401(k) vs. IUL – The Hidden Cost of Giving Up Growth

By Bill Boersma

Indexed Universal Life (IUL) insurance has become one of the most heavily marketed financial products in America. The sales pitch is appealing: participate in stock market gains without market losses, enjoy tax-deferred accumulation, potentially access policy values tax-free, avoid additional income for IRMAA calculations and leave a tax-free death benefit to heirs.

Those are all legitimate features. The problem is not the features themselves. The problem is what many consumers give up in exchange for them.

The opportunity cost of lower long-term growth potential is often so significant that the tax advantages and insurance benefits do not fully compensate for the foregone appreciation.

The Importance of Growth

Over the past 50 years, the S&P 500 has produced annualized total returns of approximately 11.8%[1].Most retirement investors do not maintain a 100 percent stock allocation throughout their lives. Instead, they gradually become more conservative through age-based asset allocation models, such as target-date funds.

A typical glide path might look like this:

Following is a table with both the 50 year blended portfolio return as well as an average of the 10-, 20-, 30-, 40-and 50-year blended returns of the S&P 500, the Bloomberg US Aggregate Bond Index and three-month Treasury bill rates. The average somewhat mitigates the historically high bond and cash equivalent returns of the 80s and 90s for those interested in seeing the effect.

The remarkable observation is that even an investor in his or her eighties or nineties typically maintains some exposure to equities and therefore is offered some growth potential.

The S&P 500 over this period exclusive of dividends, as with IUL, and with a 0% floor and 10% cap has a return of 6.64%. That is not in an IUL policy and reflects no policy expenses. This 6.64% figure is a hypothetical illustration of a 0% floor/10% cap strategy applied to historical S&P 500 index price returns. This figure is not the return of any actual IUL policy and is for illustrative purposes only.

It’s self evident that a young person in an IUL for retirement planning is likely giving up a tremendous amount of growth potential. The argument is often about avoiding large stock market losses near retirement. Protecting against that is a hallmark of retirement planning and the reason for the differing stock allocation as one gets older, but there is no stock allocation in an IUL. What 30- or 40-year-old was ever advised to steer completely clear of stocks?

The fundamental concept of an IUL sounds a lot better at age 55 or 60, however, there’s a truism regarding life insurance that gets in the way. Almost all life insurance is heavily front end weighted with fees. This isn’t good or bad, just the way it is. Many policies may need a decade for the cash value to equal the cumulative premiums. The result is that funding an IUL starting in middle age typically doesn’t give it enough time to build substantial cash value.

If you’re young you give up too much growth and if you’re older, there isn’t time for growth.

The Reality of IUL Returns

Many IUL illustrations today are shown at rates around 5.5 to 6.5 percent with some around 7.0 with return on premium to cash value lower due to policy expenses and mortality costs.

The result is that an investor may voluntarily exchange a portfolio that has historically earned 7 to 11% percent annually for one expected to earn a few hundred basis points less. The actual return on premium to cash value will be dependent on policy structure, the age and rating at policy issue, the tenure of the policy and the age at analysis.

Whether or not that sounds like much of a difference, compounding turns small differences into enormous ones. A dollar growing at:

• 10 percent becomes approximately $117 after 50 years
• 7 percent becomes approximately $29
• 5 percent becomes approximately $11

The difference is staggering.

It’s also of paramount importance to understand that running an IUL policy at maximum allowable crediting rates, as is often the case, assumes a continued full equities exposure. The AG49 regs that drive the crediting rates are based on 65-year historical S&P 500 returns and the actual cap rate of the product. As we discussed above, that is not typical or reasonable.

Few policy owners understand the static numbers in the projections they sign off on are based on the indefinite continuation of a 100% equities market that has resulted in double-digit returns. If an individual wouldn’t plan on a 100% equities portfolio in their retirement planning, then the return on the IUL policy funding retirement income should also not be based on 100% equites and should be adjusted accordingly.

