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  • Writer's pictureWing Chan

The Pros and Cons of Indexed Universal Life Insurance

Updated: Oct 10, 2023

What is an Indexed Universal Life Insurance Policy? An indexed universal insurance policy is a type of permanent life insurance policy. There are two main characteristics of permanent life insurance:

  1. No expiration date once you buy it and pay the premiums, the death benefit will be paid out to your beneficiaries when you die (unlike term life insurance, which is only valid for a certain period of time).

  2. A cash value component that can act as a savings or investment tool. What makes IUL different from other types of permanent policies is that its cash value component earns a variable rate of interest tied to a specific market index like the S&P 500, NASDAQ Composite, or Dow Jones Industrial Average. Some insurers choose the index and others allow you to choose one or multiple indices. When the chosen index performs wells, you earn a lot of interest. If it doesnt do so well, your earnings reflect that too. Since the market can be volatile, many insurers set a guaranteed minimum interest rate, also known as an interest rate floor, usually between 0% to 3%. The floor ensures that even if the index isnt performing well, you wont lose a lot of money. At the same time, insurers usually set a maximum interest rate at which the cash value component can grow. Its important to note that IUL is not considered an investment in the stock market (unlike variable universal life insurance). An IUL policys cash value growth only tracks the selected indices and grows based on the pre-set limitations. Its not considered a securities product and doesnt need to be registered with the SEC.

Indexed Universal Life Insurance versus Whole Life Insurance The way interest works with IUL is different from the way it works in whole life insurance, also a type of permanent life insurance. Whereas the interest earned in an IUL policy grows at a varied rate, the interest earned with a whole life insurance policy grows at a fixed rate set by the insurance provider. The variable rate, by its very nature, makes IUL a riskier financial product. Also unlike whole life insurance, IUL premiums are not fixed. They start out lower and grow each year. For this reason, we recommend paying more than the minimum premium payments in the beginning, when the costs are low. The excess goes into your cash value account and helps it grow faster. The idea is for your cash value to reach a point where it can cover your insurance premiums. Another way IUL differs from whole life insurance is that the death benefit is adjustable. Most whole and term policies dont allow you to change the amount of the death benefit once youve purchased the policy, but IUL gives you the option to raise or lower it as your financial needs change over the years. Some insurance companies, however, place a cap on how much you can increase your death benefit without the need for an additional medical exam. Despite the significant differences between IUL and whole life insurance, they arent completely different animals. Both types of life insurance allow you to use the cash value that accumulates to pay your policy premiums once it reaches a certain amount. Additionally, both types of policies have management fees (though the fees in IUL may be higher). And of course, both offer a death benefit that lasts your entire lifetime.

Pros of Indexed Universal Life Insurance IUL may sound complicated, but for people in specific financial situations, it can be a worthwhile way to provide coverage for loved ones and make a smart investment. Below are some of the benefits of indexed universal life insurance.

Cash Value Like most permanent life insurance policies, IUL has a cash value that can be used during the policyholders lifetime. You can make tax-free withdrawals, up to the amount you paid in premiums. These can be used down the line to help pay for long-term care costs, supplement retirement income, and more. You can also borrow against the cash value and avoid the tedious requirements of applying for a traditional loan.

Higher Return Potential Because interest earnings in IUL are tied to stock market indices, you have higher earning potential (better rate of return) when the market performs well. And since many insurers have a minimum interest rate, you have more to gain from a high-performing market and less to lose if the market doesnt perform well.

Tax-Free Capital Gains You dont need to pay capital gains when your cash value increases over time (unless you abandon the policy before it matures). This includes any policy loans youve taken out against the cash value. Tax-free capital gains also mean that you can use IUL as a way to supplement your retirement income without serious tax implications.

Flexibility Flexibility is the name of the game when it comes to IUL. Monthly premiums and the death benefit are not fixed, and you can adjust both to suit your financial situation at different points in your life. This is a big deal for people who dont want to be locked into a rigid long-term commitment.

Annual Reset The built-in annual reset feature of IUL means that your interest earnings start from zero each year. The benefit of this is that, if the market incurred losses in the previous year or two, you dont need to earn x amount to catch up and recoup your losses. Each year the slate gets wiped clean to zero, so you can start from scratch and not have to earn as much to break even or make gains.

Cons of Indexed Universal Life Insurance IUL has many benefits, but there are also several facets of this type of policy that make some wary of buying it. Below are some cons of IUL.

Caps on Returns and Participation Rate Just as insurers set a minimum interest rate to ensure that policyholders dont lose too much money from the policy, many also set a maximum interest rate. For example, if the insurance company sets a 14% cap but the market earns 22%, youll still only earn 14% in interest. Some insurers also limit the percentage of the overall index you can participate in, known as the participation rate. For example, if the index returns 10% in a given year but your policy has an 80% participation rate, youll get an 8% return instead of a 10% return.

Fees IUL includes a lot of fees like administrative expenses, a surrender charge, premium expense charges, commissions, and more. These fees can add up and ultimately detract from the potential high interest earning of the policy.

Cash Value Earnings Arent Guaranteed Whereas whole life insurance policies usually offer a guaranteed interest rate, IUL interest rates are variable, and therefore, not guaranteed. Insurers usually set an interest rate floor, which can prevent you from losing money based on the market index, but your cash value wont grow if you still need to pay your fees and premium payments. In other words, you may not be losing on your investments they will remain at zero but you will still be charged the standard fees and premiums, which will be taken out of your cash value and may leave it at a deficit.

Bottom Line Indexed universal life insurance is a fairly complicated type of life insurance policy that offers a flexible death benefit and premium payment options, along with a cash value thats invested in a stock market index. As with any life insurance policy, there are pros and cons of IUL. The question that you need to answer is whether IUL is a good investment tool for your specific situation. If youre not sure, Sproutt insurance advisors are available to help you with this important decision.

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