By Dr. James M. Dahle, WCI Founder

I recently had a life insurance salesman show up in the comments thread of a post I published years ago about not mixing insurance and investing. He thought Indexed Universal Life Insurance (IUL) was the best thing since sliced bread. In support of his position, he posted a link to an article written in 2012 by Insurance Agent Allen Koreis in 2012, entitled “16 Reasons Why Accountants Prefer Indexed Universal Life Insurance” [link no longer available]. I thought it might make for a fun post to debunk these reasons a bit, kind of like my post on Debunking The Myths of Whole Life Insurance. However, first a brief explanation of Indexed Universal Life Insurance.

 

How Does Indexed Universal Life Insurance Work?

The attraction of IUL is obvious. The premise is that you (almost) get the returns of the equity market, without any risk of losing money. Now, before you fall off your chair laughing at the absurdity of that statement, you need to realize they make a very convincing argument, at least until you look at the details and realize you don't get anywhere near the returns of the equity market, and you're paying far too much for the guarantees you're getting. Basically, if the market goes up, you get some positive return. If the market goes down, you get the guaranteed return, usually something between 0 and 3%. Of course, since it's an insurance policy, there are also the usual costs of insurance, commissions, and surrender charges to pay. The details, and the reasons that returns are so terrible when mixing insurance and investing in this particular way, come down to basically three things:

  1. Don't Count Dividends – They only pay you for the return of the index, and not the dividends. So if the S&P 500 index fund returns 8%, but 2% of that is dividends, you only get 6%, not 8%.
  2. Caps – Your maximum return is capped. So if you cap is 10%, and the return of the S&P 500 index fund is 30% (like last year), you get 10%, not 30%.
  3. Participation Rates – Some policies only give a certain percentage of the change in the index, say 80%. So if the Index Fund goes up 12%, and 2% of that is dividends, the change in the index is 10%. But if your participation rate is 80%, well, you only get 8%.

Add all these effects together, and you'll find that long-term returns on index universal life are pretty darn close to those for whole life insurance, positive, but low. Yes, these policies guarantee that the cash value (not the money that goes to the costs of insurance, of course) will not lose money, but there is no guarantee it will keep up with inflation, much less grow at the rate you need it to grow at in order to provide for your retirement.

 

Indexed Universal Life Insurance ‘Benefits' Debunked

Universal Now, on to Mr. Koreis's 16 reasons:

 

#1 You Can Never Lose Money

An indexed universal life policy account value can never lose money due to a down market. Indexed universal life insurance guarantees your account value, locking in gains from each year, called an annual reset.

That's true, but only in nominal returns. Ask yourself what you need to pay in order to have a guarantee of no nominal losses. Would you expect that to be cheap? Of course not. In investing, you get paid to take risk. If you don't want to take much risk, don't expect high returns.

 

#2 Life Insurance Is Like an IRA or 401(k)

IUL account values grow tax-deferred like a qualified plan (IRA and 401(k)); mutual funds don’t — unless they are held within a qualified plan. Simply put, this means that your account value benefits from triple compounding: You earn interest on your principal, you earn interest on your interest and you earn interest on the money you would otherwise have paid in taxes on the interest.

Unless held in a qualified plan, mutual fund gains are annually reportable and taxable, thus denying an investor the benefits of such three-fold compounding. Although qualified plans are a better choice than non-qualified plans, they still have issues not present with an IUL. Investment choices are normally limited to mutual funds where your account value is subjected to wild volatility from exposure to market risk.

There is a big difference between a tax-deferred retirement account and an IUL, but Mr. Moreis doesn't mention it. You invest in one with pre-tax dollars, saving on this year's tax bill at your marginal tax rate (and will often be able to withdraw your money at a lower effective rate later) while you invest in the other with after-tax dollars and will be forced to pay interest to borrow your own money if you don't want to surrender the policy. He mixes the comparison a little bit when he starts throwing in mutual fund associated taxes, which of course you don't pay at all in an IRA. Then he throws in the classic IUL salesman scare tactic of “wild volatility.” If you hate volatility, there are better ways to decrease it than by buying an IUL, like diversification, bonds or low-beta stocks.

universal life insurance

 

#3 No Contribution Limits

There are no limitations on the amount that may be contributed annually to an IUL.

Great, I can invest as much as I want into this terrible investment product. That's reassuring. Let's think about this for a second. Why would the government put limits on how much you can put into retirement accounts? Maybe, just maybe, it's because they're such a great deal that the government doesn't want you to save too much on taxes. Nah, that couldn't be it. Apparently that's not a concern with life insurance.

