What Is Indexed Universal Life Insurance?
Indexed universal life (IUL) insurance pays out death benefits at any age you die, so long as you maintain your premium payments. IUL policies also have a cash value component that earns interest based on the performance of a stock market index, like the S&P 500 or Russell 2000. Your cash value account's growth potential is restricted by an interest rate cap but also has an interest rate floor, which can mitigate financial loss.
IUL insurance is a unique type of policy that can grow based on market performance but also has features to hedge against risk. Keep reading to learn if an IUL policy is right for your coverage needs and investment risk tolerance.
How Does Indexed Universal Life Insurance Work?
Indexed universal life insurance issues a cash payout (also called death benefits) to your beneficiaries when you die. Coverage is typically lifelong (up to 121 years) so long as you pay your premiums. Unlike other types of permanent life policies, your premiums can be increased or decreased, which can be useful for individuals with fluctuating incomes. Your beneficiaries are also entitled to any cash value that has accumulated throughout the life of the policy.
IUL policies build cash value by depositing a portion of your premiums into a tax-deferred interest-earning savings account, an index credit account or both. The savings account earns interest at a guaranteed rate (e.g., 2.5% annually). The cash value growth in the index credit account is tied to the performance of a stock market index, like the S&P 500 or the Russell 2000.
With IUL policies, cash value growth in the index credit account is subject to an interest rate cap, floor and a participation rate.
Interest rate cap: The maximum interest rate your index cash value account can earn over the index period. If the interest cap is 10%, then you cannot earn more than 10% even if the index positive movement was higher.
Interest rate floor: The lowest interest rate your index credit account can earn over the index period. If the interest rate floor is 0%, then you cannot earn below 0% even if the index dip was negative.
Index participation rate: The percentage of positive index movement your index credit account can earn. If your participation rate was 50% and the underlying index increased 10%, then the account would earn 5% (half of 10%) over that index period.
Index Credit and Fixed Rate Account Examples
Below are two examples showing how $10,000 might grow in two different accounts with different index performances. In each example, there is a 10% interest rate cap, 0% interest rate floor and a 100% index participation rate.
Adjusted Return (10% cap, 0% floor)
In the first example, the adjusted return is 10% (+$1,000) despite the index performing at +20% because the growth is limited by the 10% interest rate cap. In the second example, index performance went down but you did not lose money due to the 0% interest rate floor.
Your policy will build cash with an interest-earning savings account, an index credit account or both. In this next example, let's see how growth functions in the investment index account and fixed-rate savings account:
Adjusted Return (10% cap, 0% floor)
Index account: $20,000
Fixed-rate account: $10,000
Index growth was +10%, resulting in a 10% growth (+$2,000) to the index account. The fixed-rate account does not follow any index and grows at a flat 2.5% rate (+$250).
Cash Value Loans and Early Payout
Your insurer may allow you to borrow against the IUL policy's accumulated cash value in the form of a loan. You would need to repay the loan, plus interest, or else the outstanding balance would be deducted from the death benefits issued to your beneficiaries after you die.
You can also cash out the accumulated equity early by surrendering the policy. This effectively cancels the policy and surrenders any death benefits that would otherwise be paid to your beneficiaries after you die. Also, be sure to confirm with your insurance agent if any surrender fees would apply if you cash out too early.
Who Is an Indexed Universal Life Policy Best For?
An IUL policy is ideal for individuals who want lifelong coverage and want to build cash value over time. After enough time has elapsed, the cash value can be quite a sizable addition to the death benefits issued to your beneficiaries after you die.
The interest rate cap and floor can be attractive to those who want a higher growth potential based on market performance with some safety nets built in. Compared to the lower fixed-rate growth of a whole life policy, cash value in an IUL policy can potentially grow at a faster rate. If the index underperforms, however, there is no financial loss if the interest rate floor is set at 0%.
Indexed Universal Life Insurance: Pros & Cons
Increased growth potential
Market downside protection
Cash value is tax-deferred