (i.e. using assets, instead of cash flow, to fund the policy)
      • Cancelling the policy in the early years
      • This risk can be mitigated with proper planning and ongoing policy servicing

Expense

  • There are 6 typical expenses associated with IUL:
    • Cost of insurance (also known as mortality charges)
      • Monthly expense to pay for death benefit
      • This expense can be reduced up to 80% by using an annuitized death benefit
    • Premium expense
      • One-time percentage of each paid premium
    • Policy expense
      • Monthly expense to cover insurance company expenses, usually for the first 10 years of the policy
    • Loan interest
      • Subtracted from policy values if not paid in cash
    • Surrender charge
      • Possible back-end expense charged if policy is canceled before a certain year (usually 10-15 years)
      • Our preferred IUL companies offer policies with no surrender charges
    • Rider expense
      • These are optional charges for optional riders, like long term care, disability, guaranteed income, etc.
  • Due to the number of possible expenses of IUL, it has the reputation with some people of being “expensive”, but in and of itself, IUL is neither expensive nor inexpensive—it depends on the policy structure, funding and utilization, and what it is being compared to
  • A properly funded, structured and utilized IUL can have a relatively low expense ratio compared to many other assets; conversely, due to non-cash-value-correlated expenses of IUL, not funding IUL properly, or cancelling it in the early years, can lead to a high expense ratio
    • To minimize the expense ratio of IUL, you should purchase as little death benefit as possible (see Internal Revenue Code (IRC) §7702) for each premium dollar paid—that way, more money is retained in your policy values
    • The expense ratio of a policy can be projected/calculated using the difference between the illustrated (gross) rate and the internal (net) rate of return (IRR)
    • For example if the gross illustrated rate of the IUL contract is 8% and the net long-term IRR is 7.6% then only .4% is lost to policy costs (or about 5% of the total return)—which compares favorably to mutual funds and other managed portfolios
    • With most mutual funds, the annual expenses that have to be subtracted from the gross return include fund fees, management fees and taxes
    • For example, if you owned Fidelity Magellan Fund (FMAGX), according to Yahoo! Finance, the annual fee paid to the fund is 0.59%
    • The management fee paid to your advisor could be around 1% (less or more depending on how much you invest)
    • Since the fund has a turnover rate of 102%, that means that most of your gains in the fund would be taxed at short-term capital gain rates (i.e. your marginal tax bracket) and have to be paid each year
    • Therefore, if a mutual fund grossed 8%, then the net after-tax return would only be 3.82%–which means you would lose 52% of “your” return to the fund, your advisor and the IRS:
      • 0.59% to the fund
      • 1% to your advisor
      • 2.59% to the IRS, assuming a 35% marginal federal tax bracket (not including potential state income tax) and taxed at short-term capital gain tax rate (due to high turnover rate of the fund)
    • Therefore, with the expenses and taxes associated with the Fidelity Magellan Fund, using the assumptions above, the fund would have to average almost 16% per year to net what an IUL would net with an illustrated return of 8% and an IRR of 7.6%
    • So, in this example, would you rather pay 5% of your long-term return to have death benefit throughout the term of the policy (and downside protection from the markets) or would you rather pay over 50% of your return to have no death benefit (and no downside protection from the markets)?
    • Again, the expense of an asset is always relative to what it is being comparing to

Rate of Return Potential

  • IUL policy values are linked to various market indexes that allow your policy values to grow up to maximum annual cap rates
  • Using long-term historical performances of market indexes, most policies will illustrate future policy value growth based on historical averages of 7%-9%, depending on the index and cap rate
  • There are several ways to potentially increase the long-term IRR (net return) of IUL policy values:
  • Purchase IUL from companies that have higher participation caps
  • Purchase IUL using leverage (also known as premium financing)
  • Use fixed participating loans when accessing the policy values
    • These are loans where you pay a fixed rate to the insurance company but you still have the upside of the market indexes for your policy values
    • Multiple life insurance companies offer a participating loan that is contractually guaranteed to never be greater than 5% for the life of the policy
    • Use participating loans during your “accumulating” years to purchase appreciating assets like real estate and other investments
      • This allows you to have the potential to experience a double positive arbitrage (the difference between what you pay in interest versus what you gain through rate of return)
        • You can earn the difference between the loan rate and the IUL index crediting rate, PLUS…
        • You can earn the difference between the loan rate and the return on the appreciating asset
  • Sell the policy on the secondary market
    • During your retirement, if you decide you no longer want or need your policy, you could sell the death benefit (i.e. contract) for more than the policy value
    • This would obviously be in your best interest but may not be in the best interest of your beneficiaries
    • The secondary life insurance market is what was referenced to earlier that hedge funds, banks and investors like Warren Buffet are involved in
    • When a policy on a senior citizen is sold/purchased on the secondary market, it is known as a “senior life settlement”
    • In the right situation, it can be a win/win for both the seller and buyer since the seller (you) is getting significantly more than the policy values, while the buyer is purchasing your death benefit at a deep discount

Tax Efficiency

  • IUL can be one of the most tax-favored assets under the Internal Revenue Code (see your tax advisor for specifics regarding your situation)
    • A properly structured, properly funded and properly utilized IUL (see IRC §101 and IRC §7702) has similar, but arguably better, tax benefits than Roth IRAs (see IRC §408A and IRC §7701)
      • Premiums are typically paid with after-tax dollars
      • Premiums can be directly and partially tax-deductible using IRC §79 and indirectly and partially tax-deductible using IRC §831(b)
      • Policy value growth is tax deferred
      • Policy value profit can be accessed tax free via withdrawals and/or policy loans (that can be paid back via the death benefit at policy maturity)
      • Policy death benefits (usually significantly more than policy values) can be received income tax free by beneficiaries
    • The three main advantages of IUL over Roth IRAs are:
      • You can put significantly more money into IUL than a Roth IRA
      • IUL has no income limitations like Roth IRAs
      • IUL has significantly more early liquidity than a Roth IRA
    • If a policy is “cashed in”, any profit in the policy would be taxable at your federal marginal tax bracket
      • This tax can be mitigated if the policy values are rolled directly to another qualifying permanent life insurance policy (see IRC §1035)
      • This is similar to doing a real estate tax-free exchange (see IRC §1031)
      • This tax-free exchange option is important since there is a high probability that future insurance policies will have more desirable features, and policy owners may want to “upgrade” their contracts without having to pay a “tax toll”

Therefore, since properly structured, properly funded and properly utilized IUL:

  • Is more liquid than most assets
  • Is one of the safest assets
  • Is relatively inexpensive
  • Has historically-based, above-average return potential, and
  • Is one of the most tax-efficient assets

IUL is the ideal candidate to be the foundation of a long-term portfolio.

Copyright 2015 Aspen Creek Asset Management, Inc., 2016 Aspen Creek Wealth Strategies, Inc.