 

#4 No Age 59 1/2 Rule

Policy owners may access their money from an IUL without IRS penalty regardless of age. Qualified plan withdrawals prior to age 59 1/2 are subject to a 10 percent penalty in addition to being taxed as ordinary income for the year the withdrawal is take.

First of all, this is retirement money. How big of a deal is it, really, that you can't get to it before age 59 1/2? Second, there are so many ways around this rule that it might as well not exist at all.

 

#5 You Control the Taxes

You control your taxes, not the fund manager. IULs grows tax-deferred, and is never taxed if taken in the form of policy loans. This allows owners to control precisely if, when and how much money will be taxable, depending upon their needs and circumstances.

Mutual fund owners are subject to the fund manager’s annual capital gains distributions whether or not they redeem any shares for additional income. Many equity (stock) mutual funds have turnover rates averaging over 80 percent annually, meaning that management sells over 80 percent of their fund’s holdings every year, replacing them with other stocks (and sometimes even buying the same stocks back after Jan. 1), often in an attempt to beat their category averages.

This is a straw man argument, and one IUL folks love to make. Do they compare the IUL to something like the Vanguard Total Stock Market Fund Admiral Shares with no load, an expense ratio (ER) of 5 basis points, a turnover ratio of 4.3%, and an exceptional tax-efficient record of distributions? No, they compare it to some terrible actively managed fund with an 8% load, a 2% ER, an 80% turnover ratio, and a terrible record of short-term capital gain distributions. What they also fail to mention, of course, is that when you borrow money from your life insurance policy it might be tax-free, but it certainly isn't interest-free.

 

#6 Mutual Funds Make Distributions Even After Taking a Loss

Mutual funds often make annual taxable distributions to fund owners, even when the value of their fund has gone down in value. Mutual funds not only require income reporting (and the resulting annual taxation) when the mutual fund is going up in value, but can also impose income taxes in a year when the fund has gone down in value.

When the markets take an extended downturn after several years of sustained growth (as they did in 2000-2002 and again in 2008), fund managers will often resort to selling appreciated stocks purchased several years earlier in order to generate gains to offset those losses. This has the effect of minimizing the fund’s published loss-in-value at year end, allowing the fund to claim that it was “only” down, say, 9 percent on the year while its peer group was down an average of perhaps 17 percent.

This is mostly just a repeat of the last (straw man) argument, but it gets a little weird when it claims that a fund manager can somehow disguise a loss by selling his winners. Look, if the fund lost 17%, you can't somehow sell some of the stocks in the portfolio and magically turn that into a 9% loss. That's not how mutual funds work. You can tax-manage the fund, harvesting losses and gains in order to minimize taxable distributions to the investors, but that isn't somehow going to change the reported return of the fund. Only Bernie Madoff types can do that.

 

#7 Indexed Universal Life Insurance Avoids “Tax Traps”

IULs avoid myriad tax traps. The ownership of mutual funds may require the mutual fund owner to pay estimated taxes. Tax-deferred accumulation inside an IUL does not create the same tax problem. IULs are easy to position so that, at the owner’s death, the beneficiary is not subject to either income or estate taxes.

The same tax reduction techniques do not work nearly as well with mutual funds. There are numerous, often costly, tax traps associated with the timed buying and selling of mutual fund shares, traps that do not apply to indexed life Insurance. Additionally, mutual fund ownership can result in the loss of tax exemptions, tax deductions, and tax credits, and mutual funds (with the exception of those held in an IRA or 401(k)) are usually subject to state and local income taxes in those jurisdictions that have such taxes. These losses do not occur with IULs and, because they grow tax-deferred, IULs are not subject to state and local income taxes during their accumulation phase.

Finally, mutual fund ownership, specifically the annual distributions made by such mutual funds, can subject the fund owner to taxation under the alternative minimum tax. The AMT always results in increased income taxes. Indexed life insurance ownership cannot trigger the AMT in the same manner as mutual funds.

This is mostly scare tactic stuff. Yes, the life insurance death benefit passes to your heirs outside of probate. Yes, if you do not put your taxable mutual fund account inside a revocable trust, it will have to go through probate. Yes, some mutual fund (especially certain types of muni bonds) distributions can cause you AMT issues (just like your regular income does). Chances aren't very high that you're going to be subject to the AMT due to your mutual fund distributions if you aren't without them.

The rest of this one is half-truths at best. For instance, while it is true that there is no income tax due to your heirs when they inherit the proceeds of your IUL policy, it is also true that there is no income tax due to your heirs when they inherit a mutual fund in a taxable account from you. Even better if they inherit an IRA (especially a Roth IRA) as they can then stretch the distributions out over decades, prolonging the tax-protected growth of the account.

