IUL vs. VUL – 4 Reasons Why Indexed Universal Life Is Better
In this article, find out the reasons why Indexed Universal Life is most likely a better product for your needs than Variable Universal Life!
Some Definitions First:
Because were are talking about the difference between a Variable Universal Life and Indexed Universal Life insurance policy, it would probably helpful to you if I were to define them first.
Most people outside of the insurance industry don’t know the difference between the two. That’s understandable as they are both complex products, so let me try to demystify them a little for you:
A Variable Universal Life is a universal life policy first (easy, right?). That means that you are not forced to pay a fixed amount of premium into the policy or forced to pay it on a fixed schedule.
It has cash value associated with it if you fund the policy adequately (put in more than the minimum required to pay the cost of insurance).
Where does the cash value go?
Unlike a regular universal policy where the cash value goes into an interest bearing account (similar to a money market), in a VUL the cash can be directly invested into mutual fund sub-accounts. These mutual fund sub-accounts are similar to the funds you might find in your 401k, 403B or TSP at work, and can invest in everything from large cap growth stocks to real estate to alternative funds.
Indexed Universal Life policies are newer and work a little differently: Everything about them being universal policies is still true, but the premium that goes into the cash account gets invested a little differently – unlike the VUL, the cash is not invested directly in a mutual fund.
Instead, you actually get an interest crediting rate based on the stock market index you and your agent picked.
Don’t know what a stock market index is? Don’t worry, it’s just a fancy term for a bucket of stocks that are put together and averaged.
The Dow Jones is the most famous index, but you may have heard of things like the Nasdaq or S&P 500 which are indexes too. (The Nasdaq tracks tech stocks, and the S&P 500 tracks the 500 largest companies).
Regardless of the index you choose, you won’t gain or lose interest in a 1:1 relationship with how the index did this year (which is a good thing!)
The policy has a crediting floor (the least amount you can receive) of 0% or 1%, and has a cap or participation rate on the upside as well.
What this means is that there is downside protection for you (if the stock market drops by half, you don’t lose any money!) If the stock market does really well, your performance will max out at the upper bound.
There are also products that provide a participation rate instead of an upside cap with a risk return graph like this:
Now, onto a bit of history:
I don’t want to rehash what I have written in more depth elsewhere, but to understand why (in most instances) an IUL policy is better than an Variable Universal life – it helps to know why IULs were created in the first place – and what solutions they provide that weren’t available from a product that was already in existence.
People had been purchasing Variable Universal life products en mass for protection and tax free accumulation starting in the mid 1980’s – not coincidentally when the stock market was roaring – and if you owned a VUL and compared it to the returns of a whole life policy at the time, it looked like you were doing awesome.
Many people don’t remember Black Monday, a one day drop in the Dow Jones of 22% – and as bad at that was, the index still finished positive that year! Any cash value you had in mutual funds was experiencing annual returns of potentially 20% and greatly outpacing even the optimistic illustrations agents were showing at that time.
As the 80’s became the 90’s, the stock market was still more or less booming with no slowdown in sight.
Unbeknownst to shareholders, the good times were just about over. The dot com burst in 2000 was the first major trip back to reality for the stock market, VUL holders included.
The stock market eventually rebounded from the depths of 2000-2001, but had a couple of disappointing years in the span up until 2007.
We are all familiar with what happened next: Along with foreclosed homes and job cuts, the Great Recession had another casualty: Variable Universal Life policies!
Why VULs Did Poorly
The negative market performance caused a lot of policies to outright collapse due to huge losses in the cash value. Even when the policies didn’t outright flop, many owners were forced to put cash into the policy, assuming they had any left. Remember that recessions are correlated with job cuts too, so lots of people had the double whammy of needing more and having less.
After this disaster – insurance companies were pressed to come up with a new product, one that had a little saner risk exposure.
VULs have the inherent disadvantage because as cash values decrease the cost of insurance actually goes up! A market down turn makes less cash available (because the value of the subaccount decreases) and requires more of it at the same time (because the difference between the amount of the cash value and face value increases, causing higher internal expenses within the policy).
Solving the first problem, a loss in Cash Value
Seeking to remedy this, insurance companies came up with a new product, the IUL!
Insurance companies still wanted the exposure to the market (so they could sell the sizzle!) but did not want to have to worry about facing down another 2008 great recession where policy values were eroded and clients were put in a tough spot.
The indexed universal life policy they came up with would be able to dodge market downturns but still be able to outperform the expensive, stodgy old line product of whole life insurance.
What’s the same?
Before we go through the difference, we might as well go through the similarities – but if this bores you go ahead and skip down to the next section!
- Both an Indexed Universal life policy and a Variable Universal life policy are designed to be permanent life policies that you carry with you your whole life (just like whole life, get it?)
