Indexed Universal Life: When Policies Go Wrong
There is a story we see far too often in the life insurance business.
Someone purchased an indexed universal life or variable universal life policy years ago. They were shown an illustration that looked impressive. The policy appeared capable of building substantial cash value while providing a permanent death benefit.
Maybe they were told it could eventually provide retirement income. They were told they could access the cash value without creating a taxable event. Maybe they were told the policy would “pay for itself” someday.
The future looked pretty good.
The policy didn’t perform as expected.
And suddenly, the policy that was supposed to be a long-term financial asset became something the policyowner had to worry about.
This is the all-too-familiar downside of certain indexed universal life (IUL) and variable universal life (VUL) policies.
That doesn’t mean every IUL or VUL is a bad policy. These products can be appropriate for certain people and certain financial objectives.
The problem occurs when a complicated permanent life insurance contract is sold primarily on an attractive illustration without adequately explaining what happens when the assumptions don’t become reality.
The Illustration Looked Great
This is often where the story begins.
The illustration may show a policy accumulating hundreds of thousands of dollars over time. It may show the policy remaining in force for life. It may even show the policyowner eventually taking income from the cash value.
The numbers can look impressive.
But an illustration isn’t a guarantee of what will happen.
The NAIC describes a life insurance illustration as a presentation showing how a policy is expected to perform under specific circumstances. Illustrations contain both guaranteed and non-guaranteed elements. For universal life policies, cash values, current death benefits and other values may depend on non-guaranteed assumptions.
That’s a critical distinction.
An illustration shows what could happen. It doesn’t mean that’s what will happen.
And the farther into the future an illustration goes, the more important those assumptions become.
The Market Didn’t Perform Like the Illustration
With variable universal life, the issue is relatively straightforward.
The policy’s cash value is invested in separate investment accounts, and the performance of those investments affects the policy’s value.
If the investments perform well, the cash value can grow.
If they perform poorly, the cash value can decline.
Meanwhile, the policy continues to have expenses and insurance charges.
The SEC specifically warns that variable life insurance involves investment risk and that poor investment performance can reduce cash value and contribute to a policy lapse.
That’s a very different risk profile than someone might assume when they hear the words “permanent life insurance.”
What About Indexed Universal Life?
Indexed universal life is a little different.
An IUL isn’t simply invested in the S&P 500.
Instead, the policy generally uses an interest-crediting strategy tied to an external index. The actual amount credited to the policy depends on the specific contract and factors such as the index, crediting method, participation rate, cap, spread and other provisions.
The NAIC describes indexed universal life as having both fixed and variable features, with interest tied to external indexes such as the S&P 500.
That’s why the phrase “you can’t lose money when the market goes down” can be misleading.
Even if the policy’s index-crediting formula produces 0% interest for a particular period, the policy’s other charges don’t necessarily stop.
The cost of insurance doesn’t disappear.
Administrative expenses don’t disappear.
Rider charges don’t necessarily disappear.
And if the policy isn’t adequately funded, the cash value can still deteriorate.
A 0% credited interest rate is not the same thing as a 0% cost to own the policy.
That’s an important distinction.
“But I Paid Every Premium.”
This is one of the most frustrating conversations for a policyowner.
They say:
“I’ve never missed a premium payment. How can my policy be in trouble?”
Because universal life insurance isn’t necessarily designed around the idea that a certain premium guarantees the policy will remain in force forever.
The policy’s ability to remain in force can depend on premiums, cash value, interest or investment performance, insurance costs, policy charges and other factors.
The planned premium may have been based on assumptions that don’t ultimately materialize.
So someone can faithfully pay the premium shown in the original illustration and still discover years later that additional funding may be necessary.
That’s when the phone call usually comes.
“My agent told me I wouldn’t have to put any more money into this policy.”
Unfortunately, what was illustrated and what is guaranteed aren’t always the same thing.
The Silent Killer: Policy Charges
Universal life policies have costs.
There are charges associated with providing the insurance. There may be administrative expenses, rider charges, surrender charges and other costs depending on the policy.
With variable life, the SEC specifically identifies sales fees, surrender charges, mortality and expense charges, cost of insurance, administrative fees, underlying fund expenses and other potential expenses.
These charges matter because they come out of the policy’s economics.
If the cash value is growing rapidly, they may not seem particularly significant.
But if the policy isn’t performing as expected, those same charges can become increasingly important.
And that’s where a policy can begin to deteriorate.
Then Comes the Policy Loan
This is another common chapter in the story.
The policyowner sees a substantial cash value and is told they can access it through policy loans.
So they do.
Maybe $25,000.
Then another $25,000.
Perhaps eventually $100,000 or more.
The money may be used for retirement income, a business opportunity, college expenses, a vehicle, a home renovation or simply to supplement income.
The problem is that the loan isn’t free money.
Interest can accrue.
The outstanding loan can reduce the policy’s net value and death benefit.
And the larger the loan becomes relative to the policy’s value, the greater the potential danger.
The SEC warns that policy loans can reduce cash value and death benefits and increase the risk of lapse. If a policy terminates with an outstanding loan, the loan may also create federal income-tax consequences.
That’s a particularly ugly outcome.
