About Indexed Universal Life Insurance
Indexed Universal Life Insurance (“IUL”) is a distinct flavor of life insurance that continues to grow in popularity due to its flexibility and enhanced growth potential.
IUL is permanent life insurance – like whole life insurance – which means that, once you purchase an IUL insurance policy, it remains in place for the rest of your life (as long as you continue paying the premiums).
Term life policies, on the other hand, expire at the conclusion of the policy’s predefined term (e.g., ten, twenty, or thirty years).
So, if you want a policy guaranteed to pay out when you die – regardless of when that actually happens – you will need permanent life insurance.
IUL Cash Value
Along with providing lifelong coverage, the other core characteristic of permanent life insurance is a cash value feature that allows a policy to act as both life insurance and a savings vehicle.
Each premium payment is split between the insurer’s underwriting costs and a cash-value account so that, the longer the policy remains in place, the greater the cash value grows.
If a policy stays in place long enough, its cash value will eventually equal – or in some cases exceed – the original death benefit (the policy’s “face value”).
Borrowing Against Cash Value
A permanent policy’s progressively increasing cash value can be borrowed against, withdrawn entirely or in part, or applied toward premiums later in the policy’s life.
A paid-up life insurance policy has accrued sufficient value to cover premium payments for the duration of the policyholder’s life.
Or, if you reach a point where you no longer need life insurance, a permanent policy can be surrendered, which means you agree to forego the death benefit, and the insurance company writes you a check for the policy’s cash surrender value.
Importantly, the money attributed to a permanent life insurance policy’s account doesn’t just sit there collecting dust. It grows in a compound interest account. How cash value grows in an IUL policy is what sets apart different types of permanent life insurance.
Types of Permanent Life Insurance
Whole life insurance is the most basic version of permanent life insurance. With dividend paying whole life, the cash value grows at a guaranteed rate comparable or greater than the highest yielding CD, supplemented by dividends from the insurance company.
When combined with fixed premiums, the guaranteed growth makes traditional whole life reliable, safe, and predictable, with zero risk of loss.
Whole life has withstood the test of time, but some policyholders are willing to trade a little risk for potentially greater upside.
For example, variable life insurance allows an investment of cash value within sub-accounts linked to the policy.
Variable life sub-accounts are comparable to mutual funds, and, like mutual funds, increase or decrease based upon investment performance.
As a result, variable life offers considerable growth potential, but there’s also the risk that the policy will lose money if markets turn sour, which can result in higher premium payments necessary to maintain the same level of coverage.
If you’re counting on a variable life policy as a source of retirement income, a market downturn can be a troubling financial setback.
IUL Blends the Two
Indexed Universal Life is a blending between the security of whole life and the growth potential of variable insurance policies.
An IUL insurance policy is linked to an equity index (such as the S&P 500) so that policy growth corresponds to index performance.
Significantly, though, indexed policies come with mitigated risk or a no-loss guaranty from the insurance company. That is, if the index goes down, the insurer will absorb some or all of the loss, and the policy won’t lose money.
Some IUL policies even guaranty a minimum rate of return regardless of index performance.
How Indexed Universal Life Insurance Works
As with other permanent life insurance policies, premium payments for an IUL policy are divided between underwriting costs and cash value.
Cash value is then, in turn, apportioned by the policyholder between a fixed account growing at a guaranteed rate and an indexed account growing based on index performance. This lets you fine-tune the policy to your preferred risk level.
Younger life insurance policyholders concerned more with long-term growth typically focus on the indexed account, whereas a policyholder closing in on retirement age can hold a greater portion of cash value in the fixed account.
IUL Insurance Companies
It’s worth noting that IUL policies vary considerably among insurance companies, and even among policies. Some insurers allow you to choose between indexes or split the investment into different indexes. And some insurers have a specific index that they use.
The money held by an IUL policy is not directly invested into securities. Instead, the insurance company pays interest on the account but determines the rate according to the relevant index (usually without regard to dividends).
IUL calculations are based on index performance over defined time-periods – typically, monthly, quarterly, or yearly. Day-to-day market fluctuations are irrelevant; what matters is the net change over the entire period.
Insurers are able to absorb losses when an index goes down by sharing the rewards when markets are up. There are a few ways IUL policies can be set up to do this.
The “participation rate” is the percentage of index gains credited as interest on a given policy.
If a policy has a 50% participation rate, interest is calculated as half of the index growth.
Thus, if the policy has a $100,000 cash value, and the index increases by 10% over the interval, the interest paid would be $5,000 (or half of the 10% growth).
Participation rates can vary considerably between policies. Some companies offer 100% participation or higher and make up for potential losses through other mechanisms.
