As indexed universal life sales climb, be sure to mind the risks
April 21, 2015 by Darla Mercado
Indexed universal life insurance has been pretty hot as of late, but how much do you know about how it works and when to use it?
Annual indexed universal life insurance premiums hit $1.56 billion at the end of 2014, reflecting a 14% increase from $1.356 billion in 2013 according to Wink’s Sales and Market Report, 2013-2014. It’s a cousin of traditional universal life insurance coverage, permanent life insurance that permits clients to pay flexible premiums. The policy does not lapse as long as there is sufficient cash value to cover the cost of insurance.
Clients can also devote more of their premium payments toward the growth of cash value in the policy, which can be used in the future as a source of tax-free retirement income.
There’s some element of added complexity that sets IUL aside from its traditional UL cousin. Primarily, there’s the fact that clients can choose to either have their cash value grow on a fixed rate of return or they can have it grow linked to the performance of an index. Unlike variable universal life insurance, clients aren’t directly investing in the market. Rather, their cash value reflects the performance of an index subject to caps and floors.
Though the policies have been a huge hit among advisers in recent years, and the subject of some considerable regulatory scrutiny, IUL isn’t a topic that’s covered in the curriculum for those studying to be certified financial planners.
So here’s a breakdown of how it operates.
INDEX EXPOSURE
What makes IUL attractive to certain clients is that they have some form of index exposure — albeit indirectly — without the same downside risk. “You give up the high returns that the market can provide,” Joe Kordovi, assistant vice president of product design at Pacific Life, said. “It’s structured by indexed accounts offering a cap on the return, but in exchange, you get the guarantee of not eroding your capital.”
The fixed account rate that a client can receive comes from the returns insurers earn on their bond portfolios. When clients decide to allocate premiums toward index-based performance, the insurer buys a package of call options that will reflect the returns of the index that the client selects.
Caps are applied to the extent to which the client will capture performance index. When the index is down, the options contract the insurer had purchased will expire, and the client’s account will credit 0% for that period. The cash value in the account won’t go down.
One of the most popular index choices is the S&P 500, and Pacific Life’s product offers clients a cap of 12%. That means that in years where the index performance exceeds that cap, clients will only capture 12%. This doesn’t ensure rock-star performance for the client. Over time, they’ll have great years, middling years and years where the index goes down and nothing is credited.
“The client is taking more risk because relative to a fixed account, you’ll earn between 4% and 5%,” Mr. Kordovi said. Whereas with index-based performance, you’ll have the risk of earning zeroes,” he added. “You have a cap at 12%, and you’ll get something in between.”
RISKS AND DANGERS
Advisers need to bear in mind that IUL comes with certain risks. For instance, all UL products and any general account product that depends on the performance of insurers’ bond portfolios will be subject to interest rate risk.
With IUL, regulators have paid close attention to illustrations from insurers that tout outsized performance, particularly in periods of low interest rates.
Broker-dealer executives have criticized insurers who depict credited interest rates on cash value as high as 8.5%, when an assumption of 5% to 6% might be more realistic.
Kristen Finefrock, manager of education and marketing at ValMark Securities Inc., said that the broker-dealer tends to be very conservative on the illustrations it shares with clients. Normally, these are around 5% to 5.5% at ValMark.
“That’s most important for advisers: Making sure that the clients’ expectations are being managed with that interest rate assumption,” Ms. Finefrock said.
There are inherent dangers with leading clients to believe they’ll have high rates of return on this product. For instance, a client might slack off on funding the cash value, and if the policy doesn’t perform as expected, this could lead to a lapse in coverage. Another danger: What if a client is taking policy loans from the cash value and paying interest, but the policy underperforms and the interest credited doesn’t cover the costs of the loan?
PROPER POLICY CARE
Honest policy illustrations go hand-in-hand with the rest of the work advisers must undertake to ensure proper care and feeding of a client’s IUL policy.
Clients who want to use the policy for tax-free retirement income will need to be comfortable with heavily funding their premiums in order to grow cash value, said Susan J. Bruno, a managing partner at Beacon Wealth Counseling.
Meanwhile, advisers need to watch the performance at least once a year, she added.
This is because a policy that’s funded excessively could be considered a modified endowment contract. Distributions from such a contract will come out “income first,” and gains in the policy are taxable and subject to 10% penalties. Meanwhile, if the strategy works, the client can take out up to the basis in policy tax-free, and then use loans from the remaining cash value for other retirement income needs.
Given the large up-front costs of IUL, policies purchased for cash value require adequate time to grow before they can be used for income. High income earners who are already maximizing savings elsewhere might be likely candidates for an IUL.
“The latest age you’d see for someone buying this is 55,” Ms. Bruno said. “It’s a cool strategy, but the sooner, the better.”
