An indexed universal life insurance policy, sometimes referred to as an IUL, are permanent insurance policies that offers some flexibility with premiums while cash growth is achieved. The growth of these policies is usually tied into a specific index, such as the S&P 500. These indexes have caps on the upside that can be earned, based on the participation rate, often with a 0% downside.
The advantage of an indexed universal life insurance policy offers reasonable levels of growth without the same risks that other investment options require. Although some policies may be quoted with average growth rates that are not reasonable, most can offer a conservative annual return of about 4%. That makes it possible to plan for final expenses or provide resources to family should something unexpected happen.
The primary disadvantage of an indexed universal life insurance policy is that most require caps to be placed on the returns that are experienced. Some companies may even set maximum participation rates to be lower than 100% to reduce the returns that can be earned. Some may have participation rates that are as low as 25%. That means, using the S&P 500 as the example, an 8% return with a 25% participation rate would produce a policy gain of just 2%.
Here are some of the additional pros and cons of IULs to think about and discuss.
List of the Pros of Indexed Universal Life Insurance
1. IULs offer a higher return potential.
One of the key benefits that is associated with an indexed universal life insurance policy is exposure to an equity index without the risk of loss. If the index suffers a loss during the policy period, the gain is simply 0%. On the other hand, a policy that has 100% participation that sees an index gain 11% would get to experience the full gain within the policy. Compared to other forms of life insurance, the returns tend to be higher over a long-term period.
2. There are high levels of flexibility with these policies.
With an IUL, the policyholder can choose how much risk they want to take with the market. The policy is structured so that the holder can change the death benefits that may be required since personal needs can change over time. The number of riders associated with IULs can be added or subtracted over time as well. This makes it possible for policyholders to design something that is fully customized to their specific needs at any given time.
3. IULs do not tax capital gains.
With an indexed universal life insurance policy, plan holders do not pay a capital gains tax on the increase in cash value they experience with it. The only exception to this advantage is if the policyholder decides to abandon their IUL before it reaches maturity. After maturity, even if a withdrawal occurs, the capital gains tax does not apply under current taxation codes within the United States.
4. There are no contribution limits.
Unlike other products that are designed to provide comfort in retirement or support in death, there are no contribution limits associated with indexed universal life insurance. This type of policy has the same type of tax-deferred growth that is associated with a Roth IRA, for example, but there isn’t a cap on the maximum amount of the policy. As long as the policyholder can afford the monthly premiums assigned to the policy, there are no limits involved.
5. There are usually lower premium rates.
Because there aren’t guaranteed interest rates and other growth factors involved, an IUL typically has a lower premium compared to other forms of life insurance which provide similar benefits. At the same time, because cash value doesn’t decrease should a target index fall, the only real threat to an indexed universal life insurance policy is inflation. The premiums are variable, based on the riders and needs of the policyholder, so some rates may be higher, but that flexibility is still an advantage.
6. Some carriers will offer a guaranteed interest rate.
Although a 0% return is often an option for IULs when an index experiences a loss instead of a gain, some carriers have started to offer a guaranteed return. This buffer helps to offset the downside and is often paid for by the caps in place from the years there was a high upside. Because of this structure, some IULs function closer to whole life insurance products while still offering the benefits of the indexed structure.
7. Policy loans are usually permitted with IULs.
Most indexed universal life insurance plans allow for policy loans that are usually free of income taxes and do not require repayment. If the policy is surrendered, however, the loan becomes subject to income taxes on the tax year that the policy lapsed.
List of the Cons of Indexed Universal Life Insurance
1. There are no guarantees that a gain will be achieved.
IULs are not like whole like insurance policies that offer a guaranteed interest rate. That means the results of an indexed universal life insurance policy are not guaranteed. They have variable returns that are based on an index, which means they often have variable premiums over their lifetime as well.
2. Participation rates can be variable.
Assuming that the policy provider is not limiting participation in the IUL, the rates of participation can still be variable from year-to-year. That means the returns that can be achieved from the IUL are variable as a percentage as well. That makes it difficult to predict what the returns will be within the policy. A 100% participation rate with 6% growth one year, but a 4% growth with 50% participation, creates a 4% growth difference for the same IUL in comparison.
3. The returns will always trail the index.
The provider of the IUL earns profits by keeping a portion of the gains that are achieved from the index. Because of that structure, the returns of the indexed universal life insurance policy will always trail the index. When there is a poor index environment, the returns that an IUL offers are often lower than other types of insurance as well. In some years of low gain, a majority of the gains may go to the insurer as profit instead of to the policyholders.
4. It may offer fewer gains compared to other financial structures.
Not everyone will benefit from an indexed universal life insurance plan. Though the idea of earning returns without the risk of a loss can be attractive from a marketing standpoint, the total costs paid may provide fewer long-term benefits compared to other financial structures. Some households may benefit by having a different type of life insurance and make separate investments instead.
5. They are designed for a specific demographic.
Most indexed universal life insurance policies are not usually a good choice for someone with low-to-moderate income levels. The demographic which benefits the most from this type of insurance product are those with high wealth levels, high income earners, and those who own businesses that bring in high profit levels. Outside of this demographic, the premium costs are too high and the potential returns provided are too low in return.
6. Not everyone needs a permanent death benefit.
Once an individual no longer requires earnings from work to support themselves, they have become financially independent. That independence often reduces, if not eliminates, the need for a permanent death benefit. Since an IUL is a permanent life insurance policy, the cost of the death benefit must always be taken out of the cash value of the account. That is an added cost that not everyone needs to pay.
7. Most IULs do not count dividends.
The returns that are tracked by the index with an indexed universal life insurance policy only tracks the change in value that is experienced. The dividends that are earned by the stocks in the index are not usually counted in that valuation. Historically, dividends account for 20% of the market returns that are experienced on any given year. That means the index might go up 12%, but only 10% may be credited because of a 2% dividend. At a 50% participation rate, the final credit might only be 5% to the policyholder.
8. Many indexes have a 50/50 shot at over-performing their cap.
Many IULs are indexed to the S&P 500. Between 1928-2014, this index had a return above 12% 44 times, or more than half of the time. Now imagine if the IUL is capped at 10%. Even at full participation rates, the full benefit of the market gains will not be realized. Assuming a 12% cap, between the years of 1999-2014, someone with an indexed universal life insurance policy would lose 69% of the funds that an IUL holder with no cap on their policy would get to experience.
The indexed universal life insurance concept offers several pros and cons which must be carefully evaluated by every individual and household that is considering this financial instrument. Be sure to take the time required to understand each potential benefit and risk and examine any alternatives that could be a better fit for your current financial situation.