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Indexed universal life insurance has unique features that make it resilient when change becomes necessary. And a lesson all retirees will eventually learn is their plan during retirement will require adjustments. Today I want to highlight the versatility IUL retirement planning brings to a plan specifically focused on how the product accommodates changing needs over ones lifetime in retirement.
What is Dynamic Income Planning?
Dynamic income planning is simply a retirement income plan that accepts the need for change. I think the easiest way to comprehend the idea is to use an example of its polar opposite, static income planning.
A lot of advisors talk about retirement income sources in fixed numbers. For example, they might tell you something like, “by the time you’re 65, you’ll be able to take $55,000 from your investments to provide for your retirement income needs.” They often will show spreadsheets or charts that depict this $55,000 of income as a constant income stream reaching out into your advanced age.
But this is rarely the way things work.
Retirees Have Changing Income Needs
Once retired, you’ll discover that your income needs fluctuate from year-to-year. Some years you’ll need/want more income. While in others, you’ll simple need/want less. Within the financial planning industry, we’ve even coined the term the retirement “smile.” This s0-called trend represents the tendency for new retirees to go a little wild for the first few years of retirement, then settle down and reside more in a groove of fewer expenses, and follow that with a period of increased expenses brought on by healthcare needs. The spending peaks at the beginning of retirement and eventual death follow a somewhat U-shaped (i.e. smile) curve.
But while the “smile” is the broad trend, a lot of retirees will face an array of fluctuations in their retirement income needs. One of the biggest forces behind changing income needs recently is inflation. Prices increased during the fist half of this decade, and we’re likely living in a new normal when it comes to inflation of everyday products. Workers can demand higher wages, but retirees are left figuring out how to afford price hikes on their own. The good news is, a lot of people have the capacity to deal with inflation through the success of their investments.
Dynamic income planning has two sides to it. On the one hand, there’s the flat out need for more income brought on by whatever source necessitates it. And on the other, there’s the rise in assets that can provide the additional income whether it’s needed or not. As good retirement planners, we need to keep focus on both components.
Where Does Indexed Universal Life Insurance Fit into a Dynamic Retirement Income Plan?
Indexed Universal Life Insurance (IUL) earns interest on its cash value based on the movement in an index. For example, the S&P500 could be such an index that sets the interest rate payable on cash value for a particular policy. The basic functionality is the interest rate payable on cash value tracks the movement in the S&P500 over a 1-year period up to some limit set by the insurance company.
Let’s say for example this limit is 11%. This means that interest on cash value will track the S&P500 up to 11%. If the S&P500 is up 8% for the year, then 8% is the interest rate payable on the policy’s cash value. But given the cap, if the index is up 20%, the interest payable on cash value is 11%.
This tradeoff comes with the additional feature of not losing money when the index is down for the year. So if the S&P500 were down 20% for the year, then the interest rate is generally zero or 1% in some cases (depends on the product as they vary from company-to-company).
This fluctuation in interest rate paid on cash value means IUL can have very good years as well as not great years. But generally speaking, the really good years tend to overwhelm the not great years. And because IUL can provide such variability in interest earned on cash, it has great potential to outperform expectations and provide for additional (dare I say dynamic) income.
Examples of How IUL can Provide Dynamic Income
I’m going to assume the same base case in all of the following examples. Those details are:
The retiree is age 65, has accumulated $1,000,000 in cash value inside an indexed universal life insurance policy, the IUL policy will use a 1-year S&P500 index account with an 11% cap rate, we’ll take all income as a loan against the policy with a 6% loan interest rate, and policy expenses in all years are 0.50% of the policy’s cash value (that’s about double what it generally comes out to in real life).
