Indexed universal life insurance, when designed properly, can be an excellent savings method for investors who are eager to preserve their hard-earned income. A type of permanent life insurance, indexed universal life (IUL) allows policyholders to accumulate a cash value. This cash value can then be invested into a fixed account (often with a guaranteed minimum interest rate), or the insured can obtain their returns depending on the performance of several different equity indices.
Fortunately, there are numerous crediting methods that can be utilized to produce returns on the cash value within the policy. The most common method used is the annual point-to-point calculation, which is based on the S&P 500 return, with a cap rate that preserves your principal and limits your upside.
Upon payment of your annual premium, the insurance provider takes away a portion of the premium for state taxes, sales load, and the cost of insurance. Once fees are taken from the premium paid, the remaining portion is split between the insurance company’s general account and the purchasing of securities on the index of your choice.
Suppose the insurance comptroller thinks that they can receive 5.27% on their combined investments. They would then invest $95 of your $100 into their general account with the expectation that in one year that $95 would grow to $100. This is how your principal is guaranteed.
The costs of derivatives assist in determining the cap rate, or rather the maximum you can make each year. Currently, most companies offer a 10-15% cap rate on the S&P 500 index. For instance, if your life insurance policy has a cap rate of 12% on the S&P 500 and the index goes 30%, then you can expect to have 12% credited to your account for the year. You will make 5% if the index does 5%. Should the index lose 20%, then your return will be null for the year. You do not receive the returns of the indices you invest in.
Principal Protected Investments
Some individuals do not care for the fact that their upside is limited by the IUL. However, in order to protect your principal, you have to sacrifice some of the upsides. A recent study conducted by the financial marketing firm Dalbar revealed that the average equity investor has maintained 3.79% over the last 30 years, while the 11.06% was maintained by the S&P 500. What’s worse is that the average fixed-income investor made approximately 0.72% per year, which is only a tenth of the return of the Barclays Aggregate Bond Index.
Indexed universal life insurance has a cash value account that grows tax-deferred. If designed properly, the cash value can then be drawn out as tax-free loans that do not need to be paid back during the policyholder’s life. The insurance company will simply use some of the death benefit to repay the loan. In the end, the only return that matters is the one you keep after taxes and inflation.
Besides a tax deferral, you can pay a zero capital gains tax by withdrawing against your cash value. This money can be used to purchase your next vehicle, to fund your child’s college, or for a down payment on real estate. The choice of whether you pay these loans back is up to you.
Stocks and government bonds are often found to have low to negative correlations. Rarely have both the U.S. government bond market and the U.S. stock market lost at the same time. Regardless, most take comfort in knowing that when the stock market is down, they can easily pull funds from their life insurance policy with principal protection. This is an effective tool if considering the risk of the sequence of returns when setting aside money for retirement.
Unfortunately, there are times when the U.S. stock market is a subpar long-term investment. For example, the S&P 500 hit 1,552 March 2000 and was at the same level 13 years later due to the tech wreck in 2000-2002 and the Great Recession in 2008-2009. This was an ideal time for indexed universal life insurance – your principal was protected during the crashes – the crashes resulted in more affordable stock, which had a good chance of increasing and reaching the cap rates on IUL policies.
A Final Thought
Indexed universal life insurance is not the right choice for everyone. However, if you design an IUL policy that purchases the least amount of actual insurance in order to get the maximum amount invested, you can add diversification to your financial portfolio, gain attractive after-tax returns, and have tax-flexibility for retirement.