Index universal life insurance is a type of permanent life insurance, which means it has a cash value component in addition to a death benefit. The money in your cash value account can earn interest based on a stock market index chosen by your insurer, such as the S&P 500 or the Nasdaq Composite.
Universal life (UL) insurance comes in a lot of different flavors, from fixed-rate models to variable ones, where you select various equity accounts to invest in. Indexed universal life (IUL) insurance allows the owner to allocate cash value amounts to either a fixed account or an equity index account. Policies offer a variety of well-known indexes, such as the Nasdaq-100 or the S&P 500.1 IUL insurance policies are more volatile than fixed ULs, but they are less risky than variable UL insurance policies, because no money is actually invested in equity positions.
Index Universal Life Insurance policies still have the flexibility associated with UL policies in that the contract components, particularly the premium and death benefit, are adjustable. The index portion refers to the fact that your cash value can be linked to a market index, such as the S&P 500. Let’s look at an example.
Mike is a 60-year old man who places $1 million into an IUL policy. Based on his age and health, the $1 million premium will buy him an initial death benefit of $3 million. However, if the market performs as projected, that death benefit should exceed $4 million. The policy terms include a minimum 1% interest rate and a maximum of 12% if the S&P 500 performs at the top end of the range.
The actual calculation is a little more complicated and involves caps, participation rates, and policy fees, but historically speaking, your index returns can be very respectable. In a persistently low interest rate environment, such as the one we’re currently in, it is possible that opting for IUL over UL may work out better for your heirs.
How Index Universal Life Insurance Works
IUL policyholders have control — within certain guidelines — over how the funds in their policy are allocated between different interest-accruing accounts. There is generally one fixed account, which gives an interest rate declared by the life insurance company, and multiple indexed account options.
When IUL policyholders decide to put funds in an indexed account — rather than receiving an interest rate chosen by the life insurance company, their cash value will be eligible to receive any earned “indexed interest credits.” Simply put, any funds in an indexed account receive an interest rate that is based in part on how a market index performs over a given period of time. The life insurance company uses the index as a benchmark to help determine any credits that the IUL policyholder may be entitled to. The rate for an indexed account may be either higher or lower than the interest rate the life insurance carrier credits on the non-indexed accounts (e.g. the fixed account), and is subject to limits.
Each indexed account option has a minimum guaranteed interest rate, protecting it against loss in the event that a market index goes down. If the option has a guaranteed minimum interest rate higher than 0%, the indexed account may even be eligible for interest during periods where the market index has gone down.
Pros of Index Universal Life Insurance
As is the case with any type of universal life insurance, it’s vital to thoroughly research any potential firms to ensure they’re among the best universal life insurance companies currently operating. With that in mind, here’s a look at some of the chief advantages of including IUL in your financial plan.
1. Higher Return Potential: These policies leverage call options to gain upside exposure to equity indexes without the risk of losses, while whole life policies and fixed universal life policies provide only a small interest rate that may not even be guaranteed. Of course, the annual return you see with an indexed universal life insurance policy will depend on how well its underlying index performs. But your insurance company can still offer a guaranteed minimum return on your investment.
2. Greater Flexibility: Indexed universal life insurance can offer flexibility when putting together a policy that’s designed to meet your investment goals. Policyholders can decide how much risk they’d like to take in the market, adjust death benefit amounts as needed, and choose among a number of riders that make the policy customizable to their needs. For example, you may choose to add on a long-term care rider to cover nursing home costs if that becomes necessary.
3. Tax-Free Capital Gains: Policyholders do not pay capital gains on the increase in cash value over time unless they abandon the policy before it matures, whereas other types of financial accounts may tax capital gains upon withdrawal.1 This benefit extends to any loans you may take from the policy against your cash value. Having a ready source of cash you can borrow against may be appealing if you want to avoid triggering taxes and penalties with an early withdrawal from a 401(k) or IRA.
Unlike a 401(k) or traditional IRA, there are no required minimum distributions for cash value accumulation in an indexed universal life insurance policy.
4. No Social Security Impact: Social Security benefits may be an important source of income in retirement. You can begin taking Social Security as early as age 62 or defer benefits up to age 70. Taking benefits ahead of your full retirement age can shrink your benefit amount, as can working while receiving benefits. You’re only allowed to earn so much per year prior to reaching full retirement age before your benefits are reduced.
Cash value accumulation from an indexed universal life insurance policy wouldn’t count toward the earnings thresholds, nor would any loan amounts you borrow. So you could take a loan against your policy to supplement Social Security benefits, without detracting from your benefit amount.
5. Death Benefit: Indexed universal life insurance, like other types of life insurance, can provide a death benefit for your loved ones. This money can be used to pay funeral and burial expenses, cover outstanding debts such as a mortgage or co-signed student loans, fund college costs for children or simply pay for everyday living expenses. This death benefit can be passed on to your beneficiaries tax-free.
Financial experts often advise having life insurance coverage that’s equivalent to 10 to 15 times your annual income.
Cons of Indexed Universal Life Insurance
There are several drawbacks associated with indexed universal life insurance policies that critics are quick to point out. For instance, someone who establishes the policy over a time when the market is performing poorly could end up with high premium payments that don’t contribute at all to the cash value. The policy could then potentially lapse if the premium payments aren’t made on time later in life, which could negate the point of life insurance altogether.
Aside from that, here are some other considerations to keep in mind.
1. Caps on Returns: Insurance companies often set maximum participation rates of less than 100% and as low as 25% in some cases. In addition, returns on equity indexes are often capped at certain amounts during good years. These restrictions can limit the actual rate of return that’s credited toward your account each year, regardless of how well the policy’s underlying index performs.
In that case, you may be better off investing in the market directly or considering a variable universal life insurance policy instead. But it’s important to consider your personal risk tolerance and investment goals to ensure that either one aligns with your overall strategy.
2. No Guarantees: Whole life policies often include a guaranteed interest rate with predictable premium amounts throughout the life of the policy. IUL policies, on the other hand, offer returns based on an index and have variable premiums over time. This means you have to be comfortable riding out fluctuations in returns while also budgeting for potentially higher premiums.
3. Fees: Indexed universal life insurance policies can come with a slew of fees and other costs, including:
- Premium expense charges
- Administrative expenses
- Fees and commissions
- Surrender charge
All of these fees and various costs can detract from the rate of return offered by your policy. That’s why it’s important to research the best life insurance companies so you understand what you’re paying for coverage and what you’re getting in return.
How Can Index Universal Life Help You Meet Your Financial Goals?
Cash value in a life insurance policy can add flexibility to your financial planning. Funds in an indexed universal life policy can later be withdrawn, taken out as loans, used as collateral, or can help cover the costs of maintaining the insurance coverage.2
Some have found cash value life insurance to be a helpful way to:
- Generate generally tax-free retirement income streams.
- Help cover the cost of education for children and grandchildren.
- Set aside financial resources for the unexpected.
- Plan for increasing costs of health care, long-term care, assisted living and other similar expenses.
Indexed universal life (both individual and survivorship) provides death benefit protection today, and flexibility to help cover your needs in the future. When funds are allocated to an indexed account option, cash values may get the dual benefit of increased upside potential through index-based growth and downside protection against market-based loss.
Indexed universal life insurance can help you meet your family’s needs for financial protection while also building cash value. These policies can be more complex compared to other types of life insurance, however, and they aren’t necessarily right for every investor. Talking to an experienced life insurance agent or broker can help you decide if indexed universal life insurance is a good fit.