Equity Indexed Universal Life Insurance May 28, 2008Posted by shaferfinancial in Uncategorized.
Tags: 401K, Equity Indexed Universal Life, IRA, life insurance, mutual funds, rate of return, Wealth Creation
When BawldGuy asked me to blog on equity indexed universal life insurance (EIUL), I thought no problem, since I had been blogging on it for a couple of years on both my site and others. Then he asked me to look at the archives from Bloodhound to see his previous blogs and I knew I had to write something a little different. In order to make sense of EIUL contracts you really need to understand the misinformation that underlie the arguments being put out by folks in books, the mass media and blogs on both sides of the issue. You need to be clear on what your wealth creation plan is and what it isn’t. So bear with me for a few paragraphs as I burn down the straw-men arguments before we get into the mechanics of EIUL’s.
Usually these discussions surround a common theme, EIUL’s versus mutual funds inside a tax deferred wrapper (401K, IRA’s). First let’s talk about mutual funds. Mutual funds were designed to reduce risk or as financial experts describe it variance. They were a boom to Wall Street as mutual funds induced many folks to invest in stocks, something they were not inclined to do in the past. They have been around for 2 generations so we have plenty of data to tell us accurately how people do investing in mutual funds.
We have plenty of studies of wealthy folks too; many specifically designed to find out how they became wealthy and what wealthy folks invest in. What they tell us is very clear. The higher the net wealth, the smaller percentage of wealth is in mutual funds. Or to be more exact, the super wealthy (net worth in excess of $10M), have less than 5% of their wealth in mutual funds (mostly bond mutual funds), the wealthy (net worth $1M to $10M) has only a slightly higher percentage of wealth in mutual funds, and the mass affluent ($100,000 to $1M) has close to 30% of their wealth in mutual funds (second in percentage only to home equity). And if you look at this class closer you see a curve that continues the trend with the higher the net worth ($500,000-$1M) looking more like the wealthy and those under $500,000 in net worth having the highest percentage of their wealth in mutual funds.
So it is very clear that those that invest primarily in mutual funds are planning to be in the $100,000-$500,000 net worth category. Now there are some real reasons for this and they can be summed up quickly:
- The rate of return people get from their mutual funds is meager. Study after study has pointed out that individuals’ rate of return from mutual funds on average ranges from 7-10% BELOW market returns (Dalbar, Inc. Vanguard, etc.). Average fees range from 2-4% of value for mutual funds. Employer managed 401K’s have the highest fees sometimes as high as 6%;
- People don’t consistently put money into mutual funds as they are instructed to, because life intervenes and the money is used to cover expenses; and
- The experts advising folks on mutual fund investments actually cause folks to have a lower rate of return than if they did it themselves.
The bottom line is that when your advisor or the mass media you are listening to tells you to invest in mutual funds they are putting you on a plan to have low six figures in net worth in today’s dollars. One can reasonable assert that investing in mutual funds will not make you wealthy, only keep you from being poor.
Tax deferral programs (401K, IRA’s) were designed by the government for two reasons. One was to encourage folks to save money. It should be noted that it was never thought to be the only retirement vehicle, but an adjunct to defined benefit pensions and social security. The second reason is to increase tax revenues. By giving a tax break as you put the money in and taxing it as you take it out, even getting a meager rate of return will assure greater tax revenue. It is pretty simple to understand. From these meager beginnings 401K/IRA’s have become the only retirement vehicle most people have outside of social security.
Those that oppose the use of EIUL’s accurately state that most people upon retirement have a decrease in income, and tend to move down a tax bracket. And they also accurately point out that the advantages of EIUL’s goes up as your retirement tax bracket goes up. So for those who plan to have a drop in income and/or a drop in tax bracket EIUL’s might not be advantageous.
By now you are probably wondering why I am talking about mutual funds and 401Ks instead of the topic at hand EIULs. I am trying to bring some clarity into the readers’ thinking in order to break down certain categories in your mind. Categories created by folks surrounding investing, retirement, wealth. Frankly, most people are on a snipe hunt when it comes to creating wealth through mutual funds. They are looking at the amount of fees charged, or which mutual fund returns slightly better than others last year, or speculation on how much their 401K’s will be worth somewhere in the future. Frankly, all that stuff doesn’t matter. It only appears to be important because of the categories you have created and put mutual funds/401Ks into; retirement funds or wealth creation. Truly, mutual funds don’t belong in those categories; they really belong in the asset protection category or more specifically the asset transfer category. I know that is a hard pill to swallow, but if you really look at information I have given you, and really think about it, you will understand why. You really are just moving some of today’s income into tomorrow’s income hoping to account for inflation.
