How Indexed Universal Life Insurance Works
Universal life insurance is a type of permanent life insurance, meaning it provides coverage for your entire life. Compared to its permanent counterpart, whole life insurance, universal life offers a little more flexibility for you to adjust your policy as you age.
Indexed universal life insurance falls under the category of “non-guaranteed” universal life insurance, which comes with a cash accumulation account that is—just as it sounds—not guaranteed. An indexed universal life policy is tied to a stock market index such as the S&P 500. The stock market provides a benchmark for which the IUL policyholder’s cash accumulation account is credited.
InvestmentNews likens IUL to
“a cousin of traditional universal life insurance coverage, permanent life insurance that permits clients to pay flexible premiums,” adding,
“Unlike variable universal life insurance, clients aren’t directly investing in the market. Rather, their cash value reflects the performance of an index subject to caps and floors.”
With IUL, you are basically “participating” in a stock market index, with maximum and minimum percentages on your return. In theory, you hope to see a higher return than you would with a traditional universal life policy, which only credits using the insurance company’s benchmarks rather than the stock market. Meanwhile, the “floor” percentage provides some protection in the case of poor performance.
Pros and Cons of Indexed Universal Life Insurance
Indexed universal life insurance is very complex, but its benefits and drawbacks are actually rather clear:
Pros
- Cash value growth is tax-deferred
- Higher return potential compared to other universal life and whole life policies
- High degree of policy flexibility and customization
- Lower risk than actually investing in the stock market
- Capital gains are tax-free
- Tax-free borrowing from cash accumulation
Cons
- Poor performance can negate contributions and dwindle cash value down to zero
- Many variables subject to change by the insurance company
- Maximum “participation rates” are typically well below 100 percent (cap on returns)
- No dividends, just a credit to your account
- Loans from cash accumulation are subject to interest
- The policy is not guaranteed, meaning the investment can flop and the policy can become unaffordable
- The Nelson Nast Institute elaborates on IUL drawbacks in an article titled, “The Top 10 Reasons Not to Buy Equity Indexed Universal Life Insurance.”
What Agents Will Tell You About IUL
We’re seeing many agents out there immortalize IUL to consumers. They tell them things like:
- “You can use the return to send your kids to college.”
- “You can retire on it.”
- “You can borrow from it.”
- “The potential for return is enormous.”
We might argue the “enormity” of IUL’s potential, but we won’t argue that it does indeed have potential. If you happen to invest in IUL during a sustained hot streak in the stock market, you could see a noticeable return. The problem is that the risk is much higher than the reward.
Bringing IUL Back Down to Earth
While IUL might be an attractive investment on paper, the way it is presented by agents has been questionable—so questionable, in fact, that in 2014, the State of New York’s insurance regulator
probed 134 insurers on how they market such policies out of concern that they were exaggerating the potential gains to consumers. After continued scrutiny, IUL was hit in 2015 with regulations that the
Wall Street Journal called, “
A Dose of Reality for a Hot-Selling Insurance Product.”
IUL aside, remember that in any cash-accumulating life insurance policy:
- You will usually have to “overfund” the policy on the front end in order to offset the annual cost of insurance increase.
- You pay interest on the money you borrow.
- The cash value is not a death benefit. When you die, your beneficiary will not see that money.
Learn more about cash value in life insurance
here.
Who Should Invest with Life Insurance?
Whether or not life insurance is a good investment for you will depend on numerous factors, such as your age, your health, and your financial standing.
That said, for the general population of working class Americans, life insurance is not a sound investment.
At our independent agency, we typically only advise the ultra-wealthy to consider investing with life insurance, mainly as a tax shelter. Even then, many experts will still tell you to
steer clear.
The problem isn’t necessarily that life insurance is a bad investment; it’s that most people don’t understand that it is an investment. If you take away one point from this article, let it be this: When investing with life insurance, there is always a risk involved. The cost of insurance is not fixed in a policy that builds cash, meaning it’s possible that your cash accumulation account could eventually dry up if either or both of the following occur:
- The index your policy is linked to does not perform well over an extended period of time.