Increasing Income for Inflation
In our first example, we’re going to look at a 3% annual increase in the income amount being provided by the IUL policy. We’ll start with $45,000 in annual income (a 4.5% withdrawal rate) and increase this amount by 3% every year. Here is the result after 30 years:
Cash Value
Index Earnings
Income
Loan Balance
Net Cash Value
$ 995,000.00
0.00%
$ 45,000.00
$ 47,700.00
$ 947,300.00
$ 1,098,927.75
11.00%
$ 46,350.00
$ 99,693.00
$ 999,234.75
$ 1,213,710.75
11.00%
$ 47,740.50
$ 156,279.51
$ 1,057,431.24
$ 1,340,482.84
11.00%
$ 49,172.72
$ 217,779.36
$ 1,122,703.48
$ 1,480,496.27
11.00%
$ 50,647.90
$ 284,532.89
$ 1,195,963.38
$ 1,635,134.11
11.00%
$ 52,167.33
$ 356,902.24
$ 1,278,231.87
$ 1,626,958.44
0.00%
$ 53,732.35
$ 435,272.67
$ 1,191,685.77
$ 1,618,823.65
0.00%
$ 55,344.32
$ 520,054.01
$ 1,098,769.64
$ 1,610,729.53
0.00%
$ 57,004.65
$ 611,682.18
$ 999,047.35
$ 1,778,970.23
11.00%
$ 58,714.79
$ 710,620.79
$ 1,068,349.43
$ 1,900,175.92
7.35%
$ 60,476.24
$ 817,362.85
$ 1,082,813.06
$ 1,911,283.40
1.09%
$ 62,290.52
$ 932,432.58
$ 978,850.82
$ 2,055,576.69
8.09%
$ 64,159.24
$ 1,056,387.33
$ 999,189.36
$ 2,045,298.81
0.00%
$ 66,084.02
$ 1,189,819.63
$ 855,479.18
$ 2,035,072.31
0.00%
$ 68,066.54
$ 1,333,359.33
$ 701,712.98
$ 2,247,635.62
11.00%
$ 70,108.53
$ 1,487,675.94
$ 759,959.68
$ 2,482,401.16
11.00%
$ 72,211.79
$ 1,653,480.99
$ 828,920.16
$ 2,504,322.00
1.39%
$ 74,378.14
$ 1,831,530.69
$ 672,791.32
$ 2,765,898.43
11.00%
$ 76,609.49
$ 2,022,628.58
$ 743,269.85
$ 3,054,796.53
11.00%
$ 78,907.77
$ 2,227,628.54
$ 827,167.99
$ 3,360,192.17
10.55%
$ 81,275.01
$ 2,447,437.76
$ 912,754.42
$ 3,366,460.61
0.69%
$ 83,713.26
$ 2,683,020.07
$ 683,440.54
$ 3,677,891.88
9.80%
$ 86,224.65
$ 2,935,399.41
$ 742,492.47
$ 4,062,047.69
11.00%
$ 88,811.39
$ 3,205,663.45
$ 856,384.24
$ 4,041,737.45
0.00%
$ 91,475.73
$ 3,494,967.54
$ 546,769.91
$ 4,463,896.93
11.00%
$ 94,220.01
$ 3,804,538.80
$ 659,358.13
$ 4,930,150.96
11.00%
$ 97,046.61
$ 4,135,680.53
$ 794,470.43
$ 5,445,105.23
11.00%
$ 99,958.01
$ 4,489,776.84
$ 955,328.38
$ 5,417,879.70
0.00%
$ 102,956.75
$ 4,868,297.60
$ 549,582.10
$ 5,983,777.24
11.00%
$ 106,045.45
$ 5,272,803.64
$ 710,973.60
Notice that income in year 30 is now more than double the original amount increasing from $45,000/year to $106,000/year. Also notice that in 8 of the 30 years the index was down so the policy earned no interest on cash value, but in 15 of the 30 years the index was up such that the policy earned the 11% cap rate on cash value (the really good years tend to overwhelm the not so great years).
It’s important to understand that using IUL for income isn’t about withdrawing money from the account but rather balancing the loan outstanding against the cash value as it grows overtime. This offers a few very unique and powerful features.
First, and somewhat more obvious, it makes the income stream income tax free to the policyholder. Second, it means much more value can be extracted because you never forfeit the growth of the cash value. With traditional investments, you redeem the shares you own and then lose the potential for any more gain from those shares. This is not the case with IUL.
The fact here is after 30 years, we substantially increased the income year-over-year and we still have over $700,000 in available value to extract from the policy. The policyholder would be 95 at this point.
Slower Increases for Inflation
While it’s certainly great to see the IUL policy’s ability to keep pace with an inflationary increase each and every year, very few people will actually do that in my experience. Retirees tend to only take the income they need. So the likelihood of someone increasing the income produced by retirement assets just because they can is extremely low.
