Deciding whether to buy life insurance is one of the biggest — and most confusing — financial choices a person will make. There are so many options: term life, whole life and universal life, to name a few. Every type offers positives and negatives and my goal is to unveil one of the newest options, “Equity Indexed Universal Life” insurance or “EIUL”.
What is Equity Indexed Universal Life Insurance?
First and foremost, an EIUL is a life insurance policy. Simply put, a life insurance policy is a contract between an insured person and an insurance company. The policy owner (who is usually the insured person but doesn’t necessarily have to be) pays a premium to the insurance company, and at the time of the insured person’s death, the insurance company pays a designated amount of money (also called a ‘death benefit’) to the policy’s beneficiaries.
An EIUL is not only a life insurance policy, but is also a financial planning tool that offers many significant advantages.
Death Benefit For Those Left Behind
If you are shopping for a life insurance policy, chances are it is because you are concerned about the well-being of your family at the time of your passing. A life insurance policy is especially important in a family that has a single income producer. It is not uncommon for an American household to have one partner who works full-time, while the other raises the kids. A person buys life insurance is in place so that if something happens to the breadwinner, the surviving spouse and children (beneficiaries) will be financially secure.
Is a household with a single income producer the only situation where life insurance makes sense? Absolutely not! In a multiple income household, the expenses (mortgage/rent, bills/utilities, car payments, etc.) are generally not going to decrease dramatically with one’s passing, even though that income is going to go away.
When purchasing an EIUL, the first decision to be is made is how much the initial death benefit should be. Figuring out this number is a whole other article in itself, but in general, a person should consider how much future income is needed to sustain the household versus how much you can budget now to afford the premium. With an Equity Indexed Universal Life insurance policy, the death benefit is paid to the beneficiaries as tax-free income, although estate taxes could come into the equation depending on the value of the policy owner’s other assets. Once a death benefit is decided, an authorized agent can run some calculations to determine if the monthly premiums for that death benefit can be afforded by the policyholder.
Investment Returns Can Be Expected
When paying EIUL premiums, some of the money goes towards the cost of the death benefit (insurance costs) and the rest gets invested. The money in the “investment account” then grows and the policy owner can access these funds via a policy loan.
How much does the money in the policy grow? The policyholder gets to pick from a selection of index funds based upon his or her risk tolerance and life expectancy (an experienced insurance agent can help you find the right fit). EIUL’s have cap rates on both their investment returns as well as on their downside risk, so there is a floor (generally 0%) and a ceiling (generally 11-16%).
This 0% floor makes this investment choice very interesting. Let’s assume there is $100,000 cash value in an account, with a 0% floor and a 13% ceiling. If the index fund chosen goes down 38% in a year (like the S&P 500 did in 2008), then at the end of that year, the cash value is still $100,000 because of the 0% floor! While the downside is limited, keep in mind the upside is limited as well. So, if the index fund goes up 23% in a year (like the S&P 500 did in 2009), the investment account will only increase by the amount of the ceiling, or 13%, for the year, for a total cash value of $113,000.
Why is investment risk important? As a person gets closer to retirement, he or she has the security of knowing that the cash value in the EIUL will never decrease, but can only increase or stay the same. Based on a 10 to 30 year history, investments in a capped index fund that tracks the S&P 500 can expect an average annual return of 7% to 9% without the volatility one would experience if invested in the index itself (via a mutual fund, etc.).
Significant tax benefits
The tax benefit is where the beauty of an equity indexed universal life insurance policy really shines. When a policyholder decides it is time to begin withdrawing investment funds (generally around retirement age), the funds are taken out via policy loans tax-free. Unlike a 401k or traditional IRA, an EIUL contains after-tax funds, so the cash balance is the actual cash balance. How do policy loans work? Very simply, the policyholder withdraws the funds from the account and agrees to pay the funds back with interest. The key to this agreement is that there is no penalty for not paying the loans back. EIUL holders generally take policy loans with no intention of paying the loan back. That being said, the death benefit decreases with every policy loan, which explains the reason for no penalty.
The suggested plan is to pay into the EIUL for a set period of time (the longer the better), then at retirement age the policyholder begins to withdraw funds to supplement retirement.
