indexed universal life policy vs bonds

[weebs]

Background info – I swept the contents of my brokerage account back into my money market (VMFXX) back in June.  I spent the last 4 months licking my wounds, researching and regrouping and it’s time to put that money back to work. 

I engaged a fiduciary financial advisor to analyze my plan to retire early.  Specifically, we focused on how to leverage the aforementioned brokerage account, which is ~25% of our stash.  I posted a case study back in April, so feel free to refer to that post for the relevant details.  FWIW, our total stash is down ~10% since April and our expenses are up significantly, with insurance, property taxes and food leading the charge.  (Yay HCOL + inflation!)

The advisor suggested I look into an Indexed Universal Life policy.  I’ll leave it as an exercise to the reader to research the product, but it’s not held in high regard around here.  The purpose of this post is not to discuss the pros/cons of IULs.  Rather, I’d like to perform an objective analysis comparing an IUL to something more traditional, like bonds.

Beginning with the IUL – the process of hydrating the IUL would take ~5 years.  At the end of those 5 years, I’d be able to take loans against the policy to help fund my retirement.  Based on the advisor’s estimates, the loan amount would cover ~75% of our current monthly expenses.  Leveraging the principal to service the loans at that rate would exhaust the principal when I turn 120 and pay out to a beneficiary in the likely event that I kicked the bucket before then.  So…there’s some runway there.  Those numbers are based on a 6% compounded rate of return on the principal and a 3% amortized loan rate.  The cap is 60% of the index’s rate of return and the floor is 0%.  The product returned a ~6.7%/year rate of return over the last ten years.  For reference, the S&P returned 12.55%/year.  I asked how the loan rate was set and was told it was tied to the performance of the issuing company.  To me, this was a HUGE red flag.  As an engineer, I distrust non-deterministic behavior.  That goes double for a cheap bastard (me) and his money.   This seems like a particularly bad time to sink money into an IUL.  The market as been super choppy and I’m not confident that returns over the next year (or more) will be enough to offset the fees, ESPECIALLY if company providing the IUL isn’t transparent about the fees and loan rates.

Next up, bonds – the current 6 month treasuries yield is 4.42%.  That’s the boring route.  I haven’t researched how to buy corporate bonds or treasuries directly, but I assume I could get even higher returns if I created a bond ladder using a combination of both.  For giggles, I ran a simulation in firecalc using:

•   A portfolio value padded with another 75K/year savings over the next 2.5 years.
•   A spending value corresponding to the proposed annual loan amount taken against the IUL.
•   5% annual rate of return.

Given the above, the simulation showed that it would take 8 years after I punch out to draw down the portfolio to just under where it is now.  At that point, I’ll be 60 and able to access my retirement accounts without penalty.

Given the above, I’m leaning against the IUL.  Complicated investment vehicles rarely benefit the buyer.  The problem is execution.  Up to this point, I’ve bought/sold funds through Vanguard, Fidelity, etc and haven’t worked directly with a broker.  I’m not worried about it, I’m just unsure of how to get the process rolling.

I’d love to have the knowledgable folks here point out anything that I missed and poke holes in my plan. TIA.

[MustacheAndaHalf]

I'll limit myself to one direct criticism of Universal Life policies in general: your investment advisor is probably getting paid money (I would call it a kickback) if you invest in it, which is a conflict of interest.  That said ...

Right now 10 year and 30 year treasuries are paying about 4%/year.  But keep in mind a treasury pays 4% of the original amount for 10 or 30 years, and then you get your money back.  Note the money does not compound: if you invest $10,000 you receive $400 per year, every year.

I believe universal life policies consist of two parts: an annuity and a life insurance policy.  I think it could be valuable for you to research those two parts on your own, searching online.  I know Vanguard offers annuities, and there's "term life insurance".  Then you can see if even higher rates of return are possible by investing in an annuity without the life insurance policy.

The past decade has been quite good for stocks, but keep in mind it started in 2010, partway through the recovery from the great financial crisis.  I think your 12% return hints at using overly optimistic years like those, when 10% or lower is more realistic.

I suspect there might be two flaws in your comparison of annuities to stocks, and both flaws favor stocks.  First, I suspect an annuity pays 6.7% of the original amount per year, but compounds much slower (if at all).  Stocks do compound at 10%/year, favoring stocks.  Second, an annuity uses up your principal - you get no money back when it ends.  With the stock market, your principal is intact and has been compounding the whole time - you can withdraw it decades later.