- They both focus on generating cash value that you can later take out tax free – but that is pretty much where the similarities end.
As you’ll see there are a couple of major reasons why anyone who is looking at one of these policies is better off going the Indexed Universal Life route.
Reason #1: IULs Have a Floor:
We already mentioned that IULs have floors (generally of 0% or 1%) The reason that this is so important is that it prevents the cash value from going down!
Some people like to compare compare having a permanent insurance product to a Roth (looking at you Bank on Yourselfers, though I’ve done it myself) but in reality, that’s not quite the case.
While the cash value inside the policy can be tax free – you are still paying for the cost of insurance – which is the difference between the current cash value and the face amount.
Well structured insurance policies build cash value quickly and efficiently, and the key to doing that is NOT to lose money.
“Rule No. 1: Never lose money. Rule No. 2: Don’t forget rule No. 1”– Warren Buffett
By installing a floor, you have already prevented the worst thing that can happen to a policy, which is loss of cash value
Reason #2: IULs have minimum guarantees
Universal life products have their risk contained – there is no scenario in which the cash values of the policy could ever experience a -40% drop in one year. Because the actuaries (read: smart people) at the insurance company know that the risk is constrained into a corridor of 0% to about 12%, they know that they can offer guarantees to the people they insure.
If that sentence doesn’t make sense to you, don’t worry – what you do need to know is that much like a guaranteed universal life policy, you can actually guarantee that the policy will cover you to age 90 or above, even if America goes into a permanent recession.
Now, if America does go into a permanent recession you probably have more important things to worry about (like drinking water) but the point stands. Done right, these policies are more solid than any piece of military equipment the Armed Forces can field.
Reason #3 IULs can be Protective or Accumulative
Because Indexed Universal Life policies have a different risk exposure and use a different mechanism than the actual market, they can be altered to your liking.
AIG in particular does a good job with this, and they have two different flagship IULs.
Want to go on offense and try to build up a huge cash value – AIG’s Max Accumulator is the perfect product as it for goes some guarantees for very aggressive cash accumulation, and is perfect for a younger risk tolerant person.
Prefer defense? Well AIG has got you covered in this instance too: Their second Indexed Universal life product is something called the Value Plus Protector – and while it gives up some of the cash value potential of its brother the Max Accumulator, it’s got excellent guarantees and is perfect for someone who is a little older or a little more conservative.
Along with AIG, many other companies have different products associated with different risk tolerances. If you want to go as aggressive as possible, check out a Symmetra policy (but don’t expect any guarantees). On the other hand, Protective has a policy that won’t make you rich, but lasts as long as you do and costs nearly the same as a GUL that has no cash value and stops at age 90.
The landscape is ever changing but the important point is that, with all of the different life insurance companies out there, there is a policy that should meet your needs perfectly!
Reason #4 IULs Don’t have Mutual Fund Fees:
Ok, so this is a complicated one – maybe the most complicated reason of all to really understand, but I will do my best to explain it.
Way back in the 80’s and 90’s when mutual funds were the only game in town, it was common for customers to be paying in the neighborhood of 1.5% to 2% (or more, if you owned international funds) of the account in fees to the manager of the mutual fund. If you were making 20% a year and there was no alternative, paying those fund fees wasn’t a big deal and was just a part of life.
While those fees have shrunk somewhat, expect to still pay at least 1% a year on your mutual fund sub-accounts in any VUL policy today. Now that we’ve all come back to our senses, and expect total stock market returns in the 7% range over a long period of time, we can see that a 1% fee cutting into that would be about 14% percent of our return pocketed by the mutual fund managers.
If 14% doesn’t sound like much to you, remember that it is compounded! By paying 1% every year to a fund manager, you they could end up eating over 18% of your return by retirement:
In contrast, the index that the IUL tracks is associated with no fees, as it is a pure index of stocks. There is no manager charging fees, so there is no 1% fee drag associated with your policy.
While it is true that you don’t have a true exposure to this index (you have 0% downside and a capped upside) in most years, your performance will be better in an Indexed Universal life policy vs a VUL.
Not everyone is better off with an IUL – some people don’t care for having any cash value in their policy and just want the cheapest permanent policy with guaranteed coverage available – a GUL.
Others may want cash value and absolutely hate the idea of their insurance policy being tied to the market – and for those people, whole life is a completely acceptable solution. Just expect to pay about twice as much (or receive half of the eventual cash value) in premium.
But, if you are looking for cash value in a policy, downside protection, and strong guarantees an indexed universal life is your best option.
Each Indexed Universal life is unique to the person who owns it, designed around their particular financial needs, goals, and specifics. So, if you are interested in hearing more about having an IUL designed just for you, send me an email at [email protected] or schedule a free personalized information session right now!