More About EIUL's
How can EIULs outperform a low-cost index mutual fund? Shouldn’t ‘t I just invest in a mutual fund inside a 401K or an IRA?
One of the common misunderstandings about EIULs is that they invest your funds into a group of stocks that mimic an index. This is wrong. Your money is not invested in the stock market. The insurance company invests in a combination of fixed rate bonds and treasuries to provide the reserves to cover the guarantees on the policies [usually 2-3%]. With the balance they invest in European style options on the index, which pay only if the index goes up. If the index goes down there is no payment and the premium paid remains with the seller of the option. The salient point is that the strategy is completely different than the one followed by index mutual funds and cannot be compared directly. But we can compare the results. And over the last 5-10-15-20-30 year time periods the EIUL index strategy beats the index funds strategy.
I have heard about the many “moving parts” involved in EIULs. What is to keep the insurance companies from changing these to my detriment?
I think that Wall Street interests have perpetuated this fear, because it makes little sense if you understand the products. Mutual funds have all sorts of “moving parts” that never get discussed. Trading costs and the large amounts of cash that must be kept on hand to account for people taking money out of their funds are a couple that come to mind. And if the mutual fund is an index fund they must rebalance to the index every year as some companies fall out of the index while others are included.
But lets talk about the main two moving parts in EIULs. The participation rate is the percentage of participation you are given on an index. Typically this is 100% but it can be more or less. For example, one index that is popular allows for a 140% participation rate with a lower cap rate. These are not fixed percentages by contract. However, in the history of the EIULs I sell, they have never changed from their initial mark. The insurance companies need the flexibility to change these to make sure their reserves are adequate compared to the payouts they are making. The fact is that we just went through a terrible economic time period and participation rates in these products remained the same for the entire industry. Stay with financially sound companies and this should not be an issue.
The second main moving part is cap rates. These are the maximum percentage you can receive during each leg of your index [typically one year]. These do move around as different interest rate environments present themselves. Basically, the insurance companies cover the product guarantees with fixed rate products. When the interest rate environment is low [like it is now], then you need to use more of the premium to cover this. That leaves less for the options and requires the cap rates to be lower. In fact, that has happened in the last couple years. When the interest rate environment goes back up, then cap rate will increase too. Historically that is what happened in these products.
Understand this point about cap rates and you really start to understand how EIULs work and how to analyze them. What really should be paid attention too are the interest rate environment and cap rates as opposed to trying to guess about future index returns.
I tend to think of the “moving parts” as an advantage rather than a disadvantage because it enables the product to maximize its performance at the same time protect the companies from disaster.
I welcome the discussion about expenses from my clients because I can demonstrate exactly what they are and explain how they work. In fact, I consider this an important part of the education process needed before someone gets involved in an EIUL.
I have heard that there are huge expenses involved in life insurance products. Is this true?
There are significant expenses and they are for the most part taken out in the first few years. All financial products have expenses that provide a nice profit for the companies and individuals that sell them. OVERALL expenses are comparable between insurance products and mutual funds. In fact, many of the mutual fund companies, even some known for low expenses, have recently increased the amount of charges to customers because of the amount of people who have withdrawn dollars from their mutual funds. There is a wide range of expenses between individual mutual fund companies as well as insurance companies. It is wise to keep an eye on total expenses in these products. It is not wise to let that one item be the primary reason for choosing a particular product.
In fact, the range of the highest total expenses, as expressed in percentage form, for a properly structured EIUL, should range from around .5% to 1.5% depending upon age at the time of starting the policy and how quickly the policy is fully funded. That is by no means extravagant and is less than the typical mutual fund expense ratio inside of 401Ks.
You can find several mutual fund companies [Vanguard and Fidelity for example] that have indexed mutual funds with expense ratios around .2%. This does give an advantage against other more expensive mutual funds, but the advantage disappears when you compare it to the returns from EIULs, which use a different strategy.
Once again, expenses are taken out largely in the first 10-15 years of an EIUL so this is not a good product for folks with a short time period in mind. In fact, anyone that is not interested in keeping an EIUL long-term should not ever consider it. That is worth repeating, this product is for people who plan on keeping it long-term and would not be a product for folks with a short-term horizon.
Now the good part. Since it is life insurance the total expense ratio is determined by how long you live. Typically, if you die before age 70 then the life insurance would more than cover all the expenses you have incurred. And if you live a long life, into your late 80s and 90s then the expense ratio goes down again. Generally the expense ratio peaks at age 75 and starts going down from there. So for many folks they will have even lower expenses than the .5% to 1.5% that was quoted above.