A worst case scenario might look like this: $10,000 invested in an annuity, paying $670/year (with no increases) for 20 years.  20 x 670 = $13,400 leaving you with a +34% more over 20 years.
Invest $10,000 in stocks for 20 years, compounding at 10%/year: $10k x (1.10 ^ 20) = $67,275.  You have +573% more after 20 years, which is about a 17x higher return than the annuity example above.

Maybe you can ask for detailed returns on the universal life policy.  If you invest $10,000 in the universal life / annuity, and place every dollar received in a bank account earning no interest, how much will that bank account have after 20 years?
Or maybe "How much money comes to me?" ... followed by "Why is it so hard to calculate how much money you pay me?"

[reeshau]

What is your purpose in looking at a UIL?  These two plans seem to have entirely different purposes.  It's like comparing apples and the color purple.

Specifically, the UIL takes 5 years to "hydrate," which I assume means you have to put money in, or at least can't take money out.  But the bonds just need to survive 8 years of withdrawals, when you can access your retirement accounts.

So, what are you trying to do?  Set up an alternative to your 401k's?  Or just bridge the early retirement years until you are eligible to withdraw without penalty?  Are you looking to FIRE ASAP, or are you willing to put it off for 5 years?

By the way, the penalty for early withdrawal may not be a big deal, anyway.  If you are in the 10% or 12% bracket, because you only need what you spend, then *with* penalty is just 20% or 22%--still less than you are paying for a marginal rate now.

Otherwise, stick with Occam's Razor.  There is only one option you can change, if you change your mind 5 years down the road.

[MDM]

The general rule is to use insurance products for insurance, and investment products for investment.  It's unlikely that your case would be an exception.

[weebs]

I'll limit myself to one direct criticism of Universal Life policies in general: your investment advisor is probably getting paid money (I would call it a kickback) if you invest in it, which is a conflict of interest.

Agreed.

Right now 10 year and 30 year treasuries are paying about 4%/year.  But keep in mind a treasury pays 4% of the original amount for 10 or 30 years, and then you get your money back.  Note the money does not compound: if you invest $10,000 you receive $400 per year, every year.

Thanks for pointing that out.  I wasn't 100% sure if it compounded.

Second, an annuity uses up your principal - you get no money back when it ends.  With the stock market, your principal is intact and has been compounding the whole time - you can withdraw it decades later.

Yep, that is a factor in my decision making process.  It feels unnatural to relinquish ownership of those assets in promise of payment. 

... followed by "Why is it so hard to calculate how much money you pay me?"

reeshau mentions Occum's Razor and I agree with his (her?) point.

What is your purpose in looking at a UIL?  These two plans seem to have entirely different purposes.  It's like comparing apples and the color purple.

Specifically, the UIL takes 5 years to "hydrate," which I assume means you have to put money in, or at least can't take money out.  But the bonds just need to survive 8 years of withdrawals, when you can access your retirement accounts.

So, what are you trying to do?  Set up an alternative to your 401k's?  Or just bridge the early retirement years until you are eligible to withdraw without penalty?  Are you looking to FIRE ASAP, or are you willing to put it off for 5 years?

By the way, the penalty for early withdrawal may not be a big deal, anyway.  If you are in the 10% or 12% bracket, because you only need what you spend, then *with* penalty is just 20% or 22%--still less than you are paying for a marginal rate now.

Otherwise, stick with Occam's Razor.  There is only one option you can change, if you change your mind 5 years down the road.

I detailed it in the use case, but TL;DR - I'm planning to FIRE in 2.5 years at age 52 and these funds will be used to fund early retirement years.  Good point regarding the penalty.  I was thinking something similar yesterday.  It wouldn't be the end of the world if we had to incur the penalty and dip into our retirement accounts early.  Totally agree with your point about being able to change my mind 5 years down the road.  Plans/situations change and I'd rather not limit my options if we need to pivot.

The general rule is to use insurance products for insurance, and investment products for investment.  It's unlikely that your case would be an exception.

This is consistent with what the others are saying - KISS.  Thanks for the responses, everyone.

[Financial.Velociraptor]

For 90% of Americans, buying term and investing the rest is the best approach. 