Additionally, sequencing of returns should be considered. The fact that returns aren’t level in the real world is the driving reason traditional retirement modeling limits the income from a portfolio to less than the expected return. However, many IUL models show income from the policy that does not take this into consideration. A poor sequence of returns could undermine the policy if the high projected income is taken. Too many comparisons show income from a traditional balanced retirement portfolio accounting for a high probability of success in a dynamic return market against projected IUL funded income from a policy with crediting pegged to a 100% securities benchmark assuming a level return year in and year out indefinitely.

But What About the Tax Benefits?

Tax Deferred Accumulation

Advocates of IUL often point to several tax advantages. IUL cash value generally grows income-tax deferred. However, so do:

• Traditional IRAs
• 401(k) plans
• Annuities

Moreover, broad equity index funds held in taxable accounts are often tax efficient and may defer taxes for decades.

Potentially Tax-Free Access

Policy loans can provide access to cash values on a tax-favored basis. This can be valuable. However, investors should ask a simple question:

How much growth potential was sacrificed in order to obtain this feature?

In many cases, the additional appreciation generated by a higher-return portfolio may substantially exceed the taxes ultimately paid.

Keeping more money after tax often matters more than avoiding taxes at all costs.

IRMAA Considerations

Policy loans generally do not increase modified adjusted gross income and therefore do not trigger higher Medicare premiums under the Income-Related Monthly Adjustment Amount (IRMAA) rules.

Again, this is a legitimate planning benefit. But avoiding an additional Medicare surcharge while sacrificing decades of higher growth potential can be a very expensive trade. The objective should not be to avoid every possible tax or surcharge. The objective should be maximizing after-tax wealth. Sometimes paying more taxes is simply the consequence of having substantially more money.

Potential Tax Issues

Life insurance does have unique tax attributes, but they’re not all positive. The often recommended method of accessing retirement income from a life insurance policy is through policy loans. A policy owner may pull basis out of the policy tax free and then switch to taking loans. This is an area that deserves much more attention than it usually receives.

A policy can build up tens of thousands, hundreds of thousands or even million of dollars of policy loans. If the policy lapses, for whatever reason, all of the loans in excess of policy basis are taxed at ordinary income, not capital gains rates. This may be glossed over with explanations of policy management or untested riders, but financial devastation through lapsed policy taxation is not uncommon. Signing up for an insurance-based retirement income program also means signing up for meticulously managing the program until the day you die to minimize the risk of a tax nightmare.

The Death Benefit Argument

Life insurance serves an important purpose. If an individual has a need for income replacement, estate liquidity, business succession planning or wealth transfer, a death benefit can be extremely valuable. But that does not necessarily mean permanent insurance is always the optimal solution.

For many families, the need for insurance is temporary. Children become financially independent. Mortgages are paid off. Retirement assets accumulate. Businesses dissolve. In these situations, term insurance often provides dramatically more death benefit for substantially lower cost.

The difference in premium can then be invested. Buy term and invest the difference is not always the correct answer, but it remains a powerful concept that should not be dismissed.

What If Permanent Insurance Is Important?

Some individuals legitimately need permanent life insurance.

• Large estates
• Special needs planning
• Business succession
• Equalization among heirs
• Charitable planning

In those situations, permanent insurance may be entirely appropriate. However, investors should still carefully consider which type of permanent insurance best aligns with their objectives.

The Case for Variable Life Insurance

Variable universal life (VUL) insurance is not appropriate for everyone and carries investment risk. Unlike IUL, VUL has no floors and sub-account values fluctuate with the underlying investments. However, it offers something many IUL policies struggle to provide: actual equity participation.

The policy owner can maintain meaningful exposure to stocks while still receiving many of the benefits that attract people to life insurance in the first place:

• Tax-deferred accumulation
• Potentially tax-favored access
• Income-tax-free death benefit
• Creditor protection in many states
• Estate planning flexibility

Unlike IUL, VUL does not impose caps that limit participation during strong markets. Over long periods of time, equities have historically rewarded patient investors. A properly designed variable life policy allows policyholders to retain the appreciation potential of equities while simultaneously enjoying the benefits associated with permanent life insurance. The tradeoff is that IUL’s 0% floor protects against negative index returns in a given period, while VUL has no floor.

