The Top 10 Reasons NOT to BUY Equity Indexed Universal Life

By Todd Langford, www.truthconcepts.com Mt. Enterprise,Texas

Insurance companies have put numerous pages on the front of Equity Indexed Universal Life (EIUL) illustrations that describe the issues below, but most people (by design) will not take the time to read and understand what these pages are saying.  I would encourage you to read those pages thoroughly before depending on an EIUL policy to increase your assets or protect your family.  Similarly, Universal Life (UL) and its cousin Variable Universal Life (VUL) have some of the same problems so I’ve spelled out the issues below and placed an * next to the ones that are specific only to EIUL.  As stated earlier, all Universal Life policies are a side fund (money market for regular UL, mutual fund-like separate accounts for VUL, and index fund-like accounts for EIUL) plus annually renewable, or one year increasing premium term insurance for the death benefit.

#10  Internal costs are not guaranteed

#9    Mortality charges are not guaranteed

#8    Market drops cause double pain

#7    Late premiums kill any guarantees

#6    Dividends from the index don’t get credited*

#5    Participation ratios are often less than 100%*

#4    Returns are usually capped at various interest rates*

#3    Guarantees are not calculated annually*

#2    All of the above can be changed by the company

#1    The risk is shifted back to the insured

Now, let’s look at each of these individually and tell the whole truth about the matter.

10.  Internal administration fees charged against cash value on any type of Universal Life policy and shown on illustrations are run under current expense levels but those can change at the discretion of the company.  Since the insurance company uses this money to run its operations, as prices of office supplies and real estate go up, they may choose to adjust these internal costs after you have bought the policy.

9.  Mortality changes, what the insurance company charges for the death benefit are removed from the cash value or paid by premiums.  In UL, these pay for annually increasing term insurance costs.  This is true for any type of UL, no matter what the side fund is invested in.  The cost for this one year term insurance can be changed at any time.

8. Market drops affect the side fund negatively no matter what the side fund is invested in.  Since the death benefit is comprised of the One Year (or annually increasing) Term Insurance plus the side fund, any market drop causes double pain.  Markets can drop regardless of whether they are supported by stocks or money markets.  When the side fund is reduced by a drop in the market or current interest rates, it now has less value so more Term Insurance must be bought to make up the difference which further reduces the side fund.  Consequently you have double pain; less cash value and higher costs.

7.  Any late premiums remove any guarantees in the policy.  In most UL policies, even if the premium is finally paid, once it is late, the insurance company is off the hook for supporting any guaranteed premiums, cash value amounts or death benefits.  In many cases, the insured may not even know that a premium was late and that the guarantees have been forfeited.  Thinking about the time frame of a 50 year policy paid monthly (600 payments) ask yourself what the likelihood is of a mistake being made by the premium payer, their bank, the post office, the insurance company clerks or anyone else along the way?

 6. *  Equity Indexed Universal Life policies provide the policy holder no credit for any dividends from the stocks making up the index.  The side fund of an EIUL isn’t actually invested in the index; instead the index is used to determine the gross crediting rate for the side fund.  If money were actually invested in the index, the investor would get both the change in Net Asset Value (whether up or down) AND the dividend income.  However, in the case of EIUL, only the change in value of the index is the determining factor and the dividend is left out of the calculation entirely.

5. *  Participation ratios are often less than 100%.  As mentioned directly above, the side fund is not invested directly in the index and many insurance companies only credit a certain percentage of the increase in the market.  Known as the participation ratio, this is often reported at 80% or less meaning you are getting only 80% of the increase in the market.

4. *  Capping returns in order to keep high returns in the market from crediting too much to the side fund is a strategy many insurance companies use.  The maximum return they’ll give credit for may be at a certain percentage rate even though the index may have generated a higher percentage rate.

3. *  Guaranteed minimum returns are not always calculated annually.  Most EIUL policies have a guaranteed minimum return so that if the index drops below this rate, the insurance company will still credit at the guaranteed minimum rate.  However, with some policies this guarantee is not applied annually but instead over an “indexing period” which could be 5-10 years.  So you could have negative years in the index (below the guaranteed minimum rate) which would be applied to the side fund.  This would cause a further reduction of value in excess of the guaranteed minimum rate in one particular year and as long as the overall average rate for the entire indexing period is not less than the guaranteed minimum rate, this would still count as meeting the minimum.

 For example, if the minimum guaranteed rate is 2% inside a 5 year indexing period, you could have crediting rates of +13, -10, +10, -8 and +9% which would validate the promised guarantee because it would average more than 2% per year over the 5 years.  The implication is that you cannot have a negative return, but as shown in the example below, you can have a negative return as long the guarantee is not calculated annually.

You’ll notice another example below of the same interest rates, but with $100,000 of existing value instead of $10,000 per year of cash flow into the account.

 2. At the discretion of the company any of the above factors can be changed at any time for the benefit of the company even after the policy has started.  This is really one of the scariest aspects of all types of UL.  There is no way to calculate what the outcome might be.  Even if you analyzed the policy under the current structure and found it to be a viable tool, future changes could cause future problems.