Now let’s talk about the EIUL. It is a life insurance contract. Life insurance is designed to solve two problems. The first is to protect against the loss of income in the case of death of an income producer. The second is asset protection from the tax man. Life insurance like mutual funds will not make you rich.
So let’s burn down those straw men right now. Neither mutual funds nor life insurance have demonstrated the ability to make their owners wealthy. Anytime a mutual fund salesman/financial planner/CPA tells you that the rate of return from mutual funds is 8, 10 or 12% they are not being entirely truthful. (Don’t respond with your own fantastic returns from mutual funds, it simply doesn’t matter in this argument). Planning to live on less money in retirement than in your working life is planning to fail, no question about it. And not planning to have enough assets to have to protect them from the tax man is not what I call a real wealth plan.
Now it’s time to put the pedal to the metal. Everyone who is planning to have a net worth less than $500,000, please raise your hand. Everyone who is planning to have a big drop in income when you retire, please raise your hand. Everyone who has no dependants or who plans to not have dependants and/or who plans to not have any assets to protect, please raise your hand. O.K., all those with your hands raised, EIUL is not for you.
Now, for the rest of you, here is how it works. Permanent life insurance has two sides, an insurance side and a cash value side. The cash value side either earns a fixed amount of interest or in the case of a variable universal life can be invested in the stock market. Equity indexed universal life insurance is of the fixed interest type, although your interest credited is connected to a stock index. EIUL’s have a floor in which the interest credited can’t go below and a ceiling in which the upside is capped. So you know each year the cash value of your life insurance will go up between those two figures, say 2% and 12%. So each year, you look at how much the benchmark index (usually the S & P 500) goes up or down and you know how much your cash value will appreciate. Now here is the key provision. You can access your cash value through policy loans. The loans costs are generally no more than the interest credited (companies have different plans so make sure you understand how your company treats loans). When you take out a loan against your policy there are no tax implications as long as it was set up correctly initially. You are under no provision to ever pay back the loan. Now previous to 1982 you could load these contracts with as much cash as you wanted. Many of the wealthy loaded up their contracts with massive amounts of cash, enough to get the attention of the IRS. The IRS subsequently put limits on how you fund the cash value and how much insurance you need to go along with the cash. So the strategy is now codified into tax law. Follow their guidelines and you have no tax problems.
Properly structuring these life insurance contracts now means minimizing the face value of life insurance, which maximizes the cash value. The cash value increases in value depending upon the index, but never goes negative. By maximizing the cash value the cost of insurance stays low. The contracts I sell have a rider on them that precludes the owners from taking out so much cash that the insurance is not covered, keeping these contracts from lapsing and a taxable event occurring. Surrender fees generally stop at year 10 to 15, but the point is once you fund the contract to keep it for life, so surrender fees are really meaningless. Expenses and commissions are front loaded, so it takes about 10 years for these contracts to really start performing. That means if you are in your 60’s this strategy probably doesn’t make sense for you.
Anytime during the contract you can access your cash value with a policy loan tax free. Some people use them for retirement income, while others use it as a bank, purchasing automobiles and paying the policy back instead of occurring interest by getting a bank loan. They can also be used as a reserve account for emergency funding. This liquidity and flexibility is what makes them so attractive to folks like me and BawldGuy. What rate of return can one expect? Well, I run them with 6.5%, but the historical amount (using data back to 1950 and plugging in that historical figure is 7.5%). I like to be a little on the conservative side. Once again, the point is to transfer assets so as to protect them from the tax man, not create wealth. Look, the bottom line is an unleveraged investment must get a rate of return well over 12% to really build wealth; neither mutual funds nor EIUL’s are likely to get that high of a return!
So what is the bottom line? You use real estate investments to create the wealth. Leverage, depreciation, 1031 exchanges, etc. all do the wealth creating. Then you protect those assets against the tax man by using EIULs. And if something bad happens to you, your family is protected.
When you take away all the “straw men” arguments it all gets clear. Protect or not protect assets? Protect or not protect dependants? Accept a moderate rate of return for these benefits?