The federal estate tax exemption limit is over $10 Million for a couple, and growing each year with inflation. It's a non-issue for the vast majority of physicians, much less the rest of America. There are better ways to avoid estate tax issues than buying investments with low returns.

 

#8 Mutual Funds Cause SS Benefits to Be Taxed

Mutual funds may cause income taxation of Social Security benefits. The annually reported earnings from mutual funds can, in many cases, cause a retired couple’s income to exceed the thresholds above which up to 85 percent of their Social Security benefits are taxed in their income bracket. The growth within the IUL is tax-deferred and may be taken as tax free income via loans. The policy owner (vs. the mutual fund manager) is in control of his or her reportable income, thus enabling them to reduce or even eliminate the taxation of their Social Security benefits.

This one is great. He's pulling out all the stops now. I'm not even sure this one deserves the description of “half-truth.” It's just sales tactics. While increased income does increase how much of your Social Security is taxable, it maxes out at 85% taxable at just $34,000, including the Social Security benefits. If you don't have enough retirement income to have fully (85%) taxable Social Security benefits, you certainly have no need for the tax benefits of an IUL. Remember that $34K includes half of your SS benefits.

 

#9 Don't Buy the Distribution

Mutual funds create an income tax trap for individuals purchasing funds late in the year. Because mutual funds must distribute realized gains to fund owners each year, fund companies usually do so in November or December. An uninformed investor purchasing such a fund during the last quarter of the year may place himself at a disadvantage by taking on a partial tax liability for gains which took place earlier in the year which never accrued to his account. An IUL presents no such problem when late-year purchases are made.

Here's another minimal issue. It's true if you buy a mutual fund for say $10 per share just before the distribution date, and it distributes a $0.50 distribution, you are then going to owe taxes (probably 7-10 cents per share) despite the fact that you haven't yet had any gains. So don't do that; buy after the distribution in a taxable account. But in the end, it's really about the after-tax return, not how much you pay in taxes. You are going to pay more in taxes by using a taxable account than if you buy life insurance. But you're also probably going to have more money after paying those taxes.

 

#10 Mutual Funds Require Complex Record Keeping

The record-keeping requirements for owning mutual funds are significantly more complex. The keeping of excellent records (redemptions, purchases, dates, values, commissions, etc.) is often one’s only defense in the event of an IRS audit. With an IUL, one’s records are kept by the insurance company, copies of annual statements are mailed to the owner, and distributions (if any) are totaled and reported at year end.

This one is also kind of silly. Of course you should keep your tax records in case of an audit. Thankfully, the mutual fund and your mutual fund/brokerage account will do all this for you. All you have to do is shove the paper into your tax folder when it shows up in the mail. Hardly a reason to buy life insurance. It's like this guy has never invested in a taxable account or something.

 

#11 Mutual Funds Can Go Through Probate

Mutual funds are commonly part of a decedent’s probated estate. Estate funds may be available to any and all creditors of the estate. In addition, they are subject to the delays and expenses of probate. The proceeds of the IUL policy, on the other hand, is always a non-probate distribution that passes outside of probate directly to one’s named beneficiaries, and is therefore not subject to one’s posthumous creditors, unwanted public disclosure, or similar delays and costs. Your heirs receive their insurance proceeds within weeks, not months or years after your passing.

We covered this one under # 7, but just to recap, if you have a taxable mutual fund account, you must put it in a revocable trust (or even easier, use the Transfer on Death designation) in order to avoid probate.

 

#12 Harder to Get Medicaid to Pay for Your Nursing Home If You're Rich

Medicaid disqualification and lifetime income. An IUL can provide their owners with a stream of income for their entire lifetime, regardless of how long they live. Insurance is often classified so that it is not considered assets for Medicaid disqualification of nursing home costs. This is beneficial when organizing one’s affairs, and converting assets to income prior to a nursing home confinement. Mutual funds cannot be converted in a similar manner, and are almost always considered countable Medicaid assets.

This is another stupid one advocating that poor people (you know, the ones who need Medicaid, a government program for the poor, to pay for their nursing home) should use IUL instead of mutual funds. First of all, poor people don't need to use a taxable account, so all their mutual funds should be in Roth IRAs or 401(k)s. And life insurance looks terrible when compared fairly against a retirement account. Second, people who have money to buy IUL above and beyond their retirement accounts are going to have to be terrible at managing money in order to ever qualify for Medicaid to pay for their nursing home costs. These folks ought to either buy Long Term Care insurance, or preferably, self-insure against this risk.

 

#13 Terminal Illness Riders Are Valuable

Chronic and terminal illness rider. All policies will allow an owner’s easy access to cash from their policy, often waiving any surrender penalties when such individuals suffer a serious illness, need at-home care, or become confined to a nursing home. Mutual funds do not provide a similar waiver when contingent deferred sales charges still apply to a mutual fund account whose owner needs to sell some shares to fund the costs of such a stay.

