If you have purchased an Equity Indexed Universal Life Insurance policy (commonly known as “IUL” and commonly sold as a vehicle to provide “tax-free retirement income”), an agent likely provided you with certain documentation about the features and performance of the policy. For instance, you may have been given a computer illustration showing how the policy value will increase over your lifetime. But while such documents may have warned that the S&P 500 may not perform in the future as it performed in the past, most life insurance companies and agents do not inform policyholders that the natural and historic volatility of the S&P 500 may create a substantial risk of lapse or reduced policy value even if the S&P 500 performs on average in the future as it performed in the past.
Simply put, the sequence of returns (when the market goes up and when it goes down) matters, primarily because fees are steadily being deducted from the policy. Although computer illustrations prepared by a life insurance company will show a constant average rate of projected return (say 8% each year) based on the S&P 500’s historical average performance, the S&P 500 in reality will not return the same rate each year. In fact, the variability of potential results, depending upon the particular sequence of S&P 500 returns experienced, is very large.
A technique known as a Monte Carlo simulation allows you to see the riskiness of the policy – something that many companies and agents may not want you to see. For example, the illustration given to a CFLID client by her agent showed her being able to withdraw tax-free income from her policy until she reached the age of 99, and then still have over $1.3 million left in the policy. But a Monte Carlo simulation shows that there is a 61% chance that the policy will lapse before she reaches her life expectancy of 84, even assuming the same historical S&P 500 returns as her illustration assumed.
If you are thinking about buying an IUL, ask the agent to run a Monte Carlo simulation on the illustration he presents to you. If he declines, then you should think again about buying the policy. If you already have a policy and are worried about whether it will last long term, and the company refuses to run a Monte Carlo simulation for you, proceed with caution. No policyholder wants to be in a situation where they are required to make substantial unplanned payments to their life insurance company in order to avoid their policy lapsing before they die.
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