Joe Allaria

This is a great question. In fact, because of how complex indexed universal life policies can be, I've even heard this question asked by other advisors. If I may, I'd like to give my true and honest assessment of indexed universal life policies.

Indexed Universal life (IULs) are a type of universal life policy. The universal portion means that premiums are flexible and the components of the life insurance policy (death benefit, savings element and premium) can be altered throughout the contract. Universal policies are also permanent insurance policies, like a whole life policy, although there are some major differences between universal life and whole life. One difference lies in the flexibility of universal life and the inflexibility of whole life.

Within universal life policies, there is a cash component as well as an insurance component. It is the cash component that makes IULs differ from VULs (Variable Universal life) and ULs (Universal life). The cash bucket inside of a indexed universal life policy grows as a result of index performance (and the indexes are usually selected by the client or advisor each year). The indexes will usually reflect broad market indexes like the S&P 500, DJIA, etc. This all seems pretty simple.

HOWEVER, the complex part kicks in when you start to study how the "interest" or "cash growth" is calculated on these policies. To truly understand this will require you to either spend ample time studying the policy you are considering purchasing inside and out or have an enormous amount of trust in the person recommending it. However, even if you trust your advisor, I would advise you to do the studying yourself. The reason is that these products all work differently and even advisors with the best intentions can overlook how these work. Let me provide some examples of what I'm talking about.

Let's say you select the S&P 500 index for your cash bucket. Your advisor tells you that you can experience the upside of the S&P 500 without any downside. That kind of sounds too good to be true. Well, it is. That's because these indexes will either have a cap on the upside earnings or a participation rate. A cap is straight forward. The S&P 500 index may have a cap of 4%. So your max upside is not what the S&P earns, it's 4%, and the downside is still 0%. If you have a participation rate instead of a cap, and the participation rate is 50%, you will earn 1/2 of what the S&P 500 gets. So, if the S&P earns 8%, you get 4%, with a downside of 0%.

Another point to consider is that the S&P 500, as used in our example, also derives some of its total return from dividend yield. So, if the S&P appreciates 4% and has a 2% dividend yield, then the total return will be 6% - BUT, this is likely not the case in an IUL since dividends are typically not part of the growth calculation.

If you study these products further, you'll also notice the phrase "point to point." This refers to the time frame that an index is evaluated. For example, staying with our S&P 500 index, let's assume you've selected the S&P 500 Annual point to point. This means that in order to calculate the interest earned, the life insurance company will evaluate the price of the S&P 500 on the day the policy becomes in force and will not apply interest until the index is re-evaluated one year later. If the index is higher, you'll get credited interest. If not, you won't. If it was higher a day before but took a brief momentary dip, you won't see any interest credited for another whole year, which negates the benefits of compound interest.

Since this has turned into a long-winded response already, let me just say these final thoughts:

1. Understand how the indexes work. Ask a lot of questions. Ask if you can choose your issue date. Know your best and worst case scenario.

2. Make sure that the illustrations that are shown to you reflect a realistic rate of return. If you the illustrations you are looking at assume a 7% annual rate of return, you need to ask them to re-run at something more conservative. Is it possible to get 7% on average over a long period of time? Yes. BUT, that is without caps and participation rates involved. To be safe and to make sure your policy does not lapse, I would suggest projecting a more conservative return (like 4%).

3. Explore other alternatives to IULs. GUL (Guaranteed Universal Life) policies, for example, are incredibly straight forward and are backed by a guarantee from the insurance company. That leaves little room for misunderstandings or misleading life insurance illustrations. UL policies are also easier to understand in my opinion. This doesn't mean GULs and ULs are better the IULs, but it means if you're unfamiliar with how IULs work, you should either do your homework or consider choosing a different policy type.

Good luck,

Joe Allaria, CFP®

Thanks for the question. Here are a few things to consider.