Let’s look instead at a scenario where the increases happen in a delayed fashion. We’ll increase every five years. And since we aren’t increasing each year, we’ll increase the income amount at each five year interval by 10%. Here are the results after 30 years:
Cash Value
Index Earnings
Income
Loan Balance
Net Cash Value
$ 995,000.00
0.00%
$ 45,000.00
$ 47,700.00
$ 947,300.00
$ 1,098,927.75
11.00%
$ 45,000.00
$ 98,262.00
$ 1,000,665.75
$ 1,213,710.75
11.00%
$ 45,000.00
$ 151,857.72
$ 1,061,853.03
$ 1,340,482.84
11.00%
$ 45,000.00
$ 208,669.18
$ 1,131,813.66
$ 1,480,496.27
11.00%
$ 45,000.00
$ 268,889.33
$ 1,211,606.94
$ 1,635,134.11
11.00%
$ 49,500.00
$ 337,492.69
$ 1,297,641.42
$ 1,626,958.44
0.00%
$ 49,500.00
$ 410,212.26
$ 1,216,746.18
$ 1,618,823.65
0.00%
$ 49,500.00
$ 487,294.99
$ 1,131,528.66
$ 1,610,729.53
0.00%
$ 49,500.00
$ 569,002.69
$ 1,041,726.84
$ 1,778,970.23
11.00%
$ 49,500.00
$ 655,612.85
$ 1,123,357.38
$ 1,900,175.92
7.35%
$ 54,450.00
$ 752,666.62
$ 1,147,509.29
$ 1,911,283.40
1.09%
$ 54,450.00
$ 855,543.62
$ 1,055,739.78
$ 2,055,576.69
8.09%
$ 54,450.00
$ 964,593.24
$ 1,090,983.45
$ 2,045,298.81
0.00%
$ 54,450.00
$ 1,080,185.83
$ 965,112.98
$ 2,035,072.31
0.00%
$ 54,450.00
$ 1,202,713.98
$ 832,358.33
$ 2,247,635.62
11.00%
$ 59,895.00
$ 1,338,365.52
$ 909,270.10
$ 2,482,401.16
11.00%
$ 59,895.00
$ 1,482,156.15
$ 1,000,245.01
$ 2,504,322.00
1.39%
$ 59,895.00
$ 1,634,574.22
$ 869,747.78
$ 2,765,898.43
11.00%
$ 59,895.00
$ 1,796,137.37
$ 969,761.06
$ 3,054,796.53
11.00%
$ 59,895.00
$ 1,967,394.32
$ 1,087,402.21
$ 3,360,192.17
10.55%
$ 65,885.00
$ 2,155,276.08
$ 1,204,916.10
$ 3,366,460.61
0.69%
$ 65,885.00
$ 2,354,430.74
$ 1,012,029.87
$ 3,677,891.88
9.80%
$ 65,885.00
$ 2,565,534.69
$ 1,112,357.20
$ 4,062,047.69
11.00%
$ 65,885.00
$ 2,789,304.87
$ 1,272,742.82
$ 4,041,737.45
0.00%
$ 65,885.00
$ 3,026,501.26
$ 1,015,236.19
$ 4,463,896.93
11.00%
$ 72,473.00
$ 3,284,912.71
$ 1,178,984.21
$ 4,930,150.96
11.00%
$ 72,473.00
$ 3,558,828.86
$ 1,371,322.10
$ 5,445,105.23
11.00%
$ 72,473.00
$ 3,849,179.97
$ 1,595,925.26
$ 5,417,879.70
0.00%
$ 72,473.00
$ 4,156,952.15
$ 1,260,927.56
$ 5,983,777.24
11.00%
$ 72,473.00
$ 4,483,190.66
$ 1,500,586.58
This results in less overall income being taken from the IUL policy, so it’s no surprise that there’s significantly more available cash by year 30. Given this, what happens if there was a significantly higher need for income in last few years of life? An expense like a nursing home bill for example.
