IUL and Leverage - Staying Out of Trouble

One of the best features of Indexed Universal Life Insurance (IUL) is the chance to achieve leverage that may enhance growth. If you buy the right policy, you may be able to borrow against its cash value without disrupting the performance of the index strategy in place at the time. These are known as participating loans (a/k/a index loans or variable loans). If that particular bucket of money grows faster than the interest on the loan that it secures, then you enhance your growth. For example, if the index returns 8% growth in that period and you are borrowing at 6%, you enhance your growth via leverage (sometimes referred to as arbitrage) by roughly 2%. The following video we found gives a good explanation, although it doesn't mention ongoing policy expense charges: (See 6-minute video.)

It is possible to borrow and then put the loan proceeds back into the policy as additional premium. This is called hyperfunding. A variation is to keep paying in premiums at the same time as you loan money to send a child to college or to fund your own retirement. This process may work, so long as the index buckets grow faster than the loan.

But index performance will always vary. There will be years when the underlying index, such as the Dow Jones Industrial Average, is flat or loses value. The policy owner does not incur an investment loss in IUL thanks to hedging. However, the loan interest on any existing loan, the ongoing Cost of Insurance, plus other expense charges will continue each and every year.

The good news is that over the past 120 years, the Dow (which is representative of the broad market) has only fallen more than twice in a row on five occasions - from 1902 to 1904, 1913 to 1915, 1930 to 1932, 1940 to 1942, and 2001 to 2003. On the other hand, the Dow increased 12 years in a row from 1989 to 2000,  8 years in a row from 1922 to 1929, and 7 years in a row from 1950 to 1956.  The Dow has never fallen 4 years in a row since they have been keeping records in 1896. Furthermore,  each of those five occasions when there were three straight annual decreases in the broad market, there followed a dramatic increase in the index in the fourth year.  In 1905, the Dow was up nearly 47%; 28% in 1916; 31% in 1933; 26% in 1943; and 14.53% in 2004. (These "snap-back" years are a good argument in favor of using an uncapped index strategy in your policy.)

So, for those people using leverage in their IUL policies, let's take a look at how much cushion is reasonable to get us through those down times. Say, a person is 75 years old and has a policy that is currently supplying him with leveraged retirement income of  $152,430 per year via participating loans. Regardless of how he got to this point, in our hypothetical he now has $3,120,671 of gross cash value with a $2,496,583 participating loan. This represents an 80% loan to value ratio.

• At this point, the policy has the minimum ratio allowable for death benefit to cash value using the Guideline Premium Test.
• He is still hyperfunding the maximum allowable annual premium of $26,259.
• On top of the annual loans he is making to fund ongoing premiums, he is also borrowing the $152,430 per year for retirement.
• There now begin three straight years where the current equity index strategy would produce no index credits to his cash value.

In our example, he has $624,088 of surplus cash with which to pay ongoing expenses. If the loan rate is 6%, then he spends .06 X $2,496,583 = $149,795 on interest this year. In the same year, he also is charged $2,578 for Cost of Insurance and $1,816 for other policy expenses. Since he is hyperfunding, he adds to the existing loan by $26,259, which pays in an additional $26,259 in premium, and which in turn adds nearly that much to the policy cash value despite the absence that year of any investment return. All of this is in addition to the ongoing practice of taking $152,430 per year in new loans for retirement.

It is easy to see that, if this pattern continues for three consecutive years, despite some growth in the cash value due to premium payments, the total loan will overtake the total cash value and risk a policy lapse. If a policy lapses, in addition to losing coverage and a stream of income, the policy owner also risks potentially severe tax consequences. While some carriers offer over-loan protection riders, they usually are draconian in nature and are not available until a certain attained age or policy duration.

So, what's a person to do? Obviously one can avoid hyperfunding altogether, or limit borrowing to a lower loan to value ratio. However, always doing so in order to protect against an extreme set of circumstances would serve to miss out on a great deal of potential policy performance.

Instead, one could begin to take remedial actions after the first year or so of zero returns. These steps may include:

Reduction or elimination of any premium to be hyperfunded in a given year;
Reduction or elimination of any planned net distribution from the policy in a given year;
An infusion of cash into the policy, which may be in the form of cash premium or loan reduction.

In order to mitigate the need to do any or all of the three actions above, here are some general guidelines for success: 

• Purchase a policy from a carrier that offers a decent uncapped strategy in order to take advantage of the dramatic "snap back" years, which nearly always seem to follow three straight down years. One of our favorite carriers offers an uncapped one-year bucket period having a 1% minimum return, along with crediting everything above 6%. Thus, if the index loses value, or gains anything up to 6%, you still get a 1% credit. If the index gains, say, 30%, you get a credit of 24%.
• Pay into the policy on a monthly basis, or use the carrier's "dollar cost averaging" capability in order to spread out the impact of market swings on plan performance. This way, every month there is a chance of completing a positive bucket performance, which helps to pay policy costs plus distributions. In addition, if the carrier has index strategies with buckets of differing duration, diversifying your strategies can also increase your odds of avoiding zero gains for an extended period of time.
• After, say, 18 months of consecutive zero returns, consider moving maturing buckets into the policy's Fixed Strategy. This will at least assure getting positive returns while waiting for the market to come back. Even in today's low-interest environment, many carriers are paying at least 4% on funds placed in their Fixed Strategies (one carrier currently pays 4.4%). This way, one should never experience more than one year of absolutely zero returns.
• Make sure that your advisor is using realistic assumptions in recommending the degree of leverage to be used, and the size of distributions for you to take. Most carriers limit illustrations to an index return rate that does not fall below a 50-50 chance of success, based on hypothetical historical performance of that strategy. A few carriers will only illustrate returns that are based on a minimum of an 80% probability of success. Applications exist that can demonstrate such probabilities based on a large number of instances over a long period of time. Basing your borrowing pattern on return rates that reflect the better chance of success is another way to stay out of trouble.
• Lastly, one may always want to keep separate funds to live on during those times when he may need to curtail his distributions from IUL.