We all yearn for financial independence and a stable retirement. In our quest for these goals, many look to new sources of stability and future income outside of savings, Social Security, and conventional instruments.
Insurance policies are ways to improve potential future income and secure retirement income. They are a core component of any sound financial or retirement plan, which includes equities, fixed investments, cash investments like money market funds, and high-yield savings accounts that provide a better APY.
They help protect policyholders and their loved ones from life emergencies and other unforeseen events like a loss of income while ensuring financial health continuity in case the policyholder encounters accidents or death.
Indexed universal life (IUL) insurance is a form of permanent life insurance. Like any permanent life insurance policy, it comes with a cash component and a death benefit. It differs from whole life insurance mainly in how the cash value operates.
In whole life insurance, the cash value increases based on a fixed interest rate set at the beginning. By contrast, IUL cash value is tied to the performance of well-known stock market indexes like the S&P 500 or the Nasdaq-100.
IUL has been a highly profitable business for the insurance industry. Many insurers are selling this product. But is it truly worth the investment they say it is?
Some critics say the IUL is too complex and sold using deceptive marketing. Proponents say it’s worth the risk, citing benefits like tax advantages and guarantees you can’t get by investing in the stock market alone. Here, we dive into indexed universal life insurance and examine whether it’s a good investment.
How Indexed Universal Life Insurance Works
IUL policies, like universal life insurance, have adjustable premiums. Skipping or underpaying premiums is possible, and you can adjust the death benefit along the way. As said, IUL is different because of how its cash value portion is invested.
The insurance company will guide those who take out an indexed universal life insurance policy in choosing the index used for all or part of your cash value segment of the policy, as well as the death benefit.
When you pay a premium on your account, part of it pays the cost of your insurance based on the insured’s life. After fees are paid, the remainder is added to the policy’s cash value.
Your total cash value is credited with interest based on increases in your chosen equity index. Some IUL policies may even allow you to select multiple indexes. Take note that it’s not directly invested in the stock market. IUL policy owners can usually borrow against their accumulated cash value. Any unpaid loans are deducted from your death benefit.
IUL doesn’t work like directly investing in an index fund. In a market downturn, you receive protection from the policy. A guarantee applies to your principal, thus insuring it against losses. However, you have a cap on your maximum return. You can divide your assets between the indexed and fixed portions of your IUL policy.
Insurance policy comparisons
To better understand universal indexed life insurance, it helps to compare it with other types of life insurance and how various policies are categorized.
There are two main classifications, namely permanent and term life insurance. Within permanent life insurance, policies are divided between universal life and whole life insurance.
Term life insurance covers a limited time frame of 10 to 30 years. It is a type of temporary coverage. The family receives a death benefit if the policyholder dies within the specified period. Term insurance is cheaper than other options.
Whole life insurance is a permanent policy. There is no time limit for beneficiaries to receive their benefits. Part of the premiums paid go to funding a cash account. The policy funds a payout when enough money accumulates in the cash account. While alive, you, as a policyholder, can withdraw funds or borrow against the cash.
Universal life insurance is also a permanent policy. It has a built-in cash value account. Universal life insurance is flexible, meaning you can adjust your premiums and death benefits. It is also possible to realize higher interest rates on your cash value component’s growth, which you can use to pay premiums.
Given these classifications, you can better differentiate indexed universal life insurance versus other policies. IULs have index caps and floors, which fluctuate with changes in the tracked index. The index caps and floors vary with each policy.
Differentiating features of IULs
Compared to other kinds of life insurance, the most apparent edge of an IUL is its ability to ride stock market returns without the risk of loss. The floor is always zero. It does this while assuring policyholders of a death benefit that is given to beneficiaries tax-free.
While the interest rate derived from the chosen equity index account may fluctuate, the policy offers an interest rate guarantee, limiting losses. Gains, however, are also capped typically between 8 and 12 percent. The capped gains offset the minimum guaranteed percentage of return.
Thus, an IUL is considered less risky than a variable UL insurance policy but more volatile than fixed universal life policies due to the other products’ lack of investment in equity positions.
Insurance riders like long-term care for nursing home costs or accelerated death benefit riders that pay benefits when the policyholder becomes terminally ill are standard features of IULs.
Moreover, with IULs, you can enjoy tax-free capital gains unless you abandon the policy before it matures. This feature gives it an advantage over other financial instruments, which could tax your capital gains upon withdrawal.
