The costs of indexed universal life (IUL) is a barrier for most people. And why wouldn’t it be? As a consumer, you should always be looking for the most amount of benefit for the least amount of cost. The problem with this analogy that IUL is expensive is because judgment is quickly made in the early years without ever considering the product’s overall lifespan.
In this episode of Money Script Monday, Kevin addresses the upfront costs incurred in the early years of an indexed universal life contract and determines if the benefits outweigh the costs.
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Hey, there. My name is Kevin Nuber. Thank you for attending today's Money Script Money video.
Today, what I want to talk about is why the charges in an IUL contract can look like they're so high in that very first year.
All of us as consumers have been conditioned in a very specific way about how to look at price.
If we go to the grocery store, go to a shelf, and we have something in mind that we want to buy, and two virtually identical products are next to each other, we're always going to buy the cheapest thing that we find, the cheaper of the two.
We're never going to pay more for something that we want.
We take this idea and we do that with everything that we purchase. But, slowly things are starting to change.
For example, today if I were to go buy a car, I can have an option of buying a regular car for let's say $30,000, or I can buy an electric car for $35,000.
Today, on the day that I purchased that car, clearly, the gasoline vehicle is going to be the cheaper of the two.
But if I look at the total cost of ownership over a long period of time, including the fact that I don't have to pay for gas with an electric car, or the tax incentives that are associated with that purchase, the cost of ownership for me over that period of time is going to be substantially less if I look at it over a longer time horizon.
This is exactly true when it comes to decisions that you make on where to put your money for retirement and for the future.
We can't just look at the cost the day that that thing is purchased. We need to look at it over your entire lifetime.
IUL Five Story Building
To explain how the cost of an IUL works, I use something called A Five Story Apartment Building.
This is a completely hypothetical story and I'm going to talk about an investment that does not exist.
Let's pretend for a second that there is an investment out there in this world that is an apartment building that happens to be exactly five stories.
And this apartment building is unique because when I put money into it, it grows completely tax-free.
When I take money out in the form of income, it's completely tax-free, and when I die it transfers to my beneficiaries completely tax-free.
Now, if these apartment buildings were real, everybody would be buying these five story, tax-free apartment buildings.
However, the federal government is in the business of collecting federal income tax, right? So, they can't possibly allow such a thing to exist unrestricted.
However, having apartment buildings and units for rent provides a good, useful, social service, and so at the same time the government needs to actually help promote it.
They say, "Okay, wait a second. We'll allow this five-story apartment building to exist. However, we're going to make an artificial barrier to entry, a cost to purchase that makes it a little bit harder in order to actually purchase this."
The way that this apartment building would exist per the government would be to say, "Okay. You can buy this apartment building, but you have to pay a mortgage on the entire apartment building. However, in the first year that you own it, you can only fill the first floor with actual tenants that are paying rent."
In this situation, the rent income that you're having come in is not going to be enough to cover the mortgage on the entire building.
It's in this year, the year that you own it, you're not making very much money at all.
However, in the second year when you fill that second floor, now the rental income is starting to be a little bit more, but you're still not profitable.
In the third year, you start to break even.
In the fourth and the fifth year, now all that excess money you have coming in the form of rental income is completely tax-free and this is a very, very profitable investment.
This is exactly how an indexed universal life contract works.
You see, the money put in as tax-deferred when it grows, it's tax-free when you take the money out.
And when you die, your named beneficiary receives the entire death benefit completely tax-free.
The IRS recognizes that your life insurance provides a very useful social service and so they need for this to actually exist.
But they're going to create a barrier to entry that does not allow you to put all of your money into it all up front.
It can be very much like this apartment building.
In the first year, you can only fill up. You would only pay one premium into the policy and in that year, the cost of insurance coming out is going to be much more than the amount of interest that you're going to be earning in it.
However, as you start paying the premium, you'll start to break even around year three.
And by year five, it's a very profitable place to put your money because the expense in the form of the mortgage on your IUL is going to be very low.
The income you're going to be having coming in in the form of tax-free interest is going to be very high.
Now, when you go and you look in this very first year, this is the place that most people look at when they try to compare the cost of an IUL.
So, let's say you have two places that you can put your money and you put them side by side.
All we are doing is just like when we went to the grocery store we have two items on the shelf and we look at the price.
If we were to look at just the price, then an IUL is most of the time going to be the most expensive place that you can put your money in the very first year.
And this example kind of illustrates this, but what I want to show you is we need to look over a longer period of time.
IUL Policy Bucket
This is a drawing of a bucket, and in this bucket this is how we explain, or we conceptualize an indexed universal life policy.
This bucket has enough room to put $125,000 into it of a premium.
This bucket has a spigot that comes out of the bottom of the bucket, and out of that drains the cost of insurance charge.
This spigot is the same size no matter how much premium you put into the policy.
And just like the apartment building, in the first year, we can only put one fifth of that premium $25,000 into this policy.
In that first year, the cost coming out is going to be 19% of the total amount of premium to be paid in.
That is perceived as being very high and if we looked at just this year, we would have to conclude that an IUL is an expensive place to put your money.
However, this is myopic, and we need to look at it over a longer period of time.
As we pay the premium in in year two, in year three, year four, year five, you can see that the expense is relative to the amount of money that you have inside this bucket goes down and down and down.
By year five, the expenses are only 2.4% and we can easily earn anywhere from 10% to 15% inside one of these policies.
The mortgage that you have in the form of expenses coming out is going to be much smaller than the amount of rental income that you have coming in in the form of interest credits inside your contract.
And now it's a completely profitable transaction and everything is completely tax-free, but this isn't where the analysis should stop because an IUL is not a five-year plan.
It's a lifetime plan.
IUL Expenses Over Time
We need to look at it over a 10, over a 20, over a 30-year period, and the numbers look much more impressive at this point.
If we look at the cost of an IUL in year 10, in year 20, in year 30, these expenses start going down rapidly.
In year 10, the expenses are only 1.8% in the spigot cost, the insurance cost relative to the amount of premium that you have inside the policy.
And in year 20, in year 30, it bottoms out at half a percent.
If we look at it, the cumulative cost over this period of time, it's going to be much lower than many of the places that you could currently be putting your money.
So, what I'm saying is that when you are making a decision on where to put money, that we need to look at it not just on the day that you purchase it, we need to look at it the way that we look at an electric car, for example.
We need to look at the total cost over the entire life that you're going to own it.
And when we calculate the costs that are associated with an IUL over a lifetime, you're going to find that it's going to be much, much cheaper than some of the other places that you can choose to put your money.
Thank you for watching today's video. Thank you very much.