In this article I’d like to discuss the Indexed Universal Life (IUL) insurance policy, a financial product that seems to polarize those in the Insurance industry. For years there have been Whole Life agents that will sling mud at this product from every direction possible, and with incredible voracity. Yet, there are options available to the consumer in the IUL that just aren’t available from any other top rated life insurance companies. So I hope you’ll agree that it’s worth a closer look.
As a financial professional and writer, it is tempting to write in such a way as to be shocking and controversial. Our culture seemingly rewards those that write shocking and controversial content. We just can’t seem to avoid clicking on the link to “5 Secrets to Instant Wealth” or “The 401k is killing more people than Hitler!”
But life isn’t always lived on the fringe, and reality may not be as shocking and controversial as we would like it to be. For those of us that want content that informs and educates, we need to seek content that attempts to be objective. And that is the goal today in our review of Index Universal Life Insurance.
A brief note on IUL Policies
On September 1, 2015, NAIC Actuarial Guideline 49 (AKA “AG 49”), was put into effect. Essentially, AG 49 requires IUL policy illustrations be based on the products general account, which means that cash value growth will be more conservative when creating an IUL illustration using an index than before AG49.
In our opinion, this is a good thing for consumers as it gives a more conservative picture of what a policyholder of indexed universal life insurance can expect. And tempered expectations are good for the industry and for the viability of IUL products long term.
So with that behind us…
Before we venture into IUL insurance pros and cons, we wanted to take a moment and bring attention to some of the best indexed universal life companies.
Top 10 Best Indexed Universal Life Insurance Companies
(According to Insurance and Estates)
- American National
- Lincoln Financial Group (LFG)
- Minnesota Life
- National Life Group
- North American Company
- Pacific Life
- Penn Mutual
For more on these companies, including information on their IUL policies, please click on any of the above company names to be taken to our accompanying life insurance review.
An IUL policy is a type of Universal Life Insurance. In similar fashion to universal life, indexed life insurance allows you to adjust your death benefit, your premium payment, and how often you make payments.
An IUL is cash value life insurance. The policy earns interest in either a fixed account or indexed account, which helps your premium grow, increasing the cash value in your policy. Both the fixed account and indexed account have floor, which is the guaranteed minimum level of interest you will be credited in that specific account. The typical floor for a fixed account is between 2-3%. The floor for an indexed account is usually 0%.
The indexed account tracks a major equity indices, such as the DJIA, S&P 500, NASDAQ 100, Russell 2000, Hang Seng, EURO STOXX 50, or MSCI Emerging Markets. It is important to understand that your cash value is not invested in sub-accounts, a la variable life insurance. Instead, the cash in the indexed account earns credited interest based in part on the performance of the underlying index, subject to the cap and participation rate.
The participation rate is used to determine how much your cash value will participate in the gains of the tracked index. The standard participation rate is usually 100% for a capped index. If the participation is 100%, then your cash value will be credited interest up to the total gains in the index, subject to the cap.
The cap is the maximum amount of interest for that segment the insurer will credit to your indexed account. Cap rates vary depending on the type of indexed account and crediting methods.
More on all this to follow below, but for now that is enough information for you to move on to the next section. Before launching into our first IUL pro let’s talk about whole life vs indexed universal life briefly.
Whole Life Insurance vs Indexed Universal Life
Indexed universal life too often gets a bad rap by the “whole life purist” crowd. And while whole life insurance is an excellent investment option, there is certainly a place for IUL in a solid financial plan.
Non Correlated vs Correlated Assets
Whole life insurance is a non correlated asset, which means that it is does not follow the movement of the stock market.
In contrast, index universal life does follow the stock market, as it is indexed to specific sector indices, such as the S&P 500 or NASDAQ 100.
Guarantees vs No Guarantees
Whole life offers specific guarantees, such as guaranteed death benefit, guaranteed cash value growth and guaranteed level premium.
Indexed universal life does not offer the same guarantees, as its performance is largely tied to the underlying indices that it follows.
Dividends vs Credited Rate
A dividend-paying whole life policy pays an annual dividend. Dividends can be used to purchse additional paid-up insurance, further increasing the death benefit and cash value growth of the policy.
