What is Indexed Universal Life Insurance and How Does It Work?

There are several policy types within the universal life family, one of which is indexed universal life insurance.

It functions as a universal life insurance policy in most respects, with the most conspicuous difference being the way the cash value in the policy is invested.

Different life insurance policy types combine life insurance with a savings provision.

But indexed universal life insurance may be the best example of a policy that adds true investing to the mix.

What is Indexed Universal Life Insurance?

At the core, indexed universal life insurance or IUL is a universal life insurance policy.

That means it provides flexible premium arrangements.

You can choose the allocation of your premium between a life insurance provision and cash value accumulation.

You can even increase your premium, and the additional amount paid allows for a faster buildup of the cash value.

Much like whole life insurance, indexed universal life insurance is a form of permanent coverage.

That is, the policy will remain in force as long as you make your required premium payments.

This is unlike term insurance, which will expire at the end of the stated term in the policy.

But indexed universal life insurance is a way of providing for life insurance coverage and accumulating additional savings for retirement.

The investment income you earn within the policy is tax-deferred, similar to retirement accounts, like IRAs.

That income will only be taxable when it’s withdrawn from the policy. This is only if the amount of cash withdrawn from the plan exceeds your premium contributions to the cash value.

The cash value accumulation can be more dramatic than in other policies since IUL cash values are invested.

Though you may be able to choose a fixed interest income arrangement.

The cash value is more commonly invested in insurance funds tied to popular stock indexes, like the S&P 500.

Many policies will also include multiple investment options, giving you some choice regarding how your money is invested.

Technically speaking, the returns you earn on your cash value are still considered interest.

But that rate is tied to one or more equity funds, giving you an opportunity to earn more than you can through conventional fixed-rate investments.

How Does Indexed Universal Life Insurance Work?

When you first purchase an indexed universal life insurance policy, you’ll determine how your premium will be allocated.

Like other insurance policies, you can make your premium payments on an ongoing basis.

But you’ll also have the option to make a one-time, lump-sum premium payment instead.

That will not only eliminate monthly, quarterly, or annual premium payments, but it will also generate a large cash value quicker than the installment method will.

You’ll also select the premium allocation between your life insurance benefit and your cash value accumulation.

But you can change that allocation at a later date to allow for either a higher death benefit or faster cash value buildup.

IUL Insurance Provisions

Within indexed universal life insurance policies, the cost of your life insurance will increase each year.

That’s because an IUL is primarily an investment plan accompanied by an annual renewable term life insurance policy.

Since you’ll be older at each renewal, the cost of the insurance coverage will gradually creep higher.

Your premium payment can remain fixed throughout your life, but the insurance provision will eat up an increasing percentage of that payment.

If the cost of insurance exceeds the premium, funds will be withdrawn from your cash value to cover the additional cost of the insurance.

Given that the cost of insurance will rise significantly as you age, and particularly past age 50, this is hardly an unlikely scenario.

If the cash value is drawn down to zero, your policy will automatically lapse unless you make additional contributions.

This is where an indexed universal life insurance policy can get downright dangerous.

If the policy lapses, it could create a tax liability.

This is because the investment income portion of the cash value will have been withdrawn – within the policy – technically exceeding your contributions toward that value.

That can leave you with the tax liability on an asset that you no longer have.

If you’re going to take an indexed universal life insurance policy, you’ll need to be aware of this possibility and make your premium payments accordingly.

IUL Investment Provisions

Your cash value will be invested in insurance company mutual funds, tied to a recognized stock market index.

However, these are not publicly traded index funds widely used by general investors.

They’re proprietary funds run by the insurance company that is provided strictly for the benefit of their policyholders.

You may be given the choice of investing in several funds at the same time, or you may be able to have both multiple index funds as well as a fixed income option.

You should be aware that IUL investment provisions have both ceilings and floors.

On the upside, the policy will limit your annual return.

If a policy sets a ceiling of 10% per year, that will be your maximum return, even if the fund rises by 12% for that year. That’s the bad news.

The good news is that you’re trading higher gains for protection during market declines.

If the policy sets a minimum annual investor return of 0%, you’ll receive no return for a year in which the market declines by 10%.

That effectively eliminates losses due to declining markets.

That arrangement makes IULs a reasonable option for someone who wants to invest in equities but doesn’t want the risk of market losses.

Participation Rate

But pay close attention to what is referred to as the “participation rate”.

