Why variable loans are a recipe for disaster
By Patrick Kelly
While the indexed UL removes stock market risk for all individuals during the accumulation period, it can place significant stock market risk squarely on the shoulders of the client if the wrong loan provision is chosen.
In this volatile stock market environment, one of indexed universal life’s most powerful features is that the policy cash value will never take a stock market loss. It’s one of the product’s crown jewels — and rightly should be.
So that means the indexed UL removes all stock market risk from the client, right?
Here’s the issue. While the indexed UL removes stock market risk for all individuals during the accumulation period, it can place significant stock market risk squarely on the shoulders of the client if the wrong loan provision is chosen. Unfortunately, many agents don’t fully understand this. And let me tell you — this is one issue that is way too big not to fully understand.
If a client utilizes the fixed loan provision within the indexed UL (the only loan provision I’ve ever supported), then it is indeed true that stock market losses will never play a factor in this individual’s life insurance policy — neither during accumulation nor distribution.
However, if a client utilizes the variable loan provision — unfortunately the provision most life insurance agents illustrate — then stock market risk becomes a huge factor during distribution at exactly the wrong time for the client. Let me explain.
Most agents understand that the first money to be withdrawn from a life insurance policy is a return of the client’s paid premium (subject to surrender charges, of course.) And because it is a return of the client’s paid premium it, can be withdrawn tax free.
Since these dollars were taxed prior to being placed into the policy, they therefore are not subject to taxation a second time.
However, when a client desires to access an amount above the paid premium (the gain), they have two ways in which to do so. For one, they can simply continue taking withdrawals from their policy. If they do this, however, the money would be subject to income taxation — not typically what the client desires.
On the other hand, the beauty of using life insurance as a wealth accumulation vehicle is it offers the client a second option for accessing his money, called the policy loan provision. This provision allows a client to access not only his principle but also his gain, income-tax free.
So the question becomes this: Which loan provision, fixed or variable, is best for the client? In my opinion there is only one right answer — the fixed loan. I believe the client should always choose (and the agent should always illustrate) the fixed loan provision. I understand that using the word always is a very bold statement, but that’s how strongly I feel about this feature. And it’s my hope that once you understand the amount of risk you could place upon the client using a variable loan, you, too, will feel as strongly as I do.
Before we look at the risk the variable loan presents, let’s briefly visit the benefits and guarantees of the fixed loan. The advantage of the fixed loan is that it is contractually guaranteed — removing all market risk and interest rate risk from the client in regard to distribution.
With most life insurance companies, after a policy has been in force 10 years or more, the client is allowed to take a fixed loan (in order to access his gain) at a 0 percent net interest rate, regardless of market conditions or the interest rate environment. In other words, whether the stock market is tanking by 50 percent or interest rates are through the roof, the client can still access his gain, tax free (because it’s a loan) and interest free (due to the guaranteed 0 percent wash loan provision) — contractually guaranteed.
Here’s an example. If a client wanted to access $200,000 of gain tax-free from his policy he could take a loan from the life insurance company for $200,000. Using a fixed loan, this $200,000 would be charged whatever interest rate was in place at that time — let’s say 4 percent to reflect current market conditions.
The life insurance company who granted the loan would take $200,000 (the same amount as the client borrowed) from his cash value and essentially set it aside in a separate, fixed account as collateral.
But here’s the great part. That collateral is contractually guaranteed (usually after 10 years) to be credited at exactly the same interest rate — 4 percent in this example — as the client is being charged on his loan.
So even if the interest rate rose to 9 percent, it wouldn’t make a bit of difference for the client utilizing a fixed loan because the charged amount and the credited amount are guaranteed to be exactly the same (again, usually after 10 years or so), producing a 0 percent net difference for the client. And this provision will never change regardless of the stock market or interest rate environment.
The variable loan, on the other hand, stands to create a complete and utter catastrophe for the client during the distribution years — the worst of all times to take on risk. And to make matters worse, guess what loan provision almost all agents illustrate to their clients?