Slower Inflation Increase with Big End of Life Expenses
We’ll keep the increases every five years. We’ll also keep them at 10% each time we make an increase. But let’s look at a substantial increase in income distributed in the last five years:
Cash Value
Index Earnings
Income
Loan Balance
Net Cash Value
$ 995,000.00
0.00%
$ 45,000.00
$ 47,700.00
$ 947,300.00
$ 1,098,927.75
11.00%
$ 45,000.00
$ 98,262.00
$ 1,000,665.75
$ 1,213,710.75
11.00%
$ 45,000.00
$ 151,857.72
$ 1,061,853.03
$ 1,340,482.84
11.00%
$ 45,000.00
$ 208,669.18
$ 1,131,813.66
$ 1,480,496.27
11.00%
$ 45,000.00
$ 268,889.33
$ 1,211,606.94
$ 1,635,134.11
11.00%
$ 49,500.00
$ 337,492.69
$ 1,297,641.42
$ 1,626,958.44
0.00%
$ 49,500.00
$ 410,212.26
$ 1,216,746.18
$ 1,618,823.65
0.00%
$ 49,500.00
$ 487,294.99
$ 1,131,528.66
$ 1,610,729.53
0.00%
$ 49,500.00
$ 569,002.69
$ 1,041,726.84
$ 1,778,970.23
11.00%
$ 49,500.00
$ 655,612.85
$ 1,123,357.38
$ 1,900,175.92
7.35%
$ 54,450.00
$ 752,666.62
$ 1,147,509.29
$ 1,911,283.40
1.09%
$ 54,450.00
$ 855,543.62
$ 1,055,739.78
$ 2,055,576.69
8.09%
$ 54,450.00
$ 964,593.24
$ 1,090,983.45
$ 2,045,298.81
0.00%
$ 54,450.00
$ 1,080,185.83
$ 965,112.98
$ 2,035,072.31
0.00%
$ 54,450.00
$ 1,202,713.98
$ 832,358.33
$ 2,247,635.62
11.00%
$ 59,895.00
$ 1,338,365.52
$ 909,270.10
$ 2,482,401.16
11.00%
$ 59,895.00
$ 1,482,156.15
$ 1,000,245.01
$ 2,504,322.00
1.39%
$ 59,895.00
$ 1,634,574.22
$ 869,747.78
$ 2,765,898.43
11.00%
$ 59,895.00
$ 1,796,137.37
$ 969,761.06
$ 3,054,796.53
11.00%
$ 59,895.00
$ 1,967,394.32
$ 1,087,402.21
$ 3,360,192.17
10.55%
$ 65,885.00
$ 2,155,276.08
$ 1,204,916.10
$ 3,366,460.61
0.69%
$ 65,885.00
$ 2,354,430.74
$ 1,012,029.87
$ 3,677,891.88
9.80%
$ 65,885.00
$ 2,565,534.69
$ 1,112,357.20
$ 4,062,047.69
11.00%
$ 65,885.00
$ 2,789,304.87
$ 1,272,742.82
$ 4,041,737.45
0.00%
$ 65,885.00
$ 3,026,501.26
$ 1,015,236.19
$ 4,463,896.93
11.00%
$ 200,000.00
$ 3,420,091.33
$ 1,043,805.59
$ 4,930,150.96
11.00%
$ 200,000.00
$ 3,837,296.81
$ 1,092,854.15
$ 5,445,105.23
11.00%
$ 200,000.00
$ 4,279,534.62
$ 1,165,570.60
$ 5,417,879.70
0.00%
$ 200,000.00
$ 4,748,306.70
$ 669,573.00
$ 5,983,777.24
11.00%
$ 200,000.00
$ 5,245,205.10
$ 738,572.13
We can increase the income to $200,000/year in years 26 through 30 despite having increased the income from $45,000 per year at inception to almost $66,000 by year 20 through 25. We’ll even still have money available to continue the $200,000 income for a few more years if needed.