UIL really shines if you are a high net worth individual who wants to pass on legacy wealth to children without the burden of the estate tax, but want access to your money until you die.  Basically you commit the proceeds (which is 'insurance' and not 'realized income') to heirs tax free and retain the right to borrow against your cash value for living expenses.  That is, it is a better tax shelter than investment.

If the estate tax is something that doesn't apply to you, it is almost certain you are better off buying separate term insurance and investing the difference whether that is in an annuity, index fund, bonds, or some mix. 

Understand this: UIL is the very highest commission product in all of financial advising.  It gets pushed HARD.  Not because it is necessarily in the client's best interest.

[BicycleB]

You've already seen bonds can be sold more easily, providing better liquidity and more control.

You can also tailor your purchases of them more precisely to your FIRE plans, for example by purchasing bonds that mature during the years from age 52 to 60.

Also, you can mix cash and bonds more easily. If you think as I do that rates may rise a little further during the next year, causing a bit of price decline for bonds, you can keep some in cash and buy most of the bonds next year, or average out the purchases over the next year to dollar cost average, while still choosing the desired maturity.

Bond funds would give less direct control of maturity but easier ability to sell at will. Obviously any of these gives more flexibility than the IUL.

PS. If you might need to withdraw from retirement accounts prior to 59 1/2, using an SEPP could give you higher withdrawals without penalty. The flexibility of bonds relative to IUL again helps you to compensate for the fixed nature of the SEPP withdrawals.

[weebs]

UIL really shines if you are a high net worth individual who wants to pass on legacy wealth to children without the burden of the estate tax, but want access to your money until you die.  Basically you commit the proceeds (which is 'insurance' and not 'realized income') to heirs tax free and retain the right to borrow against your cash value for living expenses.  That is, it is a better tax shelter than investment.

...

Understand this: UIL is the very highest commission product in all of financial advising.  It gets pushed HARD.  Not because it is necessarily in the client's best interest.

Thanks for weighing in.  We don't have kids, so I'm not overly concerned with the estate tax.  My research so far supports your second point.  I ran across a quote that sums it up nicely - "These products are sold, not bought."

PS. If you might need to withdraw from retirement accounts prior to 59 1/2, using an SEPP could give you higher withdrawals without penalty. The flexibility of bonds relative to IUL again helps you to compensate for the fixed nature of the SEPP withdrawals.

Great point.  I researched SEPPs a while back and decided it wasn't for us.  However, I changed my mind this morning based on more number crunching and continued reading.  If we work another 2.5 years and start SEPPs at that time, funds withdrawn using the easy(er?) RMD method  in addition to a 4-5% return on the money in my brokerage account provide more than enough for us to live on until we turn 59.5.  It sucks that we'd have to continue taking distributions if the market tanked, but I figured we could mitigate that by reinvesting that money in our brokerage accounts and living off our cash buffer until market conditions improve.

[EvenSteven]

UIL really shines if you are a high net worth individual who wants to pass on legacy wealth to children without the burden of the estate tax, but want access to your money until you die.  Basically you commit the proceeds (which is 'insurance' and not 'realized income') to heirs tax free and retain the right to borrow against your cash value for living expenses.  That is, it is a better tax shelter than investment.

...

Understand this: UIL is the very highest commission product in all of financial advising.  It gets pushed HARD.  Not because it is necessarily in the client's best interest.

Thanks for weighing in.  We don't have kids, so I'm not overly concerned with the estate tax.  My research so far supports your second point.  I ran across a quote that sums it up nicely - "These products are sold, not bought."

PS. If you might need to withdraw from retirement accounts prior to 59 1/2, using an SEPP could give you higher withdrawals without penalty. The flexibility of bonds relative to IUL again helps you to compensate for the fixed nature of the SEPP withdrawals.

Great point.  I researched SEPPs a while back and decided it wasn't for us.  However, I changed my mind this morning based on more number crunching and continued reading.  If we work another 2.5 years and start SEPPs at that time, funds withdrawn using the easy(er?) RMD method  in addition to a 4-5% return on the money in my brokerage account provide more than enough for us to live on until we turn 59.5.  It sucks that we'd have to continue taking distributions if the market tanked, but I figured we could mitigate that by reinvesting that money in our brokerage accounts and living off our cash buffer until market conditions improve.

Is 25% in taxable plus Roth contributions not enough for you to do a Roth conversion ladder?