Yep, you guessed it: variable loans.
Why? Because they make the illustration look so much better in regard to distribution amount — as much as 30 percent more in some cases. What I believe these agents are doing, whether they realize it or not, is setting themselves up for some very difficult conversations with their clients in the later years due to their aggressive over promising. Remember, an illustration is simply a hypothetical guess. It does not demonstrate what will happen in a policy, but rather what could happen. And this is where I believe the variable loan will cause profound and unexpected disaster for both the client (through astronomical and unexpected interest rate charges) and for the agent (through a reality that doesn’t remotely match up with the proposed illustration — not to mention a potential E&O claim.)
The problem, from a big picture perspective, is that a variable loan puts significant stock market risk back upon the client during his entire distribution years. And if one of the original reasons for a client to purchase an indexed UL was to protect him against stock market losses, then why in the world would any agent want to subject him to potentially disastrous market risk during the policy’s distribution years?
It makes no sense. But you may be saying, “Wait a minute, Patrick. What are you talking about? If the client is still guaranteed zero market losses on their cash value, even during the distribution stage, how can there be any market risk?” Let me show you.
When a client utilizes a variable loan to access their policy’s cash value they are charged an interest rate from the life insurance company, just like the fixed loan, though it is often higher than its fixed loan counterpart and can fluctuate based on the current interest rate environment.
In other words, if interest rates go up in the economy, so can the interest charges for those utilizing a variable loan. But here’s where the big problem begins. In the case of a variable loan the collateral for the loan is not removed from the policy’s cash value but rather stays within the policy, subjecting it to the market’s effect.
To illustrate this impending disaster let’s look at another example. Let’s say a client has taken $200,000 out of his policy for 10 years in a row, utilizing a variable loan charging 6 percent interest. In this scenario the total outstanding loan value after 10 years would be $2 million.
Now let’s also assume that in the eleventh year the stock market takes a negative turn. Regardless of whether the stock market loss is -1 percent or -30 percent, the cash value still experiences a 0 percent return (no loss and no gain) because, as we have mentioned, the cash value inside an indexed UL will never take a stock market loss.
But, and this is a big but (so to speak), even though the cash value inside the policy was protected against loss by having a 0 percent return, this client would still be charged the 6 percent interest rate on the entire outstanding variable loan.
Do you see the problem? It’s enormous. Let’s do the math. A 6 percent interest charge on $2 million would cost the client $120,000 for that single year in interest fees. And that fee (based on the outstanding loan value) would be charged each and every year that the market had a negative return. And what pays for this $120,000 interest charge? The cash value within the policy — causing it to fall far short of the agent’s proposed illustration.
And even if the market didn’t have a negative year but simply a meager year, 2 percent for example, the client would still be charged significant interest rate fees. In this example, his cash value would still be reduced by $80,000 in interest fees (6 percent interest charged minus 2 percent interest credited equals a net 4 percent interest fee, or $80,000, even though the stock market had a 2 percent gain.)
Do you see the problem? Is that really a conversation you would look forward to having?
Now imagine what could happen if interest rates rise from these all-time lows back to normal averages from the past. If the variable loan cost were to rise to 9 percent, then that same $2 million of outstanding loans would cost the client $180,000 in interest fees each and every year the stock market had a negative return.
And let me ask you, “Do markets have negative years?”
Of course they do. And usually far more often than once every 10 years.
I firmly believe the indexed universal life policy provides one of the most powerful wealth-building and wealth-distributing tools available in America today — if and only if the more conservative (and guaranteed) fixed loan provision is used for distribution of gains within the policy. This is a provision that will guarantee the client zero in interest fees in the later years of their policy.
The variable loan simply presents far too much risk — the very thing that the client was likely trying to avoid when he purchased the policy.
So, if you are an agent who illustrates income distributions from an indexed UL, do yourself a favor and only illustrate the fixed loan and not the variable loan. Trust me, you’ll thank me later.
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