An IUL policy is credited an interest rate determined by, either the declared rate of the insurer, or the participation rate and cap rate of the underlying indices the indexed account tracks.
So which is better, index universal life vs whole life?
Well, that is a great question and it will come down to different factors, particularly how you answer the question: “What are your goals?” Hopefully the following index universal life pros and cons article will help shed some light on what permanent life insurance is best for you — based on your unique need and goals.
The Pros of Indexed Universal Life
Death Benefit – (AKA Family Protection)
This is an insurance product and ultimately the thing you are insuring (your life) is of utmost importance. Money will never be able to replace the loss of a loved one, but avoiding the double-whammy of a family death and massive financial hardship is significant.
All life insurance products have a death benefit, so it may seem odd to discuss this as a pro, but ultimately it is the key product that is being purchased, so it shouldn’t be dismissed.
I think many people wander around ignorant of the necessity of owning a life insurance policy, but once they are educated and see the need, there is usually a tremendous sense of urgency that is only relieved by their own policy going in force.
An IUL is a cash value life insurance policy, meaning that it has a cash value and allows for cash accumulation inside the policy.
This is a distinct advantage of permanent life vs term life policy and is part of the reason that an IUL is more expensive than term.
The cash value grows over time as the individual pays into the policy. The cash value can always be accessed and used as you see fit. In addition the withdrawals are tax-free income, up to the amount of premiums paid, because the premiums were paid in after-tax dollars. And don’t forget that you can also access the growth of your account tax-free, by taking a life insurance policy loan (sometimes called a swap loan) against your cash value.
For those with a lot of extra cash to invest each year there is a limit to the amount you can pay into the policy (typically a percentage of the total policy value), this limit is known as the MEC (modified endowment contract) limit. So keep that in mind if you’re thinking this could be a tax shelter for your tremendous horde of cash in the basement.
I’m not sure why you would have a horde of cash in your basement, but I did watch a YouTube video on drug dealer mansions last night, so perhaps that is stuck in my head.
Convertible term insurance policies require that you pay your premium each and every month, if you stop paying, your policy lapses.
Whole Life policies require that you pay your premium each and every month, if you stop paying, your policy lapses.
There are some exceptions, but it is fairly rigid.
With an Indexed Universal Life policy you have the ability to pay more or less each month (there is a minimum to cover fees, and a maximum based on the MEC limit) but the policy has much more premium flexibility than the other main life insurance products in the market.
The flexibility of an IUL is great for those that have income that fluctuates throughout the year. If you work on commission and certain times of the year are much better than others, you may want to consider the flexible premium options available with an IUL.
Locked-in Gains & Annual Reset
Another great aspect of the IUL is that each year the gains are locked in or captured. In other words, every year your gain will be secured along with your previous cash value total.
Within an IUL your insurance company does not invest your cash value in the stock market. Instead they purchase options on the market index. This provides the option to make money when the stock market is up, but to avoid losing when it goes down.
In reality, the company still loses the “option price” but that is part of the cost of insurance each year and is a fixed cost. In other words, the cost is known ahead of time and therefore the insurance company can estimate accordingly.
The Annual Reset may not seem like much at first, but in reality it’s a fairly big deal. What it means is that you are always starting from zero each year. You never have to struggle to “catch up” due to previous losses. Over a 79 year period (1937-2015), the S&P 500 had two periods where it lost three years in a row, 1939-1941 and 2000-2002. It only had one period where it lost two years in a row, 1973-1974. And after those distinct losses, the market bounced back with double digit returns every time.
I share this because normally those double digit returns are just a way of getting back some of the horrible losses in the previous years.
If you have $100k invested and lose 10% in year one, 20% in year two, and 10% in year three, you’ll be at around $65k at the end of the three years. In order to get back to even, you’ll need to get around 50% in the coming year.
However, if you had $100k in cash value in your IUL over the same period of time, after those three years your cash value would still be really close to $100k – which means that the double digit returns don’t get you back to even, but springboard your policy’s cash value to new heights.
No Required Distributions or Penalties for early access
When you get ready to retire, there is no mandatory distribution in an IUL. If you have an IRA or the pesky 401(k) you’ll have to start taking distributions (withdrawals) when you turn 70 1/2. I’m sure you know already, but the reason for this mandatory withdrawal is because the IRS can’t tax that money until you start to take 401k withdrawals.
