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Every now and then, a new financial instrument is born that promises to do the same thing every other financial tool claims to do: limit downside risk while allowing substantial upside potential.
It’s the oldest phrase in the investment community, but these products rarely do more than take funds out of your control and put them into someone else’s hands.
Recently, there has been a storm of attention brought to Index Universal Life (IUL) insurance policies. I have received emails and phone calls from several investors whom I have great respect for about this new insurance structure. In fact, the last investor who approached me said, “Look, I know you aren’t a big fan of “stock market-based products”, but this is really a no-brainer.” This got me curious, so I decided to dig into this investment structure and see what the big deal is.
These policies allow the owner to “overfund” their plan, where the excess capital goes into an account that earns interest based on an index, such as the S&P 500. However, unlike variable universal life policies, IULs are much less volatile, because no money is actually invested in equities. Instead, insurance companies only mimic the returns of the index, but actually invest the capital in their own business.
The beauty of this product’s marketing pitch is that the insurance company guarantees the insured will never receive less than a 1% return, regardless of what their selected index returns. Basically, there is a guaranteed floor to your policy so that if the index goes down 40%, you’ll still receive the 1% “guaranteed return.” On the flip side, there is a growth ceiling, usually 14%. Therefore, if the S&P 500 goes up by 22%, the cash value of your policy only receives a 14% gain.
Let’s take a quick look at the last ten years to see how this would have played out if it worked as explained…
Over the previous ten years, this policy would have an average return of 8.5%, with no years experiencing a negative return.
Sounds pretty good right?
But wait! There’s more!
Unlike most retirement plans, you don’t have to wait until you are 59 ½ to take penalty-free distributions! In fact, you can usually take distributions only 12 months after your policy has been created. Once you have built up the cash value of your policy, your insurance company can provide you with a loan that has an extremely favorable interest rate. Usually, the interest rates for this type of loan will be 0%-0.75%. Because these distributions will technically be considered a loan, this money is tax-free!
You must be thinking…
“Let me get this straight…if the stock market goes up, my cash value goes up. If the stock market goes down, I still get a 1% return. I can take distributions whenever I want AND the distributions are tax-free?!…This sounds too good to be true!”
Guess what, you’re right!
There is a laundry list of reasons these types of policies are deceivingly good, but in this article, I am just going to focus on the most important and most obvious one.
In every single IUL policy that I have seen, there is a clause in the contract that reads something like this…
“All current rates are not guaranteed and are subject to change, but will never be lower than the guaranteed rates.”
Did you catch it?
This clause basically allows the insurance company to change your 14% ceiling to a mere 1% ceiling whenever they choose to!
I don’t need to run the last ten years of the S&P 500 to show you that a buyer of this policy is going to be sorely disappointed if the insurance company decides to use this power.
This is the problem with any of these tools provided by large financial institutions. They essentially do one thing: take your money out of your control.
If you are really going to get ahead of the pack, it’s not going to be as simple as dumping your retirement investments in the hands of a large insurance company with full discretion over how it returns your capital.
Achieving your goals is going to take dedication to being diversified in low-risk niche cash- flow investments. This is why I suggest creating a self-directed Roth IRA and investing in assets that you can control. This way, you control your investments and still receive the benefits of investing truly tax-free.