Another straw man argument here that actually just reminds the investor about one reason why cash value life insurance sucks (just like the loaded mutual funds used as the straw man)– the surrender penalties (AKA deferred sales charges.) Guess what the surrender penalty is on a Vanguard mutual fund in the event you want to access your money due to a chronic or terminal illness? That's right, it's $0. Yet you get to pay more for that benefit (rider) with an insurance policy. What a great deal!

 

#14 There's a Death Benefit and You Can't Lose Money

Indexed universal life insurance provides death benefits to the beneficiaries of the IUL owners, and neither the owner nor the beneficiary can ever lose money due to a down market. Mutual funds provide no such guarantees or death benefits of any kind.

Yes, Virginia, when you buy life insurance, there is a death benefit. Now, ask yourself, do you actually need or want a death benefit? I certainly don't need one after I reach financial independence. Do I want one? I suppose if it were cheap enough. Of course, it isn't cheap. On average, a purchaser of life insurance pays for the true cost of the life insurance benefit, plus the costs of the policy, plus the profits of the insurance company. No free lunch. I'm not entirely sure why Mr. Morais threw in the whole “you can't lose money” again here as it was covered quite well in # 1. He just wanted to repeat the best selling point for these things I suppose. Again, you don't lose nominal dollars, but you can lose real dollars, as well as face serious opportunity cost due to low returns.

 

#15 You Can Do Tax-Free Exchanges

IULs allow the tax-free exchange of one policy for another. An indexed universal life insurance policy owner may exchange their policy for a completely different policy without triggering income taxes. A mutual fund owner cannot move funds from one mutual fund company to another without selling his shares at the former (thus triggering a taxable event), and repurchasing new shares at the latter, often subject to sales charges at both.

Here's another benefit that isn't a benefit. While it is true that you can exchange one insurance policy for another, the reason that people do this is that the first one is such a terrible policy that even after buying a new one and going through the early, negative return years, you'll still come out ahead. If they were sold the right policy the first time, they shouldn't have any desire to ever exchange it and go through the early, negative return years again. And of course, we see the loaded mutual fund straw man show up again. If this isn't crystal clear to you yet, DON'T BUY LOADED MUTUAL FUNDS.

 

#16 It Costs Money to Rebalance

Mutual funds do not provide cost-free asset rebalancing whereas indexed universal life insurance does. This option is usually available among the major index choices (the S&P 500, NASDAQ, DJIA, Russell 2000, etc.), as well as a fixed interest option, at policy anniversaries. Rebalancing one’s portfolio within a family of mutual funds always requires the sale and purchase of shares, often generating both taxes and commissions.

Here's another one that made me chuckle. So these policies allow you to switch indexes once a year. Instead of following the S&P 500, you can follow the Dow! What a benefit! Never mind that the correlation between these indexes is something upward of 98%. They also allow you to peg your returns to the tech-stock heavy Nasdaq, although it is beyond me why anyone even looks at that index. It's simply a relic of the 90s internet craze. If you're going to use a small-cap index like the Russell 2000, you might wish to pause and consider why a good index fund company, like Vanguard, doesn't have any funds that follow it. The reason is because it's a lousy index. Not to mention that changing your entire policy from one index to another is hardly what I would call “rebalancing.” Cash value life insurance isn't an attractive asset class. Allowing you to change from one lousy index to another doesn't change that.

 

I haven't even addressed the straw man here yet, and that is the fact that it is relatively rare that you actually have to pay either taxes or significant commissions to rebalance anyway. I never have. Most intelligent investors rebalance as much as possible in their tax-protected accounts. If that isn't quite enough, early accumulators can rebalance purely using new contributions. Middle and late accumulators can generally do it with new contributions and distributions combined with wise use of tax-loss harvesting and charitable contributions, or simply by selling high basis shares. Decumulators can do it by withdrawing from asset classes that have done well. And of course, nobody should be buying loaded mutual funds, ever.

Well, I hope posts like these help you to see through the sales tactics often used by “financial professionals.” It's really too bad that IULs don't work. It would be awesome if they did. But in the end, you're going to end up with returns pretty similar to those of whole life insurance. It shouldn't be a surprise to see that these two products are treated very similarly by regulators. You just can't have your cake and eat it too, and that's the whole idea behind indexed universal life insurance.

What do you think? Do you own a policy? Are you happy with it? Unhappy? What kind of returns have you seen from your policy? Do you think the trade-off of higher returns for the guarantees was worth it? Comment below!

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