Universal Life Insurance: Index-Linked Benefits And Drawbacks

Indexed universal life insurance (IUL) is a type of permanent life insurance that lasts your entire life and builds cash value. It is a form of universal life insurance, but with a unique way of building cash value. IUL policies allow for cash value growth through an equity index account, such as the S&P 500 or NASDAQ, rather than solely through non-equity earned rates. This means that the cash value of an IUL policy grows based on the performance of an underlying stock market index.

IUL insurance offers several benefits, including the potential for higher returns, greater flexibility, and tax-free capital gains. However, it also comes with drawbacks, such as higher fees and unpredictable returns. It is important to carefully consider the pros and cons of IUL insurance before purchasing a policy.

Permanent coverage

Indexed universal life insurance (IUL) is a type of permanent life insurance that provides a death benefit as well as a cash value component. This means that it lasts your entire life and builds cash value. The cash value component allows for growth based on a stock index (a set grouping of various stocks) instead of only through non-equity earned rates.

The cash value portion of an IUL policy earns interest based on the performance of an underlying stock market index. For example, the Standard & Poor's (S&P) 500 composite price index, which tracks the performance of the 500 largest U.S. companies by market capitalization. The rate of return on the cash value component of the policy is directly linked to the performance of the chosen index.

The insurance company that issues the policy may offer a minimum guaranteed rate of return, protecting the policyholder from losses in the market. There may also be an upper limit or rate cap on returns.

IUL insurance offers permanent coverage as long as premiums are paid. The policy includes a death benefit, which is paid out to the named beneficiary or beneficiaries when the policyholder passes away. The cash value component of the policy can increase its value during the lifetime of the policyholder.

The cash value can be accessed at any time without penalty, and there are no limitations on annual contributions. The accumulated cash value can be used to lower or potentially cover premiums without reducing the death benefit.

The flexibility of IUL insurance allows policyholders to adjust their premiums and death benefit as needed. Policyholders can decide how much cash value to allocate to an equity-indexed account and a fixed-rate account, if available.

While IUL insurance offers permanent coverage, it is important to note that the policy may be cancelled if premium payments are not maintained.

Cash value growth

In a fixed-rate account, the cash value grows at a fixed interest rate set by the insurer. This rate is typically guaranteed for the life of the policy and provides a minimum return on the cash value.

The equity-indexed account is what sets IUL insurance apart from other types of life insurance. In this account, the cash value is linked to the performance of a stock market index, such as the S&P 500 or the Nasdaq-100. The cash value grows or declines based on the movements of the chosen index. If the index increases, the cash value earns interest. If the index decreases, the cash value may not earn any interest or may even decline.

To minimise large swings in interest payments, IUL policies typically have "floors" and "caps" in place. A floor is the lowest interest rate that the cash value can earn, often guaranteed at 0%, protecting the policyholder from losses if the market crashes. A cap is the highest interest rate the cash value can earn, limiting the gains if the market performs exceptionally well.

In addition to floors and caps, IUL policies may also have participation rates. A participation rate below 100% further limits the interest earned on the cash value. For example, if the index gains 10% and the participation rate is 80%, the cash value will only earn 8% interest.

The interest credited to the cash value is typically calculated on a monthly or annual basis. The specific method used can vary among insurers and policies, so it is important to carefully review the details of the policy.

Overall, the cash value growth in an IUL policy provides the potential for higher returns compared to other types of life insurance, but it also comes with the risk of unpredictable returns. Policyholders can choose how much of their cash value to allocate to the fixed-rate account and the equity-indexed account, allowing them to balance their risk and return preferences.

Premium adjustment

Indexed universal life insurance policies are a type of permanent life insurance that provides a cash value component along with a death benefit. The cash value in a policyholder's account can earn interest by tracking a stock market index, such as the S&P 500 or the Nasdaq-100. Policyholders can decide how much cash value to assign to an equity-indexed account and a fixed-rate account, if available.

The interest rate derived from the equity index account can fluctuate, but the policy does offer an interest rate guarantee, which limits losses. It may also cap gains. These policies are more volatile than fixed universal life policies but less risky than variable universal life insurance policies because they do not invest directly in equity positions.

Indexed universal life insurance policies have adjustable premiums, and policyholders can underpay or skip premiums. The cost of insurance and policy expenses are deducted from the cash value if premiums are underpaid or skipped. Policyholders may also be able to adjust their death benefit.

