High Interest Rates Boost Cash-Value Growth in Life Insurance
With the current high inflation and corresponding high bond interest rates, the cash value in indexed universal life insurance (IUL) policies can experience increased growth. This provides reassurance to IUL policy owners who are concerned about inflation, recessions, and stock market crashes.
Cash-value life insurance, specifically IUL, is a well-known alternative asset class that offers various potential benefits.
Summary of IUL benefits:
• Immediate death benefit in case of untimely death
• Immediate living benefit options for chronic, serious, or terminal illnesses
• Tax-free market-linked growth tied to selected market indices (without direct investment in the markets)
• Risk-free growth through a 0% “floor” that protects against negative market returns
• Potential protection against inflation
• Tax-free lifetime income through policy loans repaid with death benefit proceeds
• Tax-free income shields against rising tax rates
• Tax-free income prevents high tax brackets for other taxable income
• Tax-free death benefit
• Asset protection (varies by state) during the insured’s lifetime
• Elimination of all taxes and asset protection forever when owned in a dynasty trust
In summary, IUL offers growth potential and tax-free income through policy loans, while the 0% floor eliminates the risk of losses during market downturns. For instance, even though the S&P is currently down 17 percent, IUL cash values remain protected from market losses. But what about inflation and high interest rates?
Interest Rates and Options Budget
The growth of cash value in IUL is “linked” to one or more market indices, but the cash value itself is not directly invested in the markets. This risk-free growth is achieved by investing the majority of the policy’s cash value in fixed-income vehicles, usually corporate bonds, at a fixed interest rate. This ensures a known return and preserves the initial cash value (i.e., 0% floor). The remaining cash value is used to purchase market index options. If a market index increases during a crediting period, the options are exercised, leading to cash-value growth. If an index decreases, the options expire, but the starting cash value remains protected (0% floor). When corporate bonds have higher interest rates, less of the present cash value needs to be invested in bonds to maintain the 0% floor, allowing more cash to be allocated to index options. This enhances cash-value growth potential through higher caps and participation rates. In other words, higher interest rates translate to increased cash-value growth. Conversely, when corporate bond yields decrease, options budgets shrink and potential cash-value growth declines. However, there may be a lag time in these processes as insurance companies gradually replace lower-yield bonds with higher-yield bonds over months.
Inflation, IUL, and Interest Rates
Inflation erodes the cash value of IUL policies as well as the real value of policy loans and death benefits. To combat inflation, the U.S. Federal Reserve Bank raised interest rates from near zero to 4+% throughout 2022, resulting in corporate yields reaching about 5+%. Further increases are anticipated by the end of 2022. Currently, the relatively high interest rate environment enables insurance companies to expand IUL options budgets, thereby increasing potential cash-value growth. However, it is important to note that interest rates do not always align with inflation. In fact, the Fed may lower interest rates if the U.S. economy enters a deep recession.
IUL in Today’s Uncertain Economy
According to Bloomberg.com on October 17, 2023, the probability of a recession occurring within the year is 100%. Fund manager Michael Pento warns, “Right now, the market’s going lower – it could be 30%, 50%, it could be 60%, 70%…until we get a genuine pivot and/or we get an inflation rate less than 4%”. Additionally, former institutional money manager Alf Peccatiello predicts that if the Fed maintains a 5% interest rate for a year, significant damage to the real economy and a recession are guaranteed. Throughout the past century, every recession in the U.S. managed to reduce inflation by an average of 7 points.
Therefore, experts predict a short-term recession and further declines in the stock market. Once the recession intensifies, the Fed is likely to lower interest rates to stimulate the economy. Consequently, corporate bond yields will decrease, leading to reduced options budgets and lower caps and participation rates (resulting in less cash-value growth). Nonetheless, the 0% floor helps safeguard policy cash value against severe stock market declines. Moreover, a significant decline in a market index sets the stage for a substantial positive rebound in a future crediting period.
Conclusion
IUL is an advantageous yet underutilized alternative asset class that protects principal against market downturns, offers significant tax-free growth during positive market years, and provides tax-free benefits. In a high interest-rate environment, there is increased potential for IUL cash-value growth, helping to counter the effects of inflation.
Visit Shoreview Insurance or call 303-442-3100 to learn more about advanced life insurance products and planning for tax-free income, retirement, long-term care, and family legacies.
Copyright © 2022 Thomas Swenson
Disclaimer: This information is intended for educational purposes only.
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