This may not seem like a big deal to you when you read it, but if you’re trying to build your retirement account while you or your spouse is still working, these mandatory distributions can seriously slow your progress. The IUL has no such mandatory distribution requirement.
If your spouse is working and you are retired, you can live off the employment income and let your cash value grow and grow without taking out any money. You can also access your policy’s cash value via a withdrawal or loan for tax-free retirement income. (If you have a 401(k) and you are still working after reaching the age limit, you can delay the distributions, but only until you stop working, then it becomes mandatory).
Is it Tax-Deferred or Tax-Free?
The IUL is a tax-deferred policy. Similar to that of a 401(k) or an IRA, but different in many significant ways (some of which I’ve already mentioned above). If you choose to build up your cash value in an IUL and use the protection during your working years, the policy will act much like any other tax-deferred product. The cash value will grow and you will not pay tax on the growth in the cash value. If you happen to close the account (not recommended) or take withdrawals instead of policy loans, you will pay taxes on the growth.
However, unlike the IRA and 401(k) accounts, there is a way to access the cash value tax-free without incurring any penalties. In addition, you can always withdraw from your cash value up the amount of the premiums paid (your basis) without being taxed because those premiums were paid in after-tax dollars.
With an IUL you can access your cash value at any age, without penalty or compulsion. You do not have to wait for some required age to have access to your cash value. Many tax-deferred retirement accounts have an age restriction of 59 1/2 before you can access the money. If you withdraw ahead of time there are penalties and restrictions.
I don’t know about you, but I prefer to have zero limits on accessing my own cash. With an IRA you do have some stipulations for emergencies, and age distributions, but even so they can be limiting.
Excellent Growth Potential
The Indexed Universal Life insurance policy has serious upside growth potential. This is probably one of the biggest reasons why individuals looking for permanent life insurance will choose an IUL over a Whole Life policy.
Whole Life insurance has rather conservative guaranteed growth rates. The IUL can double those rates in a year in which the cap is hit.
If the market index that your policy is tracking increases 10% in a given year your account will be credited around 10%. If the market index increases 20%, your account will be credited with the max or cap, which is currently around 13% for most policies. When the index returns a rate that is higher than the cap, the life insurance company keeps the difference.
You don’t keep “excess” Returns
The additional % that the market index returns above the cap is used to make up for the years in which the company has to cover the losses of a negative year and give the minimum guarantee. Not all companies offer a minimum guarantee that is above 0%, but some do offer a guarantee around 1%. This can be a big deal in covering the cost of insurance in down years. Paying the max allowed in the first few years of a policy will really tilt the policy in your favor for the life of the product.
Doesn’t Impact Social Security
You don’t have to worry about the Indexed Universal Life policy impacting your Social Security tax situation. Many people don’t know this, but the money you make from Social Security in retirement may be taxed as income if you make more than a certain limit. The income from an IRA might just put you over the limit (currently $32,000 if filing jointly, or $25,000 if filing as an individual) and therefore cause your social security to be taxable.
Let’s say for example you get $24,000 a year from Social Security, and you take another $40,000 from your IRA each year. If your house is paid off and you don’t have any other write-offs, you may find yourself in a situation in which the Social Security benefits are taxable, and you’ll end up in a higher tax bracket.
If instead of an IRA you had an IUL policy loan for $40,000 per year, your taxable income would be zero because you would be under the base limit. For an individual or family that is living on less than $80,000 per year, you may find that your annual tax savings are in excess of $10,000. That’s a big deal. For those making more, your savings would be even greater. That’s a bigger deal.
The Cons of Indexed Universal Life
0% Returns WILL Reduce your Cash Value
One of the big selling points of the Indexed Universal Life policy is the fact that you never lose cash value, because there is a floor of 0% (sometimes 1%). The reality is that the cost of insurance in the early years can be significant, and therefore you may see your cash value decrease if you have been paying near the minimum premium each month.
It is recommended in the early years that you do what you can to pay the maximum premium. Doing this in the early years when your cash value is low and just starting to grow, will help get the ball rolling and the momentum accelerating.