Advantages:

1. Instant diversification: A mutual fund will provide you with a "basket of stocks" that will provide diversification in your portfolio.
2. Effective for smaller accounts: Since a mutual fund provides exposure to hundreds or thousands of stocks, you don't need to go out and buy hundreds or thousands of stocks on your own, which could be very prohibitive for you if you have a smaller-sized investment account and limited capital to invest with.
3. Professional money management: Mutual funds are run by investment managers who would likely be considered "experts" in their field. Mutual fund companies have resources that are above and beyond what one may have as an individual, retail investor.

Disadvantages

1. No intraday-trading on mutual funds: If you want to make a trade on your mutual fund, you'll likely not know what the "NAV" price will be when you lock in the trade. That is because the NAV (Net Asset Value) is settled at the end of each trading day. If you don't lock your trade in before the end of the stock market close, you'll receive the NAV as of the close of business the following day. This makes it difficult and/or impossible to capitalize on sudden movements in the market (if that is something you're trying to do).
2. Not tax-efficient: In a non IRA account, mutual funds will process capital gain distributions about once per year, which you will then be taxed on, even if you did not take any capital gains that year. The end investor has little impact or say on how much a fund will decide to spit out in capital gain distributions. The funds have the freedom to delay capital gain distributions in some years, essentially kicking the can down the road for later years. This could adversely impact you as the end investor.
3. Subject to the herd: If you are a disciplined investor and you know not to "buy high" and "sell low," then you won't panic when volatility occurs in the marketplace. However, when investing in a large mutual fund, chances are that many of your fellow investors will not have the same discipline. They will sell at a low point, causing the fund to sell positions in order to account for the redemption requests. In other words, your performance may suffer because of the lack of discipline of other investors that also own the same fund.
4. Impersonal connection: When investing in a mutual fund, you do not usually have easy access to the one making the investment decisions. There may be quarterly investor calls and updates, but there will be a significant lack of interpersonal communication with the main folks in charge of the fund.
5. Costs: Mutual funds always carry some kind of costs. In all cases, costs will decrease your overall rate of return. That is why it is important to limit the annual expenses of mutual funds, the potential front-end or back-end loads, and turnover costs. It takes more than a novice investor to navigate these issues, but this is one of the most important downsides to using mutual funds and thus, should certainly be evaluated and address by all investors.

Please indicate if this answer was helpful for you!

Joe Allaria, CFP®

A survivor spouse can receive the higher of the two previous benefits after the first spouse passes. So, if your husband's benefit was higher than yours, then you can begin to receive the amount he was receiving, but your benefit will go away. If your benefit was greater, than you will continue to receive your own benefit, and his would go away completely.

Please indicate if this answer was helpful for you! Good luck to you.

Joe Allaria, CFP®

A mutual fund will provide diversification through the exposure to a multitude of stocks. The reason that is recommended over owning a single stock is that owning an individual stock would carry more risk than a mutual fund. This type of risk is known as unsystematic risk. Unsystematic risk is risk that CAN be diversified against. For example, by owning just one stock, you would be carrying company risk that may not apply to other companies in the same sector of the market. What if their CEO and executive team leaves unexpectedly? What if a natural disaster hits a manufacturing center slowing down production? What if earnings are down because of a defect in a product or a lawsuit? These are just a few examples of the types of things that COULD happen to ONE company, but are not likely to happen to ALL companies at once.

Yes, there is also systematic risk, which is risk that you CANNOT diversify against. This would be similar to market risk or volatility risk. It should be understood that there is risk associated with investing in the market. If the market as a whole declines in value, that is not something that can easily be diversified against.

Therefore, if you'd like to invest in individual stocks, I would recommend researching how you can compile your own basket of stocks so that you don't own just one stock. Make sure you are sufficiently diversified between large and small companies, value and growth companies, domestic and international companies, and also between stocks and bonds, according to your risk tolerance. This is where it might be helpful to seek out professional help when constructing these types of portfolios. This type of research and portfolio construction and monitoring can take quite some time.

The alternative is to invest in a mutual fund for instant diversification...of course, there are a list of things to be aware of when choosing mutual funds as well. Fees, investment philosophy, loads, and performance are just a few components to consider when evaluating mutual funds.

These are just a few things to consider when discussing mutual funds vs. stocks.

Thank you

Joe Allaria, CFP®