Another approach is to cap interest at an agreed rate. A policy with a 6% cap credits the index’s gains to the policy up to a maximum of 6%. If the index increases by 6%, the policy receives the full 6%, but if it goes up by 8%, the interest is still calculated at 6%.
A single policy might combine a participation rate and a cap to allow the policyholder some of the fruits of a bull market while still providing the insurer with a cushion when a drop inevitably occurs.
For example, an IUL policy could be set up to allow 100% participation up to 5%, and then 50% participation for gains above 5%.
Caps and participation rates are essentially the cost of eliminating downside risk. With that in mind, insurance companies often offer IUL policies with higher caps and participation rates if you are willing to accept a lower floor (the guaranteed minimum policy performance).
For instance, a policy with a guaranteed floor of 2% growth will probably have a lower cap than a policy with a zero-loss floor.
Likewise, a policyholder willing to tolerate a potential loss of up to 2% will likely be rewarded with a higher cap and/or participation rate as compensation for sharing some of the insurance company’s risk.
Floors and caps are the chief factors in shaping an IUL policy’s predictability and growth potential.
A policy with a 2% floor and a 6% cap is a stable, secure asset that provides protection against market downturns with genuine upside in good economic periods (along with, of course, the peace of mind that comes with the death benefit).
Conversely, a policy with a negative 2% floor and a 12% cap involves some exposure to risk but also allows for excellent earnings in boomtimes.
The “right” policy for a particular person depends on a variety of criteria including age, other assets, the purpose of the coverage, and individual risk-tolerance preferences.
Other Features of IUL Policies
Within a given range, IUL policies allow the policyholder some discretion in choosing the amount of premium payments.
You can apply increased premiums toward a larger cash value or death benefit.
Conversely, you can opt to pay a lower premium if you are willing to sacrifice some of the policy’s value.
Or, you can pay a little less when you need extra cash on hand and then make up the difference with future payments.
If markets are up, you can apply some of the growth toward premiums to maintain current liquidity.
As with most things in life, you get out of it what you put into it. But the flexibility of an IUL policy’s premiums allows you to adapt the policy to fit within your overall financial strategy as your situation changes.
Along with premium flexibility, IUL also allows for variability in the amount of a policy’s death benefit.
The policy’s face value needs to remain within permissible parameters, but, within those limits, you can adjust the premium percentages applied toward death benefit versus cash value – allowing you to modify coverage and growth opportunity to your current needs and circumstances.
Younger, healthier insureds can generally credit a higher percentage of premium toward cash value due to the lower underwriting costs the insurer incurs in providing the death benefit.
The disadvantage of IUL flexibility is that, to be customizable, policies must also have a certain level of complexity.
The various investment options and formulas for calculating growth are notably more complicated than a traditional whole life policy with fixed premiums and interest.
Financially sophisticated policyholders who enjoy following investments are well-suited to IUL, but a policyholder who just wants to pay premiums and let the policy take care of itself might be better off with whole life, which is why proponents of infinite banking trend to steer practitioners towards whole life.
IUL policies also tend to have higher fees than whole life due to the more complicated investment structure.
Like most other types of life insurance, IUL policies are available with multiple riders. Riders generally come at an extra cost, but, in many cases, the cost is worth it.
Living benefits riders, which accelerate death benefits in the event of a catastrophe that does not result in death, are among the most popular IUL riders.
Many insurers offer riders covering terminal, critical, or chronic illnesses, or chronic injuries, with the benefit paid usually based upon the severity of the illness or injury.
Living benefits riders allow an IUL policy to serve as a safety net in case of long-term incapacity, while still providing death benefits and a savings component.
IUL in Retirement and Estate Planning
IUL policies are useful as security in the event of early death, and also as a tool for life insurance retirement planning and estate planning.
The growth earned by the policy is tax-deferred until actually withdrawn, and there’s no tax penalty for early withdrawals like with an IRA.
If triggered, the death benefit is not taxable income to the beneficiary.
And an IUL policy owned by a life insurance trust can be an effective means of limiting estate taxes, providing for the care of loved ones, and ensuring that adequate liquidity is available to pay for administration and taxes.
Because indexed universal life insurance policies are a sophisticated, highly-customizable financial product, it is usually a good idea to work with a broker or financial-planning expert with IUL experience when looking for a policy.
An experienced professional can guide you through the application process and help choose the coverage levels, investment options, and riders that are best-suited to your needs.
It’s better to get some help early on and find precisely the right fit than to limit your options and end up with a policy that isn’t ideal for your situation and goals.
So what are you waiting for? Give us a call today for your complimentary strategy session to see if Indexed Universal Life Insurance is the right product for you, based on your unique needs, goals and objectives.