One of the benefits of an IUL is the flexible premium. But if you consistently pay the minimum premium, the down years will definitely be a big kick in the pants and you’ll be disappointed at the cash value of the policy. This can also start a snowball effect as the costs increase as you age.
Cost of Insurance Rises as you Age
The cost of insurance in based on your age, your rating, and the amount insured. For each $1000 death benefit there is a cost that increases each year as you age. The reason the cost goes up is because you are more likely to die.
Whole Life policies average the total cost of insurance for the entire life and provide a fixed premium.
IUL policies have an increasing rate. This means that it is cheaper in the beginning and more expensive down the road. This can be scary for those that are not prepared financially and as they get older the cost of insurance skyrockets out of control.
Competent Insurance agents are not trying to sell you a product that will lapse in your old age due to crazy expenses. Yes it can happen, but that should not be the intention of the qualified agent. The intent of an IUL is to gradually decrease the “net amount of risk” (as seen by the insurance company), as you age.
What does “Net Amount of Risk” Mean?
On most IUL policies, the death benefit is equal to the original insured amount minus the cash value. In other words, if you purchased a $500,000 policy, and you had $200,000 in cash value at the time of your death, your beneficiaries would receive a check for $500,000, not $700,000. This means that the insurance company only had to pay out $300,000 at the time of your death, because you had accumulated $200,000 in cash value during the life of the policy.
All this to say, that as you get older the cost per $1000 of death benefit increases, but so should your cash value. Therefore the risk to the insurance company is relatively the same. You have a higher risk of dying because you are older, but they also have a lower amount at risk, so the two should even out.
This is all fine and good if things go as expected. But if you pay the minimum, and the policy struggles because there are a few bad years in the beginning, you may find yourself down the road with too little cash value to compensate for the increasing cost of insurance associated with your age. You can always call and lower your death benefit, but that is obviously not something that most want to be facing.
The S&P Index Crediting does NOT include Dividends
In order for the life insurance company to give you a floor of 0% for downside protection, and to also give you some of the upside of the S&P 500 index, the insurer has to buy options. These options are not the same thing as buying the underlying stock that these options represent. As a result, the company does not get the dividends that a stock owner would rightfully get.
Therefore, when you look at the S&P 500 index you must be aware that the index was created to include the dividends associated with the representative stocks. In other words, you will earn less than the index because you’re not getting the dividends.
In some years this can be a 1% difference in the index, and in other years it may be as high as a 4% difference. But it’s helpful to know that you will never get the same rate of return that the index itself returns. To be fair, almost all asset managers fail to earn the same rate of return as the index, but that’s another point entirely.
There is a Crediting Cap
As mentioned earlier there is tremendous upside to an IUL because they are buying options on a given index. However, they do cap the credit amount to limit upside potential so that in years where there is an index return of 22%, you will only be credited the max, or cap rate, associated with your policy. The cap rates are typically between 11-14% (although there are uncapped accounts available with certain insurers).
Having your upside potential limited by a cap can be frustrating if you are watching your mutual fund go through the roof and you want to get in on some of that action with your IUL. But it is usually outweighed by the converse effect of watching your IUL sit stationary while your mutual fund plummets in a bear market.
Credit caps are just a cost of doing business with an IUL policy. If you don’t like it, you may be better off with a Variable Universal policy or perhaps another product that is fully in the stock market.
Finally, it’s also true that an IUL can be complicated. This is especially true when compared with term life insurance. The fact that the cost of insurance rises as you age, and that there are some strategies for increasing death benefits and strategically managing the policy throughout the years to manage the various indexes and crediting options, means that it isn’t simple. This isn’t a big deal if you have a good agent that you trust, but it can be an issue if you don’t have an agent and prefer to just pay the premiums and forget about it.
There are plenty of good reasons to choose an IUL, but they need to understood and weighed against the disadvantages and your own personal situation and needs. It can be complicated, but if you choose to stay educated and discuss your policy once a year with your agent, it’s not something that should really be a deal breaker.
The Indexed Universal Life policy is a solid and reliable life insurance product that provides a specific set of benefits to the consumer. For those that want a taste of the bull markets without the bite of the bears, this may be the perfect product for you. Do yourself a favor and stay educated. If you need any additional help, or just have some basic questions, please don’t hesitate to reach out – we’d love to help.