With an IUL, you can also pass on death benefits to beneficiaries tax-free. It will not impact Social Security benefits. In addition, unlike a traditional IRA or 401(k), it does not have required minimum contributions.
Is an IUL The Right Investment For You?
It’s essential to see indexed universal life insurance as something that blurs the line between insurance and investment. You expect it to be different from a typical investment or insurance policy. Should you get it? Let’s round up the pros and cons.
Advantages of an IUL
Based on their features, indexed universal life insurance policies offer unique advantages over other types of insurance.
Risk aversion with market exposure
They can be tailored to the holder’s risk preference. The choice of the index reflects their preferred risk level. They may deliver higher returns than other insurance policies. IULs appeal best to those who want exposure to potential market gains without direct investment in the stock market.
Tax-advantaged growth
IULs provide tax-deferred cash value growth. They also offer a tax-free benefit, which helps with tax-advantaged savings and estate planning. They also enable tax-free capital gains.
Flexibility
An IUL accommodates flexible premium payments within limits. An IUL’s cash value can be used to cover or decrease premiums without reducing your death benefit. These policies do not reduce your Social Security benefits or require you to pay capital gains on your cash value increases.
However, abandoning the policy before maturity negates the non-payment of capital gains. In cases of emergency, policies allow you to access your cash values, granted you pay the fees.
Life insurance coverage with cash value growth in one product
IULs offer a tandem of life insurance plus cash value growth in one product, which may appeal to individuals who want this approach to investing.
Designed for long-term financial planning
An IUL is suitable for those with long-term financial goals, such as long-term investment, estate planning, or retirement planning. It is specially designed to be a long-term financial product.
Ideal for those who understand complex financial products
IULs are not run-of-the-mill insurance policies, and the mechanics can be complicated to understand. However, those with some financial background or who enjoy deep diving into their various components may find it ideal.
Disadvantages of an IUL
While IULs offer unique benefits, policyholders must be aware of the following risks:
Market risk
An IUL’s cash value is tied to an index. It could be plain vanilla indexes like the Russell 500 or the S&P 500. It could also be tied to uncustomary choices like gold, the Hang Seng, and emerging markets indices.
​​Photo by PiggyBank on Unsplash
Thus, returns will vary, resulting in premiums that fluctuate over time. If the index performs poorly, the IUL’s cash value will not grow as expected. Even with the downside protection, you could have a cash value lower than conservative investment options. IULs may also underperform the stock market during upswings.
Liquidity requirements
You must be comfortable with variable returns if you are available for an IUL. You must also expect to allocate a budget for potentially higher premiums in the future. Policyholders must be in a sufficiently liquid financial position to adapt to these variable conditions.
Capped returns and participation rates
IULs may offer better rates of return, but only up to a point. They are typically capped between 8 and 12 percent, limiting the amount of index gains credited to the cash value, a feature that could discourage some investors.
High costs and fees
Watch out for higher premiums and commission and administrative fees versus other policies. Such costs may reduce your policy’s cash value growth and overall returns.
Overlooked or undisclosed risk
With options, the holder buys or sells the underlying index at a set price and time—this can rise or fall quickly. If the timing is right, and you exercise an option “on the money,” you get a significant payoff. On the other hand, if the option expires OTM or out of the money, your investment is lost.
This scenario highlights the often overlooked risk involved in IULs over traditional insurance. There are cases wherein the overall risk is not disclosed in detail. As IULs tend to be more complex than conventional insurance, policyholders must ensure they are well-informed.
Product complexity
IULs can be more challenging for typical investors to understand. Their combined index options and life insurance features make them more complex than getting each product separately. Policyholders must be diligent about the terms and conditions of their policy. They must also understand how the cash value component is calculated and credited.
Are you interested in IULs? Make sure you’re a good fit
Indexed universal life (IUL) insurance policies are not for everyone. Before investing in an IUL, ensure you have a clear assessment of your risk tolerance, financial circumstances, and goals.
Ideal candidates for IULs are those who understand complex financial products, can tolerate a higher level of market risk, and dive into the complexities of index investing. Moreover, they must have sufficient liquidity to ride out market volatility and cover maintaining IUL policy costs.
On the other hand, if you have immediate or short-term financial needs, experience gaps in cash flow, prefer a straightforward financial product or desire low-cost investments, stay away from IULs.
Confirm your choices with a qualified financial advisor who can help you navigate the features of this exciting yet complex insurance product.
