Introduction To An IUL, One Of The Best Savings Vehicles For Retirement

Summary

• Warren Buffet has a rule that says your main goal as an investor should be to not lose money.
• An IUL provides peace of mind saving with a 0% floor so you cannot lose money when the stock market drops.
• On the flip side, the IUL cash value increases when the stock market goes up, so you participate in the growth phases and are protected during the down cycles.
• Distributions from your IUL cash value are income-tax-free.
• An IUL acts as a true compound savings vehicle.

Background

Did you know that there is a savings vehicle that participates in the growth of the S&P 500 index and has a zero percent floor, so that your money can only go up and not lose money? In addition, distributions from the savings account are tax free! Sounds too good to be true? Well, I’d like to introduce you to an index universal life insurance (IUL) policy.

This article discusses the basic concepts of IULs and future articles will go into more details.

Introduction To an IUL

Most people are familiar with term life insurance which is a commodity financial product where you buy a death benefit for a set amount of money. You typically spend the least amount of money for the greatest amount of death benefit you can get. A term life policy expires after a certain time frame and there is no cash buildup that you can access or use as collateral to borrow against. If you die within the timeframe specified by the policy, your beneficiaries will receive the death benefit. The term life policy isn’t worth anything other than the payout and only if the policy is in force when you pass away. An Index Universal Life insurance contract, on the other hand, is permanent, meaning that it combines a death benefit with a savings account, which is called the “cash value” of the contract.

The first time that I was presented with the idea of life insurance as a way to grow and protect my money, I was sceptical, too. An IUL insurance policy is not classified as an investment, like a mutual fund. According to the IRS codes that govern it, permanent cash value life insurance is there first to provide a financial resource to replace a financial loss of an individual or couple in the case of premature death to a surviving heir. That’s what classifies it as life insurance. The cash value component of the contract was designed to be a secondary benefit.

IUL products are designed to be efficient for optimizing growth of the cash inside the contract.

Growing Cash Inside An IUL

An IUL policy has two crediting methods for cash appreciation::

1. A fixed account that credits a static crediting rate that is determined at the annual anniversary of the policy.

2. The index crediting options that allow an allocation of all or a portion of the cash inside the policy to mirror an equity index, like the S&P 500. Your money is not in the stock market itself. Rather, the gains in the contract are linked to a stock market index.

With the fixed crediting method you know what the value of your money is going to be in 10 years, 20 years or however long the investment timeframe you choose.

What’s important to know is that insurance companies use the value of the market index to calculate the amount that they will credit your account for that year. The cash value of your policy is not actually participating in the market. The insurance company does not invest your money in stocks or bonds. The stock market indices are used by life insurance companies as the measure of how much to credit your account for that year.

You may be wondering how you can eliminate risk if the percentage of interest you’re making is tied to stock market index returns. The risk is managed with two governing components in the indexing portion of an IUL policy called the cap and floor.

Managing Risk With A Cap And Floor

The cap allows you to participate in market-like returns, while the floor is the mechanism that guarantees no losses, thus keeping your money in a true compounding environment.

The floor is the “safety net” built into the indexing portion of an IUL. It is set by contract to usually 0%. This means that your money is protected and will not suffer a negative rate of return. If the stock market drops, your cash value isn’t going down with it. The following table compares the S&P 500 performance over the last 20 years against an IUL with a floor of 0% and cap of 12%.

Year	S&P Return	Stock Acct Value	Cap & Floor	IUL Acct Value
2000	-10.14%	$89,860	0.00%	$100,000
2001	-13.04%	$78,142	0.00%	$100,000
2002	-23.37%	$59,880	0.00%	$100,000
2003	26.38%	$75,676	12%	$112,000
2004	8.99%	$82,479	8.99%	$122,069
2005	3.00%	$84,953	3.00%	$125,731
2006	13.62%	$96,524	12.00%	$140,819
2007	3.53%	$99,931	3.53%	$145,790
2008	-38.49%	$61,468	0.00%	$145,790
2009	23.45%	$75,882	12.00%	$163,285
2010	12.78%	$85,580	12.00%	$182,879
2011	1.00%	$86,436	1.00%	$184,708
2012	13.41%	$98,027	12.00%	$206,873
2013	29.60%	$127,043	12.00%	$231,698
2014	11.39%	$141,513	11.39%	$258,088
2015	-0.73%	$140,480	0.00%	$258,088
2016	9.54%	$153,882	9.54%	$282,710
2017	19.42%	$183,766	12.00%	$316,635
2018	-6.24%	$172,299	0.00%	$316,635
2019	28.88%	$222,059	12.00%	$354,631

The table indicates that $100,000 invested in the S&P 500 index would have grown to $222,059, while $100,000 in an IUL appreciated to $354,631. This performance is also illustrated in the following chart.

