A Universal Tale
A Universal Tale
I call this A Universal Tale because it is about how you might be able to incorporate a specific type of insurance called universal life or UL into your portfolio. As you read you will learn it is about a specific type of UL called indexed universal life or IUL. I want readers to know right up front that at the moment, I like IUL as an attractive investment alternative to most bonds. It isn’t an alternative to stocks but it competes nicely with most bond investments and appeals to people that are risk averse. This does not mean I will always like it and it does not mean it is for everyone. Said differently, it really isn’t universal. In fact it is specific. So instead of calling it UIL like the rest of the world, I prefer to call it specific. When I view this product I think of it as a specific bond alternative or SBA.
Most of you know that with the exception of estate planning situations, I am not a fan of a permanent insurance policy solution such as UL for the purpose of insuring against an untimely demise. I prefer term insurance for that. It is cheaper and easier to understand. But if I were designing an estate plan, some portion of the plan might include my SBA. I think it is superior to any other design I have seen. Again, for those that are risk averse and don’t want losses in their portfolio the properly designed SBA is also a very competitive alternative.
So why is it that I don’t like typical permanent insurance policies? If you answered because they are illiquid, costly, typically don’t provide enough return, don’t build up cash quickly and pay the insurance salesman way too much commission, you would be correct. The SBA is superior to the typical permanent insurance policy in every regard. It is more liquid, costs less, provides a higher return, builds up cash quicker and pays a significantly lower commission if well designed. So how would you design it?
Let’s look at a typical permanent insurance sale. There are really only two typical scenarios and one atypical one which I will show you later. In scenario one, Joe insurance agent determines how much you can afford in terms of premium and then from there determines how much death benefit you should purchase. In scenario two he works backwards. He determines how much death benefit you need and then determines how much the premium will be. In scenario one he maximizes the death benefit. In scenario two he maximizes the death benefit as well. Why? The answer is money. The higher the death benefit, the higher the commission. It is in their interest to sell you more rather than less. The SBA takes a different approach. It is atypical in that regard. The SBA seeks to minimize the death benefit to the lowest level allowed in our tax code. The objective is to sell you less rather than more. This is very different and can work to your advantage.
Why does it work to your advantage? Because in the typical insurance sale or contract you may pay $12,000 per year as an example in premium, and most of your money is going to pay for life insurance instead of potential cash accumulation. The split may be $10,000 for insurance and $2,000 for potential cash accumulation. In the atypical SBA design that I have seen work, the same $12,000 has a very different split. There might be $2,000 dedicated to insurance and $10,000 to potential cash accumulation. This has the effect of your policy building cash up sooner. In this way when you look at the cash value of your policy 3 years after the start date you don’t see a big fact zero like you do in many typical designs. If you have the time, and you are looking for a bond alternative, call someone and have them run an illustration for you. If you do, this is what you will see or should expect.
A well designed SBA will be indexed to some volatile stock index such as the SP500. This doesn’t mean it has anything to do with investing in the stock market mind you. It has everything to do with investing in the volatility of the stock market. So, you have to make some assumptions about the annual distribution of returns of the stock market because that is how your return will be calculated. If the index makes 30% for the year they may pay you 12% for the year which is your annual cap. If the market loses money for the year they will pay you 0% which is your annual minimum return for the year. Lastly, if it makes anywhere between 0% and 12% they will pay you the exact amount it makes for the year. So if the index makes 4.39% for the year you will make 4.39% for the year. If it makes 6.97% you will make 6.97%. If it makes 11.24% you will make 11.24%. But, you can’t make more than 12% or less than 0%.
I am sure, the above sounds too good to be true for many. But I haven’t told the complete story. If you are a student of the stock market and understand stock market rate of return distributions you will know that putting a cap of 12% on your annual return reduces your long term expected rate of return without any fees to the 6%-8% range. Furthermore, this product has fees associated with it that on average run in the 2% per year range. So your net return will probably be in the 4%-6% range. Not a terrible bond alternative in my opinion.
What else can we say about this design? The first thing that comes to mind is that if you change your mind after a few years you will get a substantial portion of your money back vs. a typical design. Secondly, if you were to die prematurely, then the rate of return to your heirs goes up exponentially since the insurance company would have to make good on their promise to insure you for the minimum allowed. Thirdly, it appeals to the risk-averse investor because even during those periods where the stock market may go down as much as 30-50% they are paying you 0%. No loses allowed in these policies. Lastly, if you have a clever tax person then you will actually be able to take annual income from these policies as a loan and not pay income tax on the money you withdraw.
My suggestion is to learn about these designs and see if they are for you.
If you want further information, feel free to contact us at www.financialtales.com.