Someone can spend years believing they have created a tax-advantaged source of retirement income, only to face a significant tax problem if the policy eventually collapses.
The Worst Phone Call
Imagine this scenario.
You’re 65 years old. You have owned your policy for 15 years. Thus far, you have paid $150,000 into it. You were told it would provide permanent insurance and potentially provide retirement income.
Now you’re told the policy needs another $15,000 or $20,000 per year to remain on track. Perhaps the death benefit needs to be reduced.
Or you need to stop taking withdrawals. Or you need to repay some of the policy loan.
Suddenly, you have a decision to make.
And you’re 15 years older than when you bought the policy.
If you need new life insurance, your age and health may make it substantially more expensive—or you may no longer qualify for the same coverage.
That’s the part of these policies that worries us the most.
It’s not that the policy didn’t perform exactly as illustrated.
It’s that by the time you discover the problem, your options may be considerably more limited than they were when you purchased it.
“But I Thought It Would Pay for Itself.”
This phrase deserves special attention.
We’ve heard variations of it many times.
“I was told I only had to pay for 10 years.”
“I was told the dividends would pay the premium.”
“I was told the policy would become self-sustaining.”
“I was told I could stop paying into it.”
Those statements can mean very different things depending on the policy contract and the assumptions behind the illustration.
In fact, regulators specifically scrutinize illustration practices involving concepts such as “vanishing premiums” and other presentations that could imply future non-guaranteed values will pay premiums.
That’s why it’s so important to distinguish between:
What is guaranteed?
and
What is illustrated?
Those aren’t necessarily the same thing.
The Sad Irony of a Policy That Was Supposed to Create Security
Life insurance is supposed to create certainty.
You buy it because you want to know that your family, business or estate will have money when you die.
But some universal life policies can create a surprising amount of uncertainty if they are aggressively funded, poorly designed, inadequately monitored or dependent on assumptions that don’t materialize.
That’s the irony.
A product purchased to create financial security can eventually become a financial concern.
Does That Mean You Should Never Buy an IUL or VUL?
No.
That would be just as irresponsible as claiming every IUL or VUL is a great investment.
There are legitimate applications for permanent life insurance.
For the right client, a properly designed policy may serve an important purpose in estate planning, business planning, legacy planning or long-term life insurance protection.
The issue is whether the product is appropriate for the specific objective—and whether the policyowner understands the risks.
Variable life insurance, for example, is intended for people with specific life insurance needs and long-term financial objectives, not simply as a short-term savings vehicle. The SEC specifically recommends understanding the policy’s costs, investment choices, features and risks before purchasing.
The same principle applies to indexed universal life:
Don’t buy the illustration. Buy the contract.
Understand what is guaranteed.
Understand what isn’t.
Understand what happens if performance is lower than illustrated.
And understand how much you may ultimately have to pay to keep the policy in force.
If You Already Own One, Don’t Panic
If you have an IUL or VUL that isn’t performing as expected, don’t simply surrender it.
And don’t let someone convince you to replace it without first understanding what you already own.
Instead, have the policy reviewed.
Ask for a current in-force illustration.
Then ask these questions:
- What is guaranteed under my policy?
- What is based on current or non-guaranteed assumptions?
- How much do I need to pay to keep the policy in force?
- What happens if future interest credits or investment returns are lower?
- What are the current insurance and policy charges?
- How much is outstanding on any policy loan?
- What happens if I continue taking withdrawals?
- What happens if the policy lapses?
- What would happen if I simply stopped paying premiums?
- Is the amount of life insurance still appropriate for my needs?
Those questions can tell you much more than looking at the current cash value on a statement.
Sometimes the Best Policy Review Is the One You Didn’t Know You Needed
We’ve seen people hold onto life insurance policies for years because they assume that if they’re still receiving a statement, everything must be fine.
That’s not necessarily the case.
A policy can look perfectly healthy today while becoming increasingly dependent on future performance.
That’s why reviewing an older universal life policy can be worthwhile—particularly if the policy is approaching 10, 15 or 20 years old, has accumulated a substantial loan, or was originally purchased with the expectation that premiums would eventually decrease or stop.
A review doesn’t automatically mean replacing the policy.
It may mean the best decision is to keep exactly what you have.
- Sometimes the death benefit needs to be adjusted.
- The policy may need additional funding.
- Sometimes there are better alternatives.
- And sometimes the policy is doing exactly what it was designed to do.
The important thing is knowing which situation you’re in.
Don’t Wait Until the Policy Is in Trouble
The worst time to discover a problem with a life insurance policy is when you’re 70 years old, you’ve borrowed heavily against it, and you’re being told that the policy may lapse without additional funding.
By then, your options may be limited.
A policy review while you still have time gives you choices.
At Frost Insurance, we believe life insurance should be understandable—not something you buy once and forget about for the next 20 years.
If you own an indexed universal life, variable universal life or other universal life policy and aren’t sure whether it’s still performing the way you expected, we’d be happy to take a look.
You don’t necessarily need a new policy.
You may simply need a better understanding of the one you already have.
Because the goal of life insurance isn’t to produce the prettiest illustration.
It’s to be there when your family needs it most.