The Retirement “SMILE”
Now let’s look at a scenario assuming the retirement “smile.” We’ll begin with a much higher income distributed from the policy, $80,000/year. Then we’ll ratchet down over the years, but return to our $200,000/year income for the last five. Now, I should caution that I would normally advice against a withdrawal rate so high in the first several years. We normally recommend no higher than 6% of cash value when income begins. That said, I want to test the resiliency here, so I’m goin to break the rules:
Cash Value
Index Earnings
Income
Loan Balance
Net Cash Value
$ 995,000.00
0.00%
$ 80,000.00
$ 84,800.00
$ 910,200.00
$ 1,098,927.75
11.00%
$ 80,000.00
$ 174,688.00
$ 924,239.75
$ 1,213,710.75
11.00%
$ 80,000.00
$ 269,969.28
$ 943,741.47
$ 1,340,482.84
11.00%
$ 80,000.00
$ 370,967.44
$ 969,515.40
$ 1,480,496.27
11.00%
$ 80,000.00
$ 478,025.48
$ 1,002,470.79
$ 1,635,134.11
11.00%
$ 60,000.00
$ 570,307.01
$ 1,064,827.10
$ 1,626,958.44
0.00%
$ 60,000.00
$ 668,125.43
$ 958,833.01
$ 1,618,823.65
0.00%
$ 60,000.00
$ 771,812.96
$ 847,010.69
$ 1,610,729.53
0.00%
$ 60,000.00
$ 881,721.74
$ 729,007.79
$ 1,778,970.23
11.00%
$ 60,000.00
$ 998,225.04
$ 780,745.19
$ 1,900,175.92
7.35%
$ 40,000.00
$ 1,100,518.54
$ 799,657.38
$ 1,911,283.40
1.09%
$ 40,000.00
$ 1,208,949.66
$ 702,333.74
$ 2,055,576.69
8.09%
$ 40,000.00
$ 1,323,886.63
$ 731,690.06
$ 2,045,298.81
0.00%
$ 40,000.00
$ 1,445,719.83
$ 599,578.98
$ 2,035,072.31
0.00%
$ 40,000.00
$ 1,574,863.02
$ 460,209.29
$ 2,247,635.62
11.00%
$ 40,000.00
$ 1,711,754.80
$ 535,880.81
$ 2,482,401.16
11.00%
$ 40,000.00
$ 1,856,860.09
$ 625,541.07
$ 2,504,322.00
1.39%
$ 40,000.00
$ 2,010,671.70
$ 493,650.30
$ 2,765,898.43
11.00%
$ 40,000.00
$ 2,173,712.00
$ 592,186.43
$ 3,054,796.53
11.00%
$ 40,000.00
$ 2,346,534.72
$ 708,261.81
$ 3,360,192.17
10.55%
$ 40,000.00
$ 2,529,726.80
$ 830,465.37
$ 3,366,460.61
0.69%
$ 40,000.00
$ 2,723,910.41
$ 642,550.20
$ 3,677,891.88
9.80%
$ 40,000.00
$ 2,929,745.04
$ 748,146.85
$ 4,062,047.69
11.00%
$ 40,000.00
$ 3,147,929.74
$ 914,117.95
$ 4,041,737.45
0.00%
$ 40,000.00
$ 3,379,205.52
$ 662,531.93
$ 4,463,896.93
11.00%
$ 200,000.00
$ 3,793,957.85
$ 669,939.07
$ 4,930,150.96
11.00%
$ 200,000.00
$ 4,233,595.32
$ 696,555.64
$ 5,445,105.23
11.00%
$ 200,000.00
$ 4,699,611.04
$ 745,494.18
$ 5,417,879.70
0.00%
$ 200,000.00
$ 5,193,587.71
$ 224,291.99
$ 5,983,777.24
11.00%
$ 200,000.00
$ 5,717,202.97
$ 266,574.27
The much higher withdrawal rates do wear on the policy longer term, but we’re still okay by year 30. Keep in mind there are additional safety features of an indexed universal life insurance policy that would protect it and the policyholder from less ideal circumstances if running out of money becomes a major possibility.
Variability is a Strength not a Weakness
For years, one of the leading criticisms made towards indexed universal life insurance is the varied interest rate paid on cash value. Some years might be really good. But those years you get nothing (or near nothing) those are really bad. And since the interest rate follows index movement, there’s just too much uncertainty about how consistently your account values will grow.
This is a theoretically negative point, but observationally speaking our experience differs considerably. The variability of earnings tends to provide way more positive than negative. Sure there are time of nervousness or disappointment when the index is down and the earnings are underwhelming. But the good years materialize way more often and that leads to extremely good results.
And if nothing else, I hope the above examples express how important that variability is. There’s no chance the IUL policy produces the same results above if earning a lower overall static interest rate on its cash value.
And these results are realistic.
They follow the real movement in the S&P500. They use an index floor and cap rate that is nowhere near the best in the industry. And it all assumes policy expenses that are double what should be the case. Suffice it is to say, we’ve built in some margin to avoid overstating the possibilities.
IUL as a retirement income tool works extremely well. It offers an array of benefits not found in the same combination with any other financial asset available. And it’s certainly worth consideration.