Navigating the Hidden Risks Emerging in the Indexed Universal Life (IUL) Marketplace
New Indexed Universal Life (IUL) products are emerging in the marketplace and becoming increasingly popular. At first glance, these IUL products offer an opportunity for even more upside potential compared to what is found in traditional IUL products. In exchange, policyholders are charged additional fees for the additional upside potential.
While the increased upside potential seems attractive, buyers should be aware of the additional risk and complexity these new products introduce.
The IUL Promise: Upside Growth with Downside Protection
A few years ago, I wrote about how IUL offers a chance at upside growth while providing downside protection. IUL can be a great option for someone who needs permanent life protection but also wants to build the policy cash value to use for expenses such as college funding, retirement income, starting a business, or emergencies.*
IUL policies credit interest up to a cap (a maximum interest rate) based on the performance of an external market index, such as the S&P 500® Index (excluding dividends), while also offering the downside protection of a “floor” (minimum interest rate). The index allows the policyholder to benefit from stock market gains, to a point, while the floor helps protect against losing money in a down market. Penn Mutual continues to remain committed to these foundational aspects of IUL — providing strong upside potential while offering even better downside protection, with a floor greater than 0%.
However, these new IUL products have started to change this basic equation and have a substantially different risk profile than what has long been associated with traditional IUL products. Here’s why.
The Hidden Downside Risk
There is a hidden downside to these new products: The additional fees paid for the potential payoff must be paid whether the index goes up or down.
The fees can be substantial. There are products out there that charge asset fees as high as 7.5% in exchange for a potential bonus — a multiplier or index credit enhancement — that pays more than the performance of the index. For example, if the policy is pegged to the S&P 500 Index, and that goes up 10%, the policy might be credited at 15% or 20% because of the bonus. That is the upside.
But if the market goes down, you still have to pay the 7.5% asset fee. Even if the policy says the floor is 0%, you still have to pay the fee, so the effective floor of the policy is really negative 7.5%.
More Moving Parts and Increased Complexity
The bonuses for these products are also often extremely complex. One product being sold only pays the bonus if there have been two positive years of market performance in a row, while another is tied to the cumulative interest paid over the last 10 years. To further complicate matters, some bonuses are guaranteed** and others are not.
As I wrote before, you need to be aware of the moving parts in an IUL policy. This includes the policy floors and caps, as well as participation rates (how much of the change of the value of the index is being passed on to you), persistency bonuses (paying more if the policy has been in place longer), and now the multipliers and bonuses of this new type of IUL policy. Companies often reserve the right to change policy caps, participation rates, persistency bonuses, and multipliers at any time.
When you pay a charge for the opportunity for this increased upside potential, not only are you now exposed to the performance of the market, you are also subject to the whims of the insurance company, which often has the discretion to change such details at any time. Make sure you understand what terms are guaranteed and which are subject to change.
Built for the Risk-tolerant Consumer
There is a real concern that people are buying these products thinking they are buying a traditional IUL policy where they can’t lose money due to market performance. But because of the hidden fees, there is a substantial risk that the policy won’t perform as anticipated.
There are definitely people who will understand how these new IUL products work and are willing to take the risk for a big potential upside, but the products offer a completely different value proposition than a traditional IUL product.
Even risk-tolerant consumers might be better served in looking at other types of insurance products. These new IUL policies have only been available over the past couple of years, so they really haven’t been tested in a down market like we experienced in 2008. Variable Universal Life (VUL) insurance, which is fully exposed to the ups and downs of the market, might be a good option for those more tolerant of risk.
The Illustration Game
One of the reasons these new IUL products are so popular is because the illustrations look promising. Insurance companies are not required to show the impact of these extra fees when illustrating the performance of a policy over time, nor are they required to show what happens if the returns hit a floor.
At the very least, make sure you ask your adviser to explain and show you the additional fees that will be charged, and how negative market returns could potentially impact the numbers you see in your illustration.
IUL Still a Great Option
IUL policies are popular for good reason. For those who need permanent life insurance, an IUL policy offers a chance to accumulate cash value for the living benefits of life insurance while protecting against market losses. Penn Mutual is committed to delivering on the promise of IUL, offering upside potential and downside protection that won’t be compromised by high fees.
As more “moving parts” are added to these policies, it’s now more important than ever to look into the details of how the policy works and understand the risks associated with it. Only then will you know whether a particular IUL policy will fit your financial needs.
* Accessing your cash value may result in surrender fees and charges, may require additional premium payments to maintain your coverage, and will reduce the death benefit and policy values.
**Based on the insurer’s claims-paying ability)