Long term commitment
Policy loans should not occur early on in a policy’s life because an early policy loan will greatly reduce the death benefit amount. An investment in an EIUL is not for someone that does not have the available cash flow to meet the premiums. That being said, if a policyholder cannot afford the premiums, he or she does not lose the policy immediately; the premiums can be paid temporarily through the available cash balance or a policy loan, but this decreases the death benefit. If the policyholder is unable to afford the premiums and there is no available cash in the policy to pay them, eventually the policy will lapse.
Figuring out expense ratios
Expense ratios are an often overlooked and misunderstood factor of investing. The expense ratio is simply the cost to operate a mutual fund or other investment. It is determined by taking the investment’s operating expenses and divided by the average value of the investment. If you are a Bogglehead follower like myself (the belief that investments should be in low-expense ratio index mutual funds), you know how important it is to keep expense ratios low on investments. With a mutual fund inside a 401k or IRA, it takes 10 seconds to find out what the expense ratio for the fund it (annual operating expenses divided by average value). The expense ratio for an EIUL, however, will vary greatly depending on the index’s performance, date of death and amount of distributions taken. One should expect an EIUL expense ratio in the 1% range.
Investment gains are capped
Yes, capped gains are both a pro and a con! If the index in which the policyholder is invested in increases, for example, by 25% every year for the next 30 years, the policyholder’s returns will be capped, thus missing out on those gains. An additional disadvantage is that dividends are not distributed from the index into the policy. Are these tradeoffs worth the 0% floor cap? That is for you to decide.
Equity indexed Universal Life Insurance illustration example
- Policyholder is 30 years old when he or she purchases the new policy
- Will pay $2,400 per year in premiums and is willing to increase this premium by 3% each year to combat inflation
- The chosen index will earn an 8.25% annual return
- Policyholder will take a $74,381 tax-free loan every year from age 69 to 90 (23 years)
- Management Fees are 1%
Disclaimer: This example is for illustration purposes only. Every EIUL proposal will vary and we offer no guarantees that an EIUL will match the example given.
|Age||Yearly Premiums Paid||Total Premiums Paid||Investment Value||Death Benefit Amount|
|68-90||No More Premiums: $74,381 Tax Free Loan Every Year for 23 Years||($1,544,779)||$622,709-$19,647||$743,827-$166,884|
|Yearly Premiums Paid||Total Premiums Paid||Investment Value||Death Benefit Amount|
|No More Premiums: $74,381 Tax Free Loan Every Year for 23 Years||($1,544,779)||$622,709-$19,647||$743,827-$166,884|
What does this example show us?
- Most insurance costs are paid in the first 15 years. This is why the total outlay is similar to the surrender value for those years.
- Death benefits increase when paying into the EIUL and decrease when taking policy loans out.
- If death occurs at age 39: $199,946 death benefit and $27,513 in premiums would be paid.
- If death occurs at age 59: $484,320 death benefit and $116,290 in premiums would be paid.
- If death occurs at age 67: $818,208 death benefit and $165,984 in premiums would be paid – this is the highest the death benefit will ever be, because the premiums have been paid in full and the policy loans are about to begin.
- If death occurs at age 75: $462,427 death benefit — the death benefit has decreased because $74,381 has been withdrawn each year for seven years.
- This is a very specific example. Keep in mind an individual never has to take a policy loan. The policyholder can continue to pay premiums until the day he or she dies, allowing the death benefit to grow dramatically. The policyholder doesn’t have to wait until a certain age to take policy loans either; he or she can take loans against the policy’s cash value at any time.
EIUL Last Words
Not every EIUL or EIUL customer is the same, make sure the performance plans makes sense to you. Most importantly, an EIUL is not a perfect investment vehicle. There is no perfect investment vehicle. But, if there was we would all use the same one. It is up to each investor to weigh the pros and cons of every opportunity out there and make an educated decision. If you are looking for a life insurance solution that offers the upside of tax-free income at retirement, I think an EIUL should be considered. Please join the conversation below if you have questions or experience with an equity indexed universal life insurance policy.