The total cash value is credited with interest based on increases in an equity index. If the index increases during the month, interest is added to the cash value. The index gains are credited back to the policy on a monthly or annual basis.

The gains from the index are credited to the policy based on a percentage rate, referred to as the participation rate. The rate is set by the insurance company and can range from 25% to over 100%. The insurance company can also change the participation rate over the lifetime of the policy.

• Flexible Premiums: Policyholders can increase or decrease their premium payments depending on their coverage needs, the growth of their cash account, and their financial situation. This flexibility allows policyholders to manage their premiums dynamically, ensuring they can adapt to changing circumstances.
• Underpayment or Skipping Premiums: Policyholders have the option to underpay or skip premiums temporarily. However, if this occurs, the cost of insurance and any applicable fees will be deducted from the cash value of the policy. It's important to monitor the cash value regularly to ensure sufficient funds are available to cover these costs.
• Death Benefit Adjustment: In addition to flexible premiums, indexed universal life insurance policies may also allow for adjustments to the death benefit. This flexibility enables policyholders to increase or decrease the coverage amount as their needs change over time. However, adjusting the death benefit may require a medical examination.
• Interest Rate Fluctuations: The interest credited to the cash value of the policy is based on the performance of the chosen equity index. While this provides the potential for higher returns, it also introduces variability. The interest rate can fluctuate, and there may be caps on the maximum interest rate that can be earned.
• Minimum Interest Rate Guarantee: To protect policyholders from significant losses, indexed universal life insurance policies typically offer a minimum interest rate guarantee. This ensures that even if the index performs poorly, the policy will still earn a minimum level of interest.
• Premium Costs and Fees: Indexed universal life insurance policies tend to have higher premium costs and potential fees compared to other types of life insurance. The complexity of these policies and the additional features they offer contribute to these higher costs. It's important for individuals to carefully consider their budget and understand all the associated fees before committing to this type of policy.

Interest calculation

Indexed universal life insurance policies typically pay interest based on the movement of underlying stock and bond indexes. The interest rate will still be variable, but your policy will have a minimum interest rate that it will always earn, regardless of market performance. There may also be an interest rate cap.

The interest rate is influenced by market performance, but IUL policies typically include a minimum guaranteed crediting rate to protect against market downturns. While this is a nice benefit, IULs also have a cap on the maximum returns you can earn.

The total cash value is credited with interest based on increases in an equity index (although your money isn't directly invested in the stock market). If you own an indexed universal life policy, you can likely borrow against the cash value accumulated in the policy. However, if you don't pay back your loans, they are deducted from the death benefit.

The chosen index's performance determines how much interest will be added to the total cash value in your indexed universal life insurance plan. This is typically re-evaluated at the start of each month, but it varies depending on the company you are working with.

There are several methods insurers use to calculate gains in indexed universal life policies, such as the Daily Average method, the Monthly Point-to-Point method, and the Annual Point-to-Point method. Methods vary among policies and insurers.

Pros and cons

Pros

Indexed universal life insurance (IUL) offers the benefit of market gains while building cash value and guarantees beneficiaries a payout upon death. It provides greater upside potential, flexibility, and tax-free gains.

IUL policies can be designed around your risk appetite, allowing you to decide how much risk you would like to take in the market. They also offer tax advantages on capital gains, as the cash value accumulates tax-deferred, and the death benefit is tax-free for beneficiaries.

IUL policies also have no impact on Social Security benefits, and the cash value accumulation does not count towards earnings thresholds.

The flexibility of IUL policies means that you can adjust your premium and death benefit as needed, and there is no penalty for making withdrawals prior to retirement.

Cons

IUL policies have higher fees than other policies, and there are no guarantees as to the premium amounts or market returns. Returns are unpredictable and may be limited, and the policy may be canceled if you stop paying premiums.

IUL policies are generally best for those with large upfront investments who want options for a tax-free retirement. The potential for higher returns also comes with the risk of lower returns, depending on how the market performs.

The complexity of IUL policies means that there is a need for ongoing understanding and management to ensure optimal performance. The rising cost of insurance is a significant risk consideration, especially during retirement.

If the policy lapses before your death, any gains will be taxed as income. Additionally, if you pass away with outstanding loans taken out against the policy, those funds may be subject to income tax.

Frequently asked questions