In many respects, it can provide the features people want from permanent insurance without requiring them to give up nearly as much long-term growth potential. Also, VUL can have the same age-based asset allocation as a 401(k) or many investment portfolios. There are also VUL products with an indexed account option, not sub-account indexes, but indexed account options like an IUL. In other words, a VUL can have an IUL option where an IUL can’t have the VUL option. For the right individual, VUL can offer meaningful equity participation alongside permanent insurance benefits. Though as noted above, not without cost, risk or trade-offs of its own.  

Why Is IUL Recommended So Often?

An uncomfortable question must be asked: If a traditional investment portfolio, even one designed for a 90-year-old investor, has a higher projected return than an IUL policy, based on historical numbers, why are so many agents aggressively promoting IUL as an accumulation vehicle?

The answer is often found in incentives. IUL products generally pay high lump sum commission or over a short period of years. When viewing it against a percentage of assets under management it may look reasonable and may even look better, however, the incentive to sell is there.

That fact alone does not make IUL inappropriate. People deserve to be paid for their work. It’s self evident to many that the large up-front commission drives some behaviors not as prevalent in the fee for service or assets under management models.

The issue arises when compensation influences recommendations and when consumers are not presented with reasonable alternatives.

Many of the most enthusiastic proponents of IUL are insurance-only agents. They do not hold securities licenses and therefore cannot offer:

• Variable universal life insurance
• Investment advisory services
• Brokerage accounts
• Professionally managed investment portfolios

As a practical matter, if all you have is an insurance license, nearly every financial problem begins to look like a fixed interest insurance solution. This can create an inherent conflict.

A consumer may be told that an IUL provides stock market participation without downside, tax-free retirement income and an income-tax-free death benefit. All of those statements may be technically correct.

What is often omitted is equally important:

• The substantial reduction in long-term return potential
• The enormous opportunity cost of giving up decades of equity appreciation.
• The fact that many of the same tax advantages are available through other planning strategies.
• The availability of term insurance for temporary death benefit needs.
• The existence of variable life insurance for those who need permanent insurance but also want meaningful equity participation.

Consumers are frequently shown what an IUL can do without being shown what they are giving up. That omission matters.

Imagine a physician who recommends only the procedures he is licensed to perform while failing to mention other treatments that may be more appropriate. Most people would question whether they were receiving objective advice. The same principle applies here.

When an insurance-only producer recommends an IUL while failing to discuss alternatives that require securities licensing, consumers should at least ask whether they are receiving comprehensive financial advice or simply being sold the only product the agent is permitted to offer.

This does not mean every IUL recommendation is improper. It does mean that consumers should be skeptical of anyone who presents IUL as the universal solution to retirement planning, wealth accumulation and estate planning. Financial products should be selected because they are the best fit for the client’s objectives, not because they produce the largest commission or happen to be the only products on the advisor’s shelf.

The unfortunate reality is that some of the industry’s most enthusiastic IUL advocates are also the least equipped to discuss the full universe of available alternatives. That is not necessarily because they are acting with bad intentions. It is because incentives and licensing limitations shape the advice that consumers receive.

Investors should therefore ask a simple question:

“Is this recommendation being made because it is truly the best strategy for me, or because it is a strategy available to the person sitting across the table?”

Incentives Matter After the Sale

As mentioned earlier, an uncomfortable reality in financial services is that compensation structures influence behavior, not because advisors are necessarily bad people, but because incentives matter.

Consider two different models.

In the first, an advisor is compensated through an ongoing fee based on assets under management. If the client’s assets grow, the advisor’s compensation grows. If the client leaves, the compensation stops. The advisor has an economic incentive to:

• Stay engaged
• Provide ongoing advice
• Be responsive to questions and concerns
• Monitor performance
• Recommend changes when circumstances evolve
• Maintain a long-term relationship

The relationship is not perfect, and fee-based arrangements have their own conflicts, but at least the incentives are generally aligned toward maintaining an ongoing client relationship.

Now consider many commissioned life insurance sales.

The agent may receive a substantial upfront commission in the first year and comparatively little, if any, compensation thereafter. In many cases, the vast majority of compensation is earned the day the policy is placed. After that, there may be little or no economic incentive to continue servicing the relationship.

