In the following article we will compare and contrast IUL insurance vs VUL insurance, highlighting the key similarities and differences between these different life insurance policies. Our goal is to help you discover what the best life insurance is for you, based on how your unique goals and objectives align with each of these insurance contracts.
IUL vs VUL
Indexed Universal Life (IUL) and Variable Universal Life (VUL) are part of the Universal Life Insurance family of products. Let’s start our discussion by first discussing universal life policies.
Universal Life Insurance
Universal life such as indexed universal life (IUL) and variable universal life (VUL) is a form of permanent life insurance, also known as cash value life insurance.
These types of permanent life insurance policies are designed to not only provide a lump sum death benefit for your beneficiaries, but also build up cash value over time.
Because they are classified as universal life insurance, both types of policies offer flexibility in regard to premium amounts and coverage, and also feature other living benefits that typically accompany cash value life insurance.
The benefits of life insurance include:
- Tax-deferred growth of the funds in the policy’s cash value account.
- Option to use funds from the cash value account to pay premiums.
- Option to take tax-free partial withdrawals from the cash account of your policy (as long as they don’t exceed the amount you have contributed to the policy).
- Option to take tax-free loans from the policy (up to the amount you have contributed to the policy) while still earning interest or growth on the remaining cash value – what is sometimes called infinite banking or using your insurance policy to be your own banker.
VUL VS IUL
While IUL and VUL share similarities as variants of universal life insurance, there are some critical differences between the two policy types. The major difference between the two is the method used to determine the return on the funds held in the cash account.
IUL insurance offers subaccounts that track the performance of stock market indexes without investing directly in the securities which make up those indexes, while VUL subaccounts directly invest in such securities, similar to mutual funds.
Another difference is that VUL insurance, because it features active management of subaccount investments, typically features somewhat higher fees than IUL.
One of the pros of index universal life is that the index-linked subaccounts found in IUL enable you as the policyholder to share, at least to some degree, in the upside performance of the stock market, while shielding you from downside risk if the market declines.
Indexed universal life policies feature participation rates and ceilings, or caps, on the amount a subaccount can earn in any one year. For instance, if a subaccount has a 60% participation rate and the stock market index tracked by the subaccount rises 15% in a year, you would receive a 9% return (60% of 15% = 9%). If the policy had a cap of 8%, meaning that the subaccount couldn’t rise more than 8% in any year, your return would be 8% rather than 9%.
Along with caps and participation rates, a floor rate is also a feature of most of these IUL policies. The floor rate is the minimum amount a subaccount can earn in any one year, and is generally no less than 0%, meaning that if the market index tracked by the subaccount declines in any year, the subaccount will not lose money. Some floor rates are set at a positive interest rate, such as 1 or 2%.
Life insurance companies offering IUL policies fund the stock market-linked returns in their subaccounts by purchasing options on the index these accounts track with a portion of the funds invested in them. This enables the insurers to generate the money needed to credit the accounts with the proportion of growth in the linked index that the subaccount is entitled to receive, taking into account the relevant participation and cap rates. The remainder of the subaccount value is typically invested in income producing investments to generate enough income to meet the floor rate offered by the subaccount and to pay other expenses associated with the policy.
By contrast, VUL subaccounts, rather than offering returns linked to a particular index, are invested in actual securities, mainly stocks and bonds, in accordance with the investment objective of the subaccount. Thus, the return on these accounts is not limited by cap rates or participation rates and will vary according to the performance of the securities selected. This means that while the upside is not limited, neither is the downside.
As a result, VUL offers the potential for greater returns from its subaccount than IUL, along with the potential to suffer losses if the subaccount you have invested in performs poorly. As mentioned earlier, the active portfolio management associated with VUL subaccounts also means that these policies typically feature higher fees than IUL.
Given the greater risk associated with VUL subaccount investments, and their higher fees, these policies are more appropriate for purchasers who are comfortable with higher levels of risk. VUL buyers typically are willing to accept the risk of losing capital in their cash value account for the potential reward of greater growth involved in investing your VUL subaccounts directly in equity-oriented securities.
IUL buyers, on the other hand, while desiring the opportunity to experience some of the stock market’s upside, want to avoid risking taking losses on the value of their cash value account. Thus, IUL is more appropriate for those with a less aggressive risk tolerance profile.
In cash value life insurance, the risk of loss in your cash value account is relevant not only in regard to reducing the amount of cash you have available to borrow against via a policy loan or partial surrender of the policy, but also to maintaining adequate cash in the policy to pay the monthly premiums.
If you are using your policy’s cash value account to pay premiums, and the value declines to the point where this is no longer possible, your policy will lapse unless you can come up with the additional funds to make the payments.
Given this risk, VUL is typically for those who are looking for private placement life insurance and have the income levels necessary to maintain the policy. This is because, if the subaccounts in the cash value portion of your policy decline, it can impede your ability to use these funds to pay premiums. And this may result in cancellation of the policy, causing you to lose the insurance coverage you had established for the benefit of your beneficiaries.
Additionally, if you wanted to purchase life insurance at some point after the policy lapsed you would have to go through the life insurance medical exam process again. If you have had any health incidents between the time you initially purchased the VUL and the time you purchased a new policy after the lapse of the first one, it could result in significantly higher premiums or being denied coverage altogether.
Purchasing a VUL policy makes more sense if you are confident that you can make premium payments on VUL throughout its lifespan, or if you have the ability to overfund the life insurance policy by making additional payments into the account so it has a sizable buffer of extra cash in case the subaccounts decline due to a downturn in the stock market.
Even if these conditions apply, you should be careful to also take into account your risk tolerance before deciding if a VUL if right for you. The greater volatility in the performance of VUL subaccounts and the resulting increased potential of losing principal means that these policies are most appropriate for those who are comfortable with the fluctuation associated with stock investments.
For those who do not want life insurance as an investment, IUL policies represent a less risky way to participate in some portion of the potential gains from the stock market. Because these policies offer downside protection from any stock market decline, they are popular with risk averse investors who still want to take advantage of the opportunity to benefit from the growth potential of stocks.
There is no one size fits all policy or company. Each individual’s goals, objectives and needs must be considered to know what the best route to take will be. At I&E, we analyze the total picture of each individual to help find the best path to financial freedom and independence along your journey. Give us a call today for a complimentary strategy session to see just what we can do for you.
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