 1. Where as typically the point of all insurance purchased is to shift the risk from the insured to the company, all types of UL shift the risk backwards or from the insurance company to the insured.

 With a mutual life insurance company, a whole life policy gives you a share of the entire profits of the company via dividends.  The carrot being sold with EIUL is that it might exceed the return of a whole life policy.  Yet this begs the question: How could the insurance company pay out more than the profits of the company and still be in business?

 It has been explained to me that the insurance company buys options in the market to cover the risk of potentially having to credit any portion of high market returns in the index that exceeded their general portfolio rate to policy holder cash values.  If this was a sound investment strategy, why wouldn’t the insurance company use this strategy on their overall portfolio?  I think the insurance company knows that the stock market is going to under perform their portfolio rate over time.  This could reduce EIUL profits and increase the profits of the company, which then get distributed as dividends to whole life policy owners.

 As a whole life policy owner,  I should be pleased that EIUL could contribute additional profits to the company which might increase dividends to Whole Life, my concern is that EIUL policies are going to create a detrimental effect on the life insurance industry as a whole.  I believe this may be the next major blight on the industry since under funded Universal Life (UL) so heavily promoted in the 1980’s.  The unfortunate outcome is that any negative media affects the entire industry because the media doesn’t differentiate between the new faulty products and the old tried and true whole life products that have been around for close to 200 years. As we know, the biggest danger with negative press is that is causes panic and the people will think the entire life insurance industry is bad and many perfectly structured whole life policies could get cancelled to the detriment of the policy holder and their family, just like what happened in the 1980’s.

 Remember #2 above, since the insurance company has the ability to change #10- 3, they can always keep the Universal Life policies from outperforming their portfolio.  Why would I want to take the safe portion of my assets and the protection of my family and expose it to risk?  Doesn’t that defeat the whole purpose of insurance?  In my mind, I buy insurance and shift the risk to the insurance company, because they are experts at mitigating that risk and storing the cash to support it.

 If you are seriously considering purchasing an EIUL product, please make sure you read and understand all the risks you and your family are assuming.  Because of the complexity and numerous moving parts for this product, many of the people selling it that I’ve spoken with don’t even understand it themselves.  For me, I prefer a number of simple, guaranteed, tried and true whole life policies.  These protect my Human Life Value and store my cash in the most efficient manner I know.

Using the Loan Analysis Calculator we can see that when the savings rate and loan rate are the same, the gross costs of each mortgage are identical to each other when properly measured over the same time frame.  However, when the mortgage interest deduction is taken into account, the longer mortgage has less cost.

In order to show the difference in the accounts when the same cash flows are applied, simply click the radio button next to payment on the longer mortgage, and put in the same payment required for the shorter mortgage.

This is going to assume that the earnings on the difference in the payments, is going to be the savings rate so keep that at a Life Insurance IRR number.  To get a more accurate analysis, run a life insurance illustration which does not include the additional payment and then run one, with the additional payment as a PUA, to see how much money would be available in the future to pay off the mortgage early.  Also, you will have the difference in the tax deductions to add to PUA’s as well.

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The Total Internal Rate of Return is based on the cash value (and we also have one based on the death benefit) and it starts very low and increases over time.  It usually shows a negative 100% first year because we have zero cash value in the first year but the IRR appreciates and increases over time. It is however, weighed down by the early years as IRR is a “cumulative” column as opposed to an annual column.

Annual Rate of Return on Cash Value calculates the ROR on the cash value for every year without carrying the baggage from previous years. Whereas the IRR calculation has all the previous negative years that are weighing it down. The annual ROR on Cash value looks at each year separately, so you’ll see a positive annual return on cash value earlier, typically around the 3^rd or 4^th year, sometimes a bit later.

Investopedia explains Compound Interest as “The more frequently interest is added to the principal, the faster the principal grows and the higher the compound interest will be. The frequency at which the interest is compounded is established at the initial stages of securing the loan.”

Investopedia explains Simple Interest by saying “Simple interest is called simple because it ignores the effects of compounding. The interest charge is always based on the original principal, so interest on interest is not included. This method may be used to find interest charge for short-term loans, where ignoring compounding is less of an issue.”

If your payment frequency is less than your compounding frequency then compound interest occurs between payments.  So if you are paying monthly but your financial institution (bank or insurance company) computes their interest daily, as most do, then compounding occurs between your monthly payments every single day.

Most bank loans charge compound interest because the interest frequency is daily (compounded on a daily basis) and payment frequency is monthly, therefore there is interest charged on interest daily as it accrues throughout the month.  Then the monthly payment wipes out the accrued interest and some principal, and the process starts all over again.

In the same fashion, a life insurance loan is most often compounded daily and the payments are made either monthly or annually so it too is a “compound interest loan”.  

For example, if a companies APR is 5.5%, the daily rate (because they compound daily, like most banks) is .014669%  (or .00014669).  If you multiply .00014669 times 365 (days in a year) it equals .05354185 or 5.35%.    So why is the sum of the daily rates (5.35%) less than the stated annual rate of 5.5%?  The answer is that 5.5% is the actual APR (just like at a bank) and takes into account the daily compounding that has occurred.

