One of the more controversial retirement income products, Indexed Universal Life Insurance (IUL) is a financial tool with potential benefits as well as possible pitfalls. IUL is a favorite target of financial pundits who seem to either passionately hate it or think it is a gift of the gods. There doesn’t seem to be a lot of lukewarm opinions when it comes to this type of insurance.
Like most things in life, IUL has both good and bad qualities and some features that are challenging to fully understand. In this short article, I’d like to break through some of the noise surrounding indexed universal life insurance. It’s definitely not for everyone, but there are people for whom it might make sense.
What is IUL anyway?
When you see the word “indexed” referring to a universal life policy, it indicates that the insurance company uses crediting strategies that are tied to market indexes. These kinds of crediting strategies give your policy the potential to earn higher annual interest than what a traditional universal life policy’s fixed account yields. When properly designed, funded, and managed, IUL may give you attractive growth options and tax advantages along with limited risk. It is essential that you have a sufficient understanding of how IUL crediting strategies work before diving into this product.
IUL versus other kinds of life insurance.
If you want to understand indexed universal life insurance more easily, you should first know some insurance basics.
Generally speaking, life insurance comes in two varieties: term and permanent. The most well-known types of permanent insurance are whole life and universal life.
You may be familiar with whole life insurance which is a permanent policy with no time limit on when your heirs will get the benefit. In a whole life policy, the insurance company places some of the monthly premium into a cash account. The idea is that once you’ve accumulated enough cash in that account, you’ll receive payouts. Whole life is touted for its’ so-called “living” benefits, such as the ability to borrow against this cash or withdraw specific amounts while you are still alive.
Term life insurance, on the other hand, is a more temporary type of insurance that covers you for a certain period of time, typically anywhere from 10 to 30 years. If you die within the coverage period, your beneficiaries get a death benefit they can use to help with funeral and other expenses. Generally speaking, term is the least expensive type of life insurance for most people.
IUL, is another variety of permanent insurance. Unlike traditional universal life insurance, though, IUL doesn’t earn interest at a fixed rate. Instead, its cash value account is tied to performance of a specific market index such as the S&P 500.
A plus for IUL is that unlike investing directly into an index fund, you don’t lose money when the market goes down. In an IUL, your principal is guaranteed against losses. This is a great feature, but with some IUL policies it comes at a price. That’s because many indexed universal life policies cap the maximum returns you can earn. This means that if the market is doing particularly well, you might not get the returns you’d get with another financial product.
Another tradeoff of IUL is that it is often more complicated and not suited to people who like to “set and forget” things. IUL is a fundamentally sound product as long as it is properly designed, funded, and managed. If you decide to purchase one of these policies, you must understand that you’ll need to adjust the policy occasionally, especially if it is not performing as well as the original illustration you received. If you don’t like fiddling with things, IUL is probably not your best choice.
Fees and the cost of insurance (COI) are deducted from an IUL’s premiums. Remaining premium stays in the cash value account to achieve growth. A portion of your account’s growth will be used to pay for any future policy costs. If you have surplus cash value, you could possibly use it for tax-exempt distributions.
How does Index Crediting work?
Indexed universal life’s most intriguing value proposition goes something like this:
“Hey John! What if your portfolio got beaten down in bad year and you could replace your loss with a ZERO, hit the magic reset button, and then start over from a lower market position next year? Wouldn’t that be amazing? Well, with IUL you can do exactly that!”
While this is true, you need to be aware that it may be challenging to get significant portions of market rebounds with an IUL due to its caps and participation rates. Also, in a well-designed IUL, your ongoing fees and costs could average anywhere from 0.50% to 1.5%. Still, IUL has often proved to be at least as effective as many other retirement vehicles that don’t offer you the possibility of safe, steady growth.
Also, in spite of what the anti-IUL crowd would tell you, an IUL insurance carrier is not keeping profits above 10% for themselves. In reality, index crediting protocols are, for the most part, profit-neutral for the carriers. IUL issuers are managing options-hedging strategies as a value-added feature to get you to remain a client for life.
The mechanics behind IUL’s cap & floor growth strategy and how it works with S&P 500 Options.
Every universal life policy has an interest rate that’s declared annually. For this example, let’s say it’s 4%. With indexed universal life you have a choice of that same 4% stated crediting option. Or, you can decide to use an S&P or other index crediting strategy. This crediting strategy may come with a 0% floor and a 10% cap. Your IUL company is able to give you a 0% floor with no stock losses because the strategy is tied to how the index call options work. Your maximum loss with when buying options is the cost of those options. In this case your max loss is the 4% fixed account growth rate you could’ve had. Technically, you have no market risk per se. You are basically risking the 4% you had for the potential of 10% if the S&P grew by at least that much.
An IUL’s floor is guaranteed. However, the cap is adjusted annually by insurance companies depending on interest rates and stock market volatility. Both volatility and interest rate changes affect option pricing, and thus, how much S&P 500 index exposure the UL fixed yield will buy.
Are there other benefits of indexed universal life insurance?
As I explained, one of the most appealing features of an indexed universal life insurance policy is that you can participate in stock market gains while hedging against losses. And, while crediting strategies may mean you might get as much of any upticks as you would with other vehicles, IUL is a great way to add some market exposure to your portfolio without taking on too much risk.
Some other positive features of IUL include:
Tax-free growth and distributions. Instead of being tax-deferred like annuities or other retirement products, distributions from IUL policies are tax-free. This means that, similar to a Roth IRA, you won’t pay taxes on the money you withdraw from your IUL’s cash value account.
IUL’s have unlimited contributions. Traditional retirement accounts such as 401ks or IRAs limited your contributions while IULs do not.
No age requirements. Most qualified plans and other retirement programs make you wait until you reach age 59 ½ before you can make withdrawals penalty-free. With IUL’s, there is no age requirement.
Your death benefit creates a legacy. An IUL provides a death benefit for your heirs that is generally not taxed.
You can take out loans. Depending on the kind of policy you have and how much is in your cash account, you may be able to borrow money from your IUL. These loans are penalty-free, tax-free, and don’t subject you to a credit check. You also don’t need to pay the loan back.
What are some downsides?
As I have pointed out, when correctly structured and managed, IUL is a great way for some individuals to add market exposure to a portfolio while avoiding risk. However, there are, as is the case with every financial product, a few drawbacks, including limits to upside gains, complexity, and high fees and administrative costs.
Also, in the big picture, IUL’s are best when used as long-term vehicles. One rule of thumb is that you should not take any income from an IUL policy for at least 10 years. If you’re a short-term investor, there are probably much better, less costly options.
The bottom line: For certain people, an indexed universal life policy is an efficient, flexible tool to take advantage of market gains while buffering against volatility. These are, however, complicated instruments requiring proactive management and an in-depth understanding of the policy’s mechanics. If you are thinking of purchasing IUL, you should partner with an expert in this type of insurance; one who can thoroughly explain the pros and cons and answer all your questions.
