Universal Life

I received many responses to my diatribe on permanent life insurance. Several pointed out legitimate uses for these products, which I included in the post, albeit near the end. And then a polite reader emailed me an illustration for an indexed universal life insurance policy. Wait until you find out how it works.

The proposal calls for an annual premium of $100,000 paid for 20 years. I wonder how many people have an income high enough and steady enough to commit to paying this premium.

According to IRS data from 2016 tax returns, 1.3 million taxpayers had an adjusted gross income (AGI) greater than $500,000. This accounts for less than 1% of tax returns filed. I think it’s fair to say these are the people who could purchase this policy, although not all of them should. Considering there are about 1.1 million licensed insurance agents, they each have the opportunity to sell exactly one of these policies in their entire career.

Rather than focus on the ways this can go wrong, I want to highlight the “investment options” within the policy. This is a variable life insurance policy, which means you can take stock market risk with the cash value.

There are four Indexed Account options:

  • Capped Indexed Account
  • High Capped Indexed Account
  • High Par Capped Indexed Account
  • Capped Hang Seng Indexed Account

Capped Indexed Account

Provides a “segment interest credit” based on a one-year, point to point calculation of the S&P500 Index, without dividends. Take the price of the index on day 1 and compare it to the price on day 365. The difference gives you a number that is the starting point for the calculation of segment interest credit. This rate of return is then multiplied by 1.55. That’s right, a leveraged return.

If the index declines, the return credited is 0%. Leveraged upside with no downside.

But there’s a limit to the upside. The “segment cap rate” is 10.25%. If the price return of the S&P500 is more than 10.25%, you are limited to a credit of 10.25% *1.55 = 15.89%.

Leveraged upside, with no downside risk. If something sounds too good to be true, it is. Where’s the catch? I found two.

First, the insurance company reserves the right to reduce the “segment cap rate” to 3.25%. This limits potential upside to 5.04% per year. Do you think the insurance company will exercise this right if we get several years of mid-digit market growth in a row, hence triggering the leverage credit amount?

Second, there’s a monthly “index performance charge” of 0.165% or about 2.0% annualized. There’s no way to determine the total costs of this product without reading the full contract, but this is one of many costs.

High Capped Indexed Account

Same as above except – the segment cap is now 14.5%, but the multiplier is 1.3. Here the insurance company has the option to lower the Segment Cap Rate to 3.75% for a max return of 4.88%.

High Par Capped Indexed Account

Same as Capped Indexed Account except – the segment cap is 8.5, the multiplier remains 1.55, AND (just for fun) there’s a participation rate of 160%.

Example: Point to point S&P500 change = 6.0%

Segment Interest Credit = 6.0 * 1.55 * 1.6 = 14.88%

Here the insurance company can reduce the segment cap rate to 3.0% and the participation rate to 140% for a max return of 6.51%.

Capped Hang Seng Indexed Account

I saved the best for last. Just in case you were bored with the S&P500 Index, you can choose to participate in the Hang Seng Index, a basket of stocks traded on the Hong Kong exchange.

The measurement is a point to point price change excluding dividends over a one-year period. The multiplier is 1.3, and the segment cap rate is 14.5%. If the index is down over the measurement period, the credited interest rate is 0%.

Example: Point to point Hang Seng Index change: 10%

Segment Interest Credit = 10% * 1.3 = 13%

The insurance company reserves the right to reduce this Segment Cap to 3.75% for a max return of 4.88% before expenses.

How does one decide which of these indexed accounts to select each year? No worries, you can split your policy amongst all four.

Did I mention that the insurance company reserves the right to change the underlying index at any time to any index? Do you want to pay $2,000,000 in total premiums to have the rules of the game changed in 25 years to a complete unknown? It’s not easy to back out without losing a lot of money.

The end result is an illustration that shows a net cash value outpacing a traditional portfolio earning a 6%. Maybe the stars will align and a lucky policy owner will experience this outcome. I highly doubt this will ever happen for several reasons.

  1. The first expense people cut when faced with a budget crunch are permanent life insurance premiums.
  2. The sequence of returns risk here is astronomical. Buy this policy or start taking withdrawals before a bear market, and these projections crumble.
  3. Make the mistake of borrowing too much against this policy, causing its cancellation, and you owe income tax on the entire distribution.
  4. Live too long and you might find yourself forced to pay premiums to keep the policy in force to avoid taxation of the withdrawals and loans.
  5. And many, many more …

If your head is spinning from this explanation, imagine the difficulty when an insurance agent is feeding you a million reasons this is the best thing you’ll ever buy.

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