By the same token, many people discuss credit card that charges 1.5% per month as if it were an 18% annual rate.  However, in reality, 1.5% per month is actually 19.56% per year as shown below.

To say a loan with a life insurance company is simple interest and not compound interest is entirely false.  If it were true, you wouldn’t get credit back (at interest) for making loan payments between anniversary dates.

The Whole Truth

An issue that is often incorrectly talked about as an advantage, is the idea that the insurance company charges a lower interest when interest is paid up front (in advance) versus at the end (in arrears).  The whole truth is that there is a different factor (not a different interest rate) used to calculate the amount of up front interest that has to be paid.  This factor can be calculated by reducing the Annual Interest Rate by the Annual Interest Rate.  Yes you read that right!

The calculation looks like this.  In order to figure out the factor used to calculate the amount of interest to pay in advance, you need to use a Present Value Calculator.  Assuming the insurance company states they have a 5.5% loan interest rate, then as shown in the example below, you put 1.00 as Future Value, no payment, 5.5% as the Interest Rate and 1 year.  This equals .947867298578199. 

When we subtract that .947867298578199 from 1, we get .052132702 so now we know what the beginning of year factor is.  It is 5.2133% (rounded).

You can see why people looking at these 2 numbers (5.5 v. 5.21) think that the rate of interest charged is less when paid up front.  In reality the annualized rate is 5.5% (the end of year rate) regardless of whether the interest is paid up front or in arrears.

The factor (5.21%) shouldn’t be confused with an interest rate as its only a factor used to determine how much interest to pay when paying up front.  It is true that the amount of interest you pay when paying up front is less than the amount of interest you pay when paying at the end of the year, but the reason for that is simply the fact that you didn’t borrow as much money.

For example:  if you have a loan of $10,000 at 5.5% APR and you pay the loan at the end of the year, you’ll have to pay back $10,550.  If you pay the up front interest of $521.33 (10,000 * .052133) then it means that you’ve only borrowed $9,478.67.  When you multiply that $9478.67 by 1.055 (1 + 5.5%, our APR in arrears) it equals $10,000 which means you paid 5.5% on the amount you actually borrowed.  Insurance companies bill for their interest up front so they make sure they get the interest.

Another way to look at this is $9478.67 (the amount we actually borrowed) multiplied by 5.5% (interest rate charged in arrears) = 521.33 (the interest charged) and when you add 521.33 to 9478.67 it equals $10,000 so in summary, it is true that you pay less interest when you pay up front because you’ve borrowed less, not because the rate is lower.  The rate is exactly the same in both scenarios.

Life insurance companies charge interest when we borrow their money just like banks and credit unions and other financial institutions do.  Many statements are made in the market place about how we borrow our cash value.  This is incorrect.

The whole truth is we borrow against our cash value, or to be more specific we borrow the insurance companies’ money and use our cash value as collateral.  They charge us interest for this privilege because we have now removed money from the pool of capital they have to invest. 

This is a good deal for everyone because the insurance company earns money, the owner of the policy gets use of the money while at the same time their cash value keeps growing and all the other policy holders know the insurance company is investing their money properly since the interest charged is reflective of the rates in the market place.

One might question the “market place” rate.  Some companies charge a fixed rate, some charge a variable.   Some have both available due to direct recognition.

Generally, with a direct recognition contract, the collateralized cash value has a dividend rate that is a certain number of basis points lower than the interest charged on the loan. So if the current-gross-dividend-crediting rate is less than the gross-direct-recognition-crediting rate, then the collateralized cash value is affected positively. If the current-gross-dividend-crediting rate is greater than the direct-recognition-crediting rate, then collateralized cash value is affected negatively. 

For example, let’s say the current-gross-dividend-crediting rate is 6.5 percent, and the loan rate is 8 percent with all loaned cash value getting a “100 basis point” (1 percent) reduction from the loan rate (bringing it down to 7 percent). That being the case, since 7 percent is obviously greater than 6.5 percent, borrowing against your cash value actually improves your situation because your gross-dividend-crediting rate will be at 7 percent for the borrowed cash value and 6.5 percent for the non-borrowed cash value.

After all the analysis we’ve done on many companies and policies, we’ve found either way works just fine. Maybe consider having both!

This interest does not add to your cost basis or directly increase the policy’s cash value that is being collateralized.  However, the earning of the life insurance company (both from their investments in the market place as well as their investments in policy loans) are what they use to pay dividends to all policy holders.

If you choose to pay at a rate higher than what the insurance company charges, then this higher amount (the difference between what they charge and what you pay) can go to your existing policy in the form of a Paid Up Addition (PUA) which would increase basis, or to a new policy as premium so either way that can go to build your cash value.

As a reminder, PUA money goes 95% or so to cash value with only 5% or so increasing death benefit. This drastically raises the amount  available to you for use in future years and is the most efficient place to store cash.