In October, we passed the 90th anniversary of “Black Tuesday,” the ruinous stock market crash of 1929.
The financial industry has come a long way since then. Human psychology has not. We still worry about market downturns. On the other hand, financial professionals remind us that it should be just as worrisome when our assets earn less than the rate of inflation.
This is how indexed universal life insurance (IUL) is proving its resolve well beyond its primary mission to provide tax-free death benefit protection.[1] It can help protect the assets in the cash value as well.
Consider Cautious Charlie
Charlie is 57 with a wife and two teenage kids and works as a security consultant. He gets paid to prevent bad things from happening to his clients. And he doesn’t want bad things to happen to him, his family or his financial strategy.
Charlie is like so many other careful planners who are cautious about the market’s volatility, especially when losses can hurt his market-based assets earmarked for retirement. That’s why he’s also funding his IUL policy at a high level with the intention of using the cash value to help supplement his retirement income using policy loans and withdrawals, or a life insurance income rider.[2]
Frankly, he just wants to sleep well at night, knowing his financial strategy has his back.
Upside Potential, Downside Protection
It may sound like a fairy tale, but interest crediting potential based in part on a market index with no downside due to market volatility is very real and easily accessible through an IUL policy.
The index crediting options you choose within an IUL policy are credited interest based in part on the movement of their respective indexes. In the end, different factors determine how much interest is credited, and the 0% floor guarantee helps protect the cash value in that index from market losses at all times.[3]
My prior blog post outlined IUL’s key features. Now, let’s dive deeper into several types of crediting options and how they differ yet complement each other. Generally, they’re categorized as follows:
- Major market indexes – These include domestic indexes, like the broadly known S&P 500[4] benchmark, more specialized indexes such as the small-company focused Russell 2000[5], or globally leaning indexes that track, for example, stocks traded on exchanges in other countries. These track the returns of broader, globally diversified benchmarks.[6]
- Proprietary Indexes – Banks and other financial institutions will create their own index strategies to offer to insurers, often exclusively, for IUL products. They can be comprised of carefully selected holdings diversified across asset classes like stocks, bonds, real estate and cash, geography, or all of the above.
- Volatility-Controlled Indexes – These indexes have a primary goal to manage extreme ups and downs. They typically track a hand-picked basket of diverse asset classes, such as stocks, bonds, real estate, commodities, cash and more. They apply proprietary algorithms to seek assets that appear to be less volatile than the market in general. The goal is to limit high volatility and seek a smoother ride.[7] Remember Cautious Charlie? This crediting option is generally designed to address market skittishness like his.
- Cap Focus Strategy – Caps are simply the stated maximum interest that will be credited no matter how high the index goes. A Cap Focus Strategy may either have no cap or a much higher cap vs. other options, and will typically also provide a guaranteed minimum cap. This strategy is generally geared to those who are bullish on the index.
- Participation Focus Strategy – Participation Rates determine the max percentage the strategy will share in the positive changes of its index. So, if the S&P rises 10%, a 60% participation rate for an S&P indexed option would limit the credit to 6%. This option generally appeals to those with a moderate index outlook.
- Higher Minimum Floor Strategy – Most crediting strategies come with a built-in 0% floor guarantee, no matter how low the market goes. However, for a little less upside potential, some IUL products offer higher floor guarantees, such 1%, for even more guaranteed interest crediting.
- Fixed Term Strategy – This option earns a specific rate of interest that the insurer declares, credited daily, and guaranteed for one year. You’re not getting the benefit of the interest crediting potential based on indexing, but it’s another option to add a more conservative wedge to your overall crediting strategy.
Segment-by-Segment
When you choose a crediting strategy, your index credits don’t go to the policy’s entire cash value. Rather, they are applied to individual indexed segments.
Each segment is created when premiums (after policy expenses) are swept into your selected index.[8] A common time-period for a segment is about 12 months, at which point the insurer compares the value of the index at the beginning to the ending date of the segment (typically called a point-to-point strategy).
This is a key point, because over the years your policy can experience and benefit from a lot of segments, each getting its own credit amount. The process helps spread out interest crediting over different cycles that an index might experience.[9]
Which Index Strategy is Best?
I can’t go there. It’s up to you and your financial professional. It depends on your objectives and tolerance for risk and your market outlook, to start with. Because no one can predict how the markets and indexes will perform, understanding how different strategies work can help you decide which ones to choose at any given time. But just having options really lets you potentially benefit from different approaches, asset classes, geographies and market conditions over time.
Indexed universal life insurance policies do not directly participate in any stock or equity investments.
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[1] Internal Revenue Code § 101(a)(1). There are some exceptions to this rule. Please consult a qualified tax professional for advice concerning your individual situation.
[2] The use of cash value life insurance to provide a tax-free resource for retirement assumes that there is first a need for the death benefit protection. The ability of a life insurance contract to accumulate sufficient cash value to help meet accumulation goals will be dependent upon the amount of extra premium paid into the policy, and the performance of the policy, and is not guaranteed. Policy loans and withdrawals reduce the policy’s cash value and death benefit and may result in a taxable event. Withdrawals up to the basis paid into the contract and loans thereafter will not create an immediate taxable event, but substantial tax ramifications could result upon contract lapse or surrender. Surrender charges may reduce the policy’s cash value in early years.
[3] The 0% or 1% “floor” provided by an indexed universal life insurance policy ensures that during crediting periods where the index is negative, that no less than 0% or 1% interest is credited to the index strategy. However, monthly deductions continue to be taken from the account value, including a monthly policy fee, monthly expense charge, cost of insurance charge, and applicable rider charges, regardless of interest crediting.
[4] “Standard & Poor’s®”, “S&P® ”, “S&P 500® ”, and “Standard & Poor’s 500™” are trademarks of Standard & Poor’s and have been licensed for use by National Life Insurance Company and Life Insurance Company of the Southwest. This Product is not sponsored, endorsed, sold or promoted by Standard & Poor’s and Standard & Poor’s makes no representations regarding the advisability of investing in the Product. The S&P Composite Index of 500 stocks (S&P 500®) is a group of unmanaged securities widely regarded by investors to be representative of large-company stocks in general. An investment cannot be made directly into an index.
[5] The Russell 2000 Index is a trademark of Russell Investment Group and has been licensed for use by Life Insurance Company of the Southwest. The Products are not sponsored, endorsed, sold or promoted by Russell Investment Group and Russell Investment Group makes no representation regarding the advisability of purchasing the Products.
[6] Indexes based on international securities are subject to political influences, currency fluctuations and economic cycles that are unrelated to those affecting the domestic financial markets and may experience wider price fluctuations.
[7] There is no guarantee that index objectives will be met. An Index with volatility control may experience positive Index value change less than that of similar indices that do not include volatility control. This may result in less interest that will be credited. When included in a fixed indexed life insurance policy with the protection of a 0% or 1% floor, the benefit of reduced downside will not be realized for index returns below 0% or 1%.[8] Occurs after 12 months of policy expenses are held separately in a fixed account.
[9] This helps reduce interest rate risk associated with one annual crediting anniversary, but it does not, however, guarantee an advantage over an annual crediting method.