[Financial.Velociraptor]

UIL really shines if you are a high net worth individual who wants to pass on legacy wealth to children without the burden of the estate tax, but want access to your money until you die.  Basically you commit the proceeds (which is 'insurance' and not 'realized income') to heirs tax free and retain the right to borrow against your cash value for living expenses.  That is, it is a better tax shelter than investment.

...

Understand this: UIL is the very highest commission product in all of financial advising.  It gets pushed HARD.  Not because it is necessarily in the client's best interest.

Thanks for weighing in.  We don't have kids, so I'm not overly concerned with the estate tax.  My research so far supports your second point.  I ran across a quote that sums it up nicely - "These products are sold, not bought."

My guess is the person selling you this product doesn't even understand it.  Have they developed a spreadsheet showing you the impact of different levels of contribution via a "Paid Up Additions" (PUA) rider?  These products can be customized to maximize either the life insurance component or the cash value component (up to a limit where it no longer qualifies as "insurance").  If the salesperson truly understands the product, they will have a discussion with you about your goals for the policy, your on going cash needs, your comprehensive investment picture, tax planning, and more.  And they will optimize how much the ratio of insurance to investment is via PUA to fit your exact needs.  My guess is, they are trying to sell you the maximum amount of insurance they can sucker you for without optimizing any of the genuine (but very high fee) benefits of whole life.  Caveat Emptor.

[weebs]

Is 25% in taxable plus Roth contributions not enough for you to do a Roth conversion ladder?

I considered a roth ladder, but we're still working and getting punished by the tax man, so I'd rather not bump our income even higher.

Have they developed a spreadsheet showing you the impact of different levels of contribution via a "Paid Up Additions" (PUA) rider?  These products can be customized to maximize either the life insurance component or the cash value component (up to a limit where it no longer qualifies as "insurance").  If the salesperson truly understands the product, they will have a discussion with you about your goals for the policy, your on going cash needs, your comprehensive investment picture, tax planning, and more.  And they will optimize how much the ratio of insurance to investment is via PUA to fit your exact needs.  My guess is, they are trying to sell you the maximum amount of insurance they can sucker you for without optimizing any of the genuine (but very high fee) benefits of whole life.  Caveat Emptor.

Nope, we haven't discussed it.  It's interesting that the product can be customized as described, but I've decided to invest our money elsewhere.  Now just to figure out where & how...

[YttriumNitrate]

I engaged a fiduciary financial advisor to analyze my plan to retire early. ...  The advisor suggested I look into an Indexed Universal Life policy.

"Fiduciary" and "Universal/Whole Life" usually do not go together. A fiduciary advisor has to recommend the best products for you, not just ones that are merely appropriate. I'd suggest looking for a different advisor.

[BicycleB]

Is 25% in taxable plus Roth contributions not enough for you to do a Roth conversion ladder?

I considered a roth ladder, but we're still working and getting punished by the tax man, so I'd rather not bump our income even higher.

@weebs, I think the idea on a Roth ladder is to contribute from 401k to Roth after you leave your job, so that those taxable contributions would have a low tax rate. While working, you contribute to 401k or traditional IRA, not not Roth.

For 5 years (slightly less depending on exact dates), the contributions in the Roth need to season before penalty-free withdrawal is allowed prior to age 59 1/2. If you are setting money aside in cash or taxable bonds, that would carry you through until the seasoned Roth contributions can be withdrawn for living expenses. Done properly, it should reduce your tax bill, not increase it.

[weebs]

Is 25% in taxable plus Roth contributions not enough for you to do a Roth conversion ladder?

I considered a roth ladder, but we're still working and getting punished by the tax man, so I'd rather not bump our income even higher.

@weebs, I think the idea on a Roth ladder is to contribute from 401k to Roth after you leave your job, so that those taxable contributions would have a low tax rate. While working, you contribute to 401k or traditional IRA, not not Roth.

Yep, that's how I understand it.  My response was a bit vague.  What I meant to say is that I don't want to start a Roth ladder while we're still working.  I'm open to doing one after we retire.

[kenaces]

In general, I agree with others that have criticized the life insurance product you are considering.

I assume the policy is indexed to SP500 or something similar.  Given this, you are basically comparing buying bonds and equities(inside a fancy expensive product).  While some of these indexed policies offer minimum ROR guarantees you are still taking on some market risk - ie how much can you "borrow" from the policy if the market is down 50% in the first two years of investing?