That’s the percentage of upside gains you’ll earn when an index fund rises in value.

That can range from a low of 25% to as much as 100%.

For example, if the participation rate stated in the policy is 75%, you’ll earn 7.5% in a year in which the fund earns 10%.

But you’ll never earn more than the ceiling rate of your policy.

You’ll naturally want to favor a policy with the highest participation rate.

But you can expect you’ll pay higher fees within the policy than you would for one with a lower participation rate.

IUL Loan Provisions

Like whole life insurance policies, you can borrow against the cash value of an IUL.

But you must be aware that any outstanding loan balance at the time of your death will result in a reduction of the death benefit paid your beneficiaries in the amount needed to pay off the loan.

Cash Withdrawals

In addition to taking loans against your cash value, you can also take direct cash withdrawals.

But this is where indexed universal life insurance policies get complicated.

Once again, the investment income earned in an IUL policy is tax-deferred until it’s withdrawn.

But if the cash withdrawals you take from the policy exceed the cash contributions from your premium payments, the portion considered to be investment income will be taxable.

Indexed Universal Life Insurance Policy Fees

As you might expect, a policy as complicated as an IUL comes with an assortment of fees.

This can include a premium load charge, a monthly charge, an annual fee, and a mortality charge.

Though the monthly charge typically applies only in the first few years the policy is in force, the mortality charge will increase as you get older.

Taken together, they generally range between 2% and 3% of the value of your policy.

This will naturally reduce the net investment returns you earn on the policy.

As is typical with cash value life insurance policies, surrender charges will apply if you attempt to cash-out of the policy early.

Those fees may range between 1% and 10%, gradually declining over the first 10 years or so the policy is in force.

The Potential for a Policy Lapse

This can happen if you make fixed payments that are eventually exceeded by the cost of the life insurance provision.

The life insurance company will withdraw the shortfall from your cash value, which has the potential to completely eliminate that value.

If that happens, your policy will lapse, and your insurance coverage will disappear.

Death Benefit or Cash Value Paid to Your Beneficiaries – Not Both

You’ll have a choice to provide your beneficiaries with either the death benefit of the policy or the cash value.

You’ll naturally want to choose the one you believe will be higher at the time of your death.

That’s a guessing game at best.

During the early years of the policy, the cash value will be low.

So, you’ll want to leave the death benefit to your beneficiaries.

But if the cash value rises in the future to where it’s higher than the death benefit, you’ll want to leave them with the cash value.

That’s not an easy call to make when you first take the policy.

In addition to the fact that the insurance company may not give you that choice.

What happens to the cash value in the policy if your beneficiaries get the death benefit? It reverts to the insurance company. Ouch!

How Much Does Indexed Universal Life Insurance Cost?

Surprisingly, indexed universal life insurance premium rates are roughly equal to those of whole life insurance.

Though the policies are riskier than whole life insurance, they can potentially provide greater long-term cash value accumulation.

Indexed Universal Life Insurance Pros & Cons

Pros:

• Flexibility with regard to both the premium allocations and the investment options.
• You can invest in the stock market with zero chance of losing money.
• Tax-free growth on investment gains.
• No contribution caps if you plan to use the policy as a retirement assets supplement.

Cons:

• Investment income is limited by the participation rate. This will generally be less than 100%, which means you’ll earn less than you would if you invested directly and an index fund.
• High fees can reduce the return on your cash value by as much as 3% per year.
• You can lose money on your cash value in a down year in the index funds due to the fees charged within the policy.
• The cost of the life insurance provision within your policy will increase as you age, consuming consistently more of your premium payment.
• IULs can be more difficult to qualify for based on the condition of your health.
• Contains complicated provisions not easily understood by those outside the insurance industry.
• IULs are often sold using rosy projections about future investment gains that don’t stand up to reality.

Is an IUL Insurance Policy Best for Me?

As you can see, indexed universal life insurance is a complicated financial product.

It’s not just insurance with a savings provision. It’s insurance with a savings provision and an investment provision.

That’s the part that makes it more involved than whole life insurance.

Unless your purpose for purchasing life insurance is to provide you with additional retirement assets, the better strategy will be to purchase a low-cost term life insurance policy.

Then you can invest any premium savings in a publicly-traded stock index fund.

That will give you the lowest cost life insurance possible in combination with full participation in the investment gains of the stock index.

And if for no other reason than that you will pay far less in fees with that combination, it’s likely to result in a better long-term financial outcome.