The cap is determined on an annual basis and is predicated on how well the insurance carrier’s general account is performing. In the summary table above, the cap is set at 12%. It is a hypothetical example, because caps can vary from year to year, but it illustrates the concept of how floors and caps can protect your money while leaving it open to upside potential. If for instance the market index increases 8% for the year, you get credited 8%. On the other hand, if the market increases more than the cap, let’s say by 18%, your account is credited by only the 12% cap rate. You may think that this is unfair to only earn the cap when the market is having a bumper year, but it is important to remember that with an IUL, you also have the floor that protects your investment when the market tanks like it recently did in 2020 when the S&P 500 fell by a 1/3rd, or 2008 when the index plunged by almost 40%. With the 0% floor, your policy would not have lost money during these wild, stressful down years.

The IUL policy is designed to protect your money from market losses while providing you with a competitive rate of return. The price that you pay for this protection is that you will not participate in all of the above average gains above the cap. The cap and floor in an IUL create more predictability, more stability, and less stress.

Rate Lock And Reset

Annual gains in your policy are locked in and the following year’s annual index value is reset. This lock and reset concept is best explained with an example.

If the start date of the IUL contract is today and the S&P 500 index is currently valued at 2,100, your start value would be 2,100 for the year. This time next year, the insurance company would compare this year’s current value of the S&P index to next year’s S&P 500 value. If the index goes up by 10% to 2,310, the policy would credit the increase in the value up to the policy cap. Once the policy is credited, the gains are locked in. The accumulated cash is protected and becomes the principal for the next year’s crediting cycle. If at the end of the next year, the S&P 500 index value dropped 30% to 1,617, the IUL policy would credit 0%, because the index dropped below what you started at. So, although the market dropped, you have not lost money and your principal remains the same as the previous year. If the index appreciates by 20% the next year, your policy will be credited the 12% cap. The IUL policy therefore gets the benefit of the big market move up, because of the low reset, starting value of the index. Because the insurance company resets the index value every year, you have the opportunity to participate in the upside movements of the market. The index value resets every year and that’s why your money grows uninterrupted in a true compounding environment.

A True Compounding Savings Vehicle

In an IUL your money grows with market-linked returns while keeping it safe. With an IUL you get true compounding. Compounding is a process whereby the value of an account is always increasing over time because the interest is calculated on the initial principle and also on the accumulated interest. It’s interest on interest and it will make a deposit grow faster because you’re making money on your principal and interest every year. In a “true” compounding environment, you never lose any value. The principal on which interest is calculated for the current compounding period is the sum of the principal and interest from the previous period. This is why the old adage: “he who understands it earns it, he who doesn’t pays it,” is so true. Even Albert Einstein supposedly said that compounding interest is the eighth wonder of the world.

If you knew you were going to end up in the same place, what would you rather live through: the ups and downs of speculation with your money or the nice smooth ride of true compounding? I suspect you’d take the smooth ride every time because it’s far less nerve-racking. This is why I think true compounding is one of the greatest inventions in history.

Accessing Your Cash

There are 2 basic ways to take distributions from your IUL policy: policy loans and withdrawal-to-basis options. When you take a loan from your policy, you have the option to pay back the loan, pay just the annual interest on the loan, or to not pay back the loan at all. If you choose to not pay back the loan, the borrowed money and accumulated interest on the loan are paid back to the insurance carrier from the death benefit when you pass away. The withdrawal-to-basis option allows you to withdraw all your premiums paid into the policy while conserving the size of the death benefit.

Both of these distribution options provide you income-tax-free access to the cash in your policy account.

This article covers the basic principles of IULs and future articles will go into more details. Please let me know if there are any particular topics that you would like me to cover in these articles. Until then, you can learn more about IULs by clicking here.