Protect What Matters
Indexed Universal Life Doomed for Failure Part 15
Many agents will talk about market returns in double digits as if they mean something. Most of us would happy if we could get a 12% to 14% interest return on our money. In an IUL, not only are those returns not enough, it’s not even close to what we need to keep a policy from lapsing in the long run. This is very important to understand so I will not breeze over it.
We have previously covered in our IUL discussion that the insurance company does not directly invest in the stock market. Instead, they buy call options on the index. But, where does the money to buy the options come from? They will not take their investment capital and put it at that kind of risk. Insurance companies are required to invest in safe investments such as high-quality bonds, real estate, mortgages, and others. The emphasis is “safety” on their portfolio. Now, what insurance companies can put at risk is the interest that is earned on the portfolio.
One of the options available in an IUL is what is known as a “fixed account”. A fixed account is an account to which a fixed percentage is paid every year out of the investments it makes. Now, let’s assume that your fixed account can get paid 3% as one of the fixed account choices. The other choice is that they can take that 3% and buy options on the stock index. By doing this, the insurance company can participate with the market on the upside (gains), and in the case of losses, all the insurance company loses is that 3% it used to buy the options.
Now, it’s important to understand the economics and market cycles. When interest rates are low on bonds, investors take the stock market in hopes of higher returns. When bonds are returning low interests, the stock market grows as more and more investors switch their money from bonds to stocks in search of higher returns. Makes sense, don’t you think. Here is a simple way to remember it: “When bond yields are low, stocks will grow”. Of course, this will not always be the case, but you get the point; it has been proven more often than not through different economic cycles.
Now let’s look at an opposite scenario. Let’s say that bonds start to rise and begin yielding 6%, 7%, 8% and better returns. Suddenly, those investing in the market realize that their money is at risk by being in the stock market. And, why take a risk when you can obtain nice returns in the bond market. Suddenly, the market is not worth the risk. The result is that the stock market begins to shrink as investors move their money from the stock market to the safety of the bond. When this happens, the market suffers as prices fall, and growth comes to a halt, at best. A phrase to remember this is “When bond yields are high, stocks will die”. Again, this is not always the case but most of the time it is.
Now that you understand this phenomenon, you’ll be able to see the real battle that IULs face. So, here we have an insurance company that is going to use bond yields to purchase call options on the index. The more money they have, the greater the participation rate they can get on the options. When IULs talk about caps, they are referring to the cap on the return that you can potentially get in a single year. A cap of 12% means that if the market did 20% or 25% you’d be capped at 12%; in other words, the most you will get is 12%. Now, caps are determined by the amount of bond income the insurance company is getting, and can use to buy the option, and how much of that option they can actually buy. Let’s take a simple example:
If we have $100,000 invested in bonds at 3% interest, that gives us $3,000. We can then take those $3,000 and go buy call options. Those $3,000 are not enough to allow me to participate with 100% of the market growth. In other words, the $3,000 only allows me to participate in a percentage of the growth. To put it a different way, the $3,000 gives me the right to receive, as an example, $0.40 of every dollar, or $0.45 of every dollar. This is determined by the agreement made between the market-makers on the options exchange and the insurance companies. Insurance companies don’t like caps; they would love to have uncapped returns but it’s not possible with the yield that the bond is returning. So here is the result of this all:
In years where the bond yields are low, the markets are typically thriving; but, because bond yields are so low, insurance companies don’t have enough to buy high caps. The more money insurance companies have, the higher the caps they can negotiate. So, if bonds have low yields, IULs have low caps. Historically, this is when the market is growing and you, as an owner of an IUL, would love to participate in this high earning environment but you can’t because the caps have been lowered by the low bond yield. Conversely, if the bond yields are higher, the market is either declining, or flat, not growing. So, now that the insurance company has more money to buy options with higher caps, caps are meaningless because the market is not yielding returns at or above the cap. In other words, the cap on an IUL in a given year may be at 20%, but if the market is only yielding 3% or 4%, that cap may as well be at 100% (uncapped), it still would make no difference.
Can you see the inherent problem IULs have? They will always be on the wrong side of the market. When the markets are moving and thriving, IULs are stuck with low caps due to the low bond yield. When the market stinks, IULs have high caps or even no cap but it’s really not a benefit because the market is not performing. This is a substantial downfall of an IUL that is not talked about or understood. It’s kind of an illusion, the smoke and mirrors of the IUL, and no one can control it; it’s simply math and economics.
Well, we’ve come to the end of our study on the IUL. I hope that this information was useful and educational. You are now armed with more knowledge than 90% of the agents selling IUL policies. It is my wish and desire that you put this information to good use and that you empower others by sharing your new learned knowledge.
If you have any questions and/or would like to have a personal evaluation of your current situation, please don’t hesitate to contact us. You may call us, e-mail us, and/or complete the contact request below and we will get in contact with you.
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