This time of year I get many phone calls from clients to wish me happy holidays and report on their EIULs.
Most are reporting that they are receiving a credit in the 12-14% range this year, right at the cap rate or just below. And some are reporting that they are starting to get a feel for why this strategy works so well. The one idea about EIULs that is really hard to get people to understand is the overall effect of the interest credit strategy over long period of times. After a few years, you start to really get it. So I thought I would go over it here to give the readers an opportunity to see why my clients are so satisfied with how it works for them. Too much energy is spent on worrying about how much the return will be each year and not enough understanding of the long term effects. I have had potential clients have me build illustrations with a wide variety of interest returns, one person a different one for every .5% difference, to satisfy their need for some certainty!!!
How the EIUL Works
The first idea that must be understood is that your money is not in the market. This is a fixed rate product not a variable product. What that means is that your money is added into the general fund of the life insurance company. The interest credit they pay on the life insurance policies, all fixed rate policies, is backed by the investments of the company with the investing guidelines and reserve requirements required by the government.
In EIULs they tie the interest credit to an index or group of indexes with a 0% floor and a floating cap rate. The cap rate floats within a small range dependent upon overall interest rates environment that determine how much money needs to be used to make the guarantees on the insurance products. Each year you get an interest credit that can’t go negative. The insurance company is subsuming that annual risk for you. And it is that risk which is so damaging for retirement accounts. Each year your account starts at the point it ended the year before locking in positive movements. So you latch up each year like a staircase [except the years with a negative index movement].
The Last Decade Returns of the S&P 500
2012 will give around a 13% return.
Forgetting expenses for a second, Had you invested $1000 into the index at the start of 2002 by the end of 2011 you would have had $1,326.
The Last Decade Returns of an EIUL
If you had put that money into the Minnesota Life EIUL using actual cap rates for each of those years you would have $2,264. Dramatic difference, right! Now this last decade is not really that different from what the average 10 year span looks like. A couple of dramatic downdrafts, a couple of great years, and the balance with solid positive returns. It doesn’t always work out that the negative years are separated nicely, like the last decade, but that is the general way the market works. There are some very dramatic and quick drops, and a wide range of positive returns that go on for several years. But, what should be noted is the amount of time needed to overcome those drops. If you are going to need those funds for retirement you better hope you don’t have a large drop close to your retirement date! Despite some really good years those in the market haven’t recovered from 2008 yet. And that is what the difference between $2,264 and $1,326 is telling you. Not enough recovery time yet. Sometimes it takes decades to recover!
If you add an EIUL into your mix of retirement funding mechanisms, then you can use that very quality to better take advantage of your real estate or even an 401K/IRA. Because each year you know you can take money out of your EIUL without devastating future earnings. You might have a difficult year with your real estate and have to use that cash flow for maintenance or lost rent or a myriad of items real estate investors deal with. You might want to sell some real estate or might want to not sell because of the market and taxation situation, but with the security of being able to fund your personal needs with tax free money from your EIUL that decision can be made based on what is best in the long run, not on current need for cash. If the equities market goes negative taking a hiatus from selling funds for income can make your money last decades longer. Having this flexibility can be a life saver as you react to current conditions.
Of course, everything can go exactly as planned :-), and then you just have tax-free cash coming at you year after year after year to provide you with those things you want in retirement.
Average Rates are Misleading
Wall Street has done us all a disservice by concentrating our focus on one number, average return. That number hides all sorts of risk and at best is a sin of ommission. In a recent post Jeff Brown notes the fallacy of looking for appreciation to make your real estate investments work. Yet, I hear people talk about average rate of appreciation from real estate all the time. Now here is a surprising truth, the EIUL interest credit strategy only depends upon variation, not on overall appreciation. Imagine a market, like today’s perhaps, that makes dramatic drops and then slowly goes back to where it came from, then another dramatic drop and a slow climb back. At the end of the day those in the market have gotten nowhere [actually lost $$], while those in an EIUL have made excellent returns. And that is the power of EIULs interest crediting strategy!