Several years ago, my family purchased a timeshare. It gave us easier, more consistent access to one of our favorite vacation spots in Bear Lake Utah.
A short while later, a salesman came to the home seeing if we wanted to “upgrade” the timeshare. This gave us access to literally thousands of other destinations across the world. With a large down payment and new contract, we switched.
But as time went on, the complexities of this upgrade began to show. Getting the place we wanted at the right price was extremely difficult. We didn’t want to back out of the new deal, because of the large down payment (now a sunk cost) that we had already put into it. Despite all of this, we eventually cancelled the upgrade to our simpler plan.
Financial products come in a wide variety of “flavors.” With life insurance, you can get coverage that is very plain vanilla, like a fairly simple term or whole life policy, or you can add layers and layers of nuanced features--as with Indexed Universal Life Insurance, or IULs. But my experience with IULs has taught me that the devil is in the details.
Here is a quick rundown of IULs and why you should stay away from them.
The Basics of How IULs Work
Universal life insurance gives the owner some added flexibility compared to whole life insurance, such as when and how much your premiums are paid. Like whole life insurance, the cash value of these policies builds over time. This is different than term life insurance, which expires after a certain period and does not build cash value.
IULs take universal life insurance a step further--a big step! In addition to the cash value, flexible premiums and other features, the cash that goes into the IUL can be invested into index funds in the stock market.
With an IUL there is a guaranteed floor and ceiling to how the investments perform. For example, the floor may be a guaranteed 2% return, and the ceiling may be 10%. This means that if the stock market goes up 15% one year, you earn only 10%, but if the market goes down 10% another year, you still get a guaranteed 2%.
A Riddle, Wrapped in a Mystery, Inside an Enigma
So an IUL provides insurance, builds cash value, and earns a return from the stock market regardless of the ups and downs. Sounds great, right?
On the surface this sounds amazing, but the complexity and limited clarity of how the returns are calculated can confuse the most savvy financial advisor. A full IUL policy is typically over 50 pages! You don’t need that much space to explain something, unless it’s extremely complicated.
Buried in the terms, contingencies, requirements, and options of the policy is a description of the IUL’s various fees. I recently fully reviewed one of these policies with an insurance agent. After he highlighted the fees throughout the policy, they amounted to somewhere between 12-18% of the monthly premium!
That’s money that does not go to you, toward your insurance or investments. The biggest problem is these details are very difficult for the average person to discern...they aren’t required to be pointed out by the agent either.
Who’s Taking the Risk?
How can an insurance company guarantee a minimum and maximum stock market return? Providing this guarantee involves a \ complicated investment strategy called “portfolio hedging” using an investment tool called options.
All you need to understand is this means the insurance company is taking on the stock market risk. They pay you some of the return at a guaranteed floor and ceiling (remember you don’t get the full 15% if that’s what the market does) and they benefit from the additional upside.
As explained earlier, managing this sort of complex investment arrangement isn’t free...or cheap. There are fees all along the way for managing this “investment piece” of your IUL.
A False Sense of Security
The biggest selling point of IULs is this: Get stock market-like returns without the downside risk. To those who have fears of the ups and downs of the stock market, this can bring a lot of peace and comfort. If only it were true.
When the long-term returns of the stock market are compared to the after-fee returns of an IUL, it simply isn’t possible for them to perform even remotely close to each other. You may take comfort in knowing that you won’t lose money in the market with an IUL, and that may technically be correct, but is it better to lose money to your fees instead? It’s still money lost.
Water and Oil Don’t Mix
Indexed Universal Life insurance makes an attempt to mix complex investment strategies with universal life insurance. My general advice is it’s best to leave investing to the products that are best suited for it, such as 401ks or IRAs. These tools have excellent tax advantages unavailable to IULs and they can be utilized at much lower fees.
Life insurance has its place in every business and family financial plan. Beware of overly complex products that blur the lines between investing and insurance, suggesting that the two can be happily combined. You’ll end up paying for it.
Editor's Note: I've only skimmed the surface of IULs in this article. If you'd like additional reading on the topic, check out this series of blog posts from financial blogger--the White Coat Investor. He does a great job of explaining them, and the reader comments offer some added discussion as well.