If you’re in the market for life insurance, you may have come across “indexed universal life insurance.” Indexed universal life insurance is a sub-type of a permanent life insurance policy (you can read more about life insurance here). If you decide upon a permanent policy and you want to invest in an indexed account (such as an S&P 500), indexed universal life insurance might be worth your consideration.
What Is Indexed Universal Life Insurance?
John Hancock Insurance describes indexed universal life as, “a type of permanent life insurance that offers the same features as traditional universal life but with an opportunity to earn interest linked to the performance of an indexed account, while protecting the policy’s cash value from market risk.”
In a 2014 interview with Fox Business News, Robert Quinlan of Quinlan Care, LLC, a New York based insurance agency/brokerage firm described the difference between universal life insurance (UL) and indexed universal life insurance (IUL) as follows:
UL is a permanent form of life insurance where the excess of the premiums above the current cost of life insurance (the cost of term insurance today) is credited to the policy. The cash account is credited each month with interest that is declared by the insurance company on an annual basis. There is also a guaranteed minimum interest rate, like 2% or 3%. Each month the cash account is also debited for the current cost of the life insurance to cover when you die. Monthly fees are also withdrawn from the cash account.
Indexed Universal life insurance is not similar to UL because instead of crediting money to the cash account based on a carrier’s declared interest rate, Indexed UL’s earnings rate is pegged to a financial index such as a stock index. What is a stock index? It is a way to measure the value of the stock market by computing the prices of selected stocks. It also allows investors and financial professionals to compare the value of specific investments. A commonly used one is the Standard and Poor’s 500 stock index, which is the value of 500 stocks that is tracked every day on the financial markets.
Indexed UL policies aren’t directly invested in the stock market like a variable universal life insurance policy. Instead, the financial value of the index is used to calculate how much interest is credited to your policy’s cash account. The carrier will cap or limit the upside amount that can be credited to your account. The carrier will also buffer your downside with a guaranteed interest rate if the stock market declines in value. The insurance company’s ability to credit your account depends on how well the carrier’s investment portfolio (largely invested in bonds) performs.
Per Quinlan, some of the advantages of indexed universal life:
It may include above average returns when the selected index does well.
The death benefits are income tax free. The death benefits are not subject to a lengthy probate process and the face amount is paid directly to the policy beneficiary.
Cash values account will grow tax deferred of income taxes similar to an IRA, and there are no limits on the amount of money you can contribute per year. Additionally, loans can be taken from the policy and generally free of income taxes, and the loans do not have to be repaid. However, Quinlan warns that if the policy is surrendered, any loan outstanding is subject to income taxes in the year the policy lapsed.
Indexed universal life permit tax free exchange of one policy to another.
While Indexed Universal Life does offer some attractive benefits, there are plenty of sources who warn against buying this type of policy. MD Magazine recommends not purchasing this (or a permanent life policy) if you’re at a point in your life that you’ve reached financial independence and no longer need life insurance.
Additionally, there’s some complexities with indexes in terms of how the interest or cash growth is calculated for these policies. In an article on Investopedia, Joe Allaria suggests the buyer needs to understand the policy inside and out or “have an enormous amount of trust in the person recommending it.”
Allaria offers the following example:
Let's say you select the S&P 500 index for your cash bucket. Your advisor tells you that you can experience the upside of the S&P 500 without any downside. That kind of sounds too good to be true. Well, it is. That's because these indexes will either have a cap on the upside earnings or a participation rate. A cap is straight forward. The S&P 500 index may have a cap of 4%. So your max upside is not what the S&P earns, it's 4%, and the downside is still 0%. If you have a participation rate instead of a cap, and the participation rate is 50%, you will earn 1/2 of what the S&P 500 gets. So, if the S&P earns 8%, you get 4%, with a downside of 0%.
Another point to consider is that the S&P 500, as used in our example, also derives some of its total return from dividend yield. So, if the S&P appreciates 4% and has a 2% dividend yield, then the total return will be 6% - BUT, this is likely not the case in an IUL since dividends are typically not part of the growth calculation.
If you study these products further, you'll also notice the phrase "point to point." This refers to the time frame that an index is evaluated. For example, staying with our S&P 500 index, let's assume you've selected the S&P 500 Annual point to point. This means that in order to calculate the interest earned, the life insurance company will evaluate the price of the S&P 500 on the day the policy becomes in force and will not apply interest until the index is re-evaluated one year later. If the index is higher, you'll get credited interest. If not, you won't. If it was higher a day before but took a brief momentary dip, you won't see any interest credited for another whole year, which negates the benefits of compound interest.
In an article for AOL Finance, John Jamieson suggests that IUL policies “will almost always be illustrated with unrealistic compounded rates of return.” MD Magazine suggests the same, adding that IUL policies “don’t get anywhere near market returns due to the costs of the insurance, the additional fees, the loss of dividends, the cap rates, and the participation rates.”
Quinlan states that this type of policy should be purchased by someone who has a need for permanent life insurance and is “financially sophisticated.” The bottom line is that a potential buyer for an Indexed Universal Life policy will have to put in a solid amount of research and weigh the pros and cons, as there seems to be a number of detractors for IUL policies. There are a fair amount of life insurance policies on the market, and more than likely, there’s a policy that fits your financial and investment needs. You can begin by comparing quotes here.