- The cost of your premium (which increases with each year you age) exceeds your cash accumulation income.
The financial risk is compounded by the fact that this can all happen without you realizing until it’s too late, in which case you might find yourself both unable to pay your premium and unable to secure new coverage.
“Should I Buy Indexed Universal Life Insurance?”
We want to make it clear that this article is not meant to be a march against IUL. It can be the right product for the right investor, however, that “right investor” is essentially the top 10 percent of earners. For IUL to be a truly smart investment, you should be able to answer, “yes” to all of the following questions:
Are you making at least $250k per year?
IUL is not designed for the middle class or novice investor.
Is your income stable at that level?
If you are in a bubble market, or if your income could drop substantially, IUL is not the type of investment you want to be making. It is very expensive, with many variables and a high level of risk.
Are you maxing out all of your other investment options?
“Before buying complicated insurance products like universal and indexed universal life insurance, make sure you’re taking full advantage of other tax-deferred investing alternatives such as traditional or Roth IRAs, combined with stand-alone term life insurance first. For most people, this will be a more affordable choice, and potentially a better long-term value.”
Do you have a high risk tolerance?
Can you handle seeing the stock index perform poorly knowing that it directly affects your life insurance and your ability to protect your family from financial hardship after you die? This is the final gut check that deters even extremely wealthy investors from IUL.
Safer Options
The whole point of buying life insurance is to reduce risk, not create it. If you are realizing that IUL is not right for you, consider two options that are safe “investments” with no risk attached:
“Buy Term and Invest the Difference.”
Instead of investing with universal life, many financial experts will repeat the age-old mantra, “Buy term and invest the difference.” This saying refers to term life insurance, which offers guaranteed coverage for a set number of years.
When you buy term life insurance, you can take the money that you would have been investing in universal life and put it toward a more straightforward investment, such as stocks, bonds, or mutual funds.
The benefits of term life insurance are:
- Affordable coverage
- Flexible options
- A fixed rate for a set period of time
- No startup costs
- No surrender charge
- No hidden fees
- The freedom to cancel or change your policy at any time
Term life insurance is ideal for those who are looking to insure their family for a mortgage, children’s college tuition, or income loss protection. Learn more about term life
here.
Guaranteed Universal Life Insurance
At JRC, we are strong proponents for the risk-free counterpart to IUL:
guaranteed universal life insurance (GUL). A GUL policy is a hybrid between term life and universal life that can enable you to leave a legacy behind, tax-free. Most clients in their 50s and 60s choose GUL over term life because GUL lasts up to a specific age—rather than a set number of years—that can be well into their 100s.
The benefits of GUL are:
- Your cost of insurance will not change, even as you get older or if your health changes.
- Your coverage isn’t tied to an investment. You pay for the life insurance protection only, just like term life insurance.
- You aren’t pouring extra money into your policy. Trust the financial experts on this–you’re better off putting your money into a savings, or perhaps paying down your mortgage.
- You will pay less up front. Guaranteed universal life insurance is a fraction of the cost of non-guaranteed universal life.
- You don’t run the risk of losing coverage from unfavorable investments or changes in the market.
For an in-depth comparison between non-guaranteed and guaranteed universal life insurance,
click here.
Shop the Market
Most importantly, take the time to review the options before you buy any life insurance policy. Instead of putting all of your eggs in the basket of a big-box insurer, let an independent insurance agency like JRC shop the entire market on your behalf.
Since we are not employed by any one insurer, we are able to shop 40+ carriers with ease. We then relay quotes to you, and provide consultative support to help you make a decision you can feel confident in—all at no charge, with no obligations. Click the button below to get started today, or give us a call toll-free at:
855-247-9555 and speak with an expert.