There is also generally no legal requirement that an insurance agent proactively monitor the policy, update illustrations, evaluate performance or periodically determine whether the strategy remains appropriate. In many jurisdictions, there may not even be a legal duty to contact the client again unless the agent voluntarily undertakes ongoing monitoring responsibilities.

Stated bluntly, some agents are compensated as though they are entering into a lifelong advisory relationship while having no legal obligation to provide one.

The result can be predictable. Policies that require ongoing monitoring frequently receive little or no monitoring. Illustrations that should be updated are not updated. Declining cap rates are ignored. Underperforming policies go unnoticed. Loans become problematic. Premium assumptions prove unrealistic. Clients assume someone is watching the store when, in reality, no one may be.

Furthermore, unlike with investment management, P&C insurance and health insurance, a new agent coming in to help generally does not get any compensation for doing so. Agents picking up an orphaned policy are often looking to establish a relationship for the opportunity at a new sale.

Life insurance must be managed.

Life insurance is not a “set it and forget it” product. It is a dynamic financial instrument whose success often depends upon:

• Future crediting rates
• Cost of insurance charges
• Policy expenses
• Loan management
• Premium adequacy
• Changes in assumptions and policy performance

A product that requires ongoing management but is sold under a compensation structure that heavily rewards the initial sale and minimally rewards long-term service creates an obvious misalignment of incentives.

Many consumers understandably believe they have hired a financial professional who will monitor the policy for years or decades. In reality, they may have purchased a product from someone who has no continuing legal obligation to answer the phone, review the policy or provide additional advice after the commission has been paid.

That does not describe every insurance agent. Many agents provide exceptional long-term service. But from a structural perspective, one should not ignore the obvious difference between:

• A compensation model that rewards ongoing relationships and continued service; and
• A compensation model that pays most of the compensation upfront and imposes little or no continuing duty thereafter

Before purchasing any financial product, particularly one as complex and long-term as IUL, consumers should ask a simple question:

“Who is responsible for monitoring this policy ten, twenty or thirty years from now, and what incentive do they have to do so?”

Final Thoughts

Taxes matter. IRMAA matters. Death benefits matter. Asset protection matters. But growth matters too.

In fact, growth may matter more than anything else because compounding drives nearly every successful long-term financial outcome. Too often, investors focus on the attractive features of IUL without fully appreciating the enormous opportunity cost created by lower potential return.

The question should never be:

“How can I avoid taxes?”

The better question is:

“After considering taxes, insurance needs and investment returns, which strategy leaves me with the most wealth?”

For many investors, the answer may be a combination of traditional investment accounts and term insurance. For others with permanent insurance needs, variable life deserves serious consideration. But before giving up decades of equity appreciation, investors should make certain that the benefits they receive in return are truly worth the cost.

Be aware of why a particular policy may be marketed towards you. Your best interest and the agents aren’t always aligned.

Understand the importance of management. What’s the plan if your agent leaves the business, retires, dies or otherwise leaves the picture?

The bottom line is that this is a big decision and requires more than a sales process. Take your time, ask questions, look for an advisor over a salesperson and don’t hesitate to engage an independent third party.

Bill Boersma is a CLU, AEP and LIC and the founder and owner of OC Consulting Group. More information can be found at www.OC-LIC.com, www.BillBoersmaOnLifeInsurance.info or email at bill@oc-lic.com or call at 616-456-1000.

The opinions expressed in this article are those of the author and should not be construed as specific investment advice.

The examples shown are based on historical market returns and are for informational purposes only. Actual policy performance will vary and may be affected by future cap rates, policy charges and market returns. Past performance is not indicative of future results. Indexes are unmanaged and do not encourage fees. One cannot directly invest in an index. Guarantees are based on the claims-paying ability of the issuing company.

Securities offered through Valmark Securities, Inc. Member FINRA, SIPC. Investment Advisory Services offered through Valmark Advisers, Inc. a SEC Registered Investment Advisor.

OC Consulting Group and its affiliates are separate entities from Valmark Securities, Inc. and Valmark Advisers, Inc.

[1] https://dqydj.com/sp-500-return-calculator/

[2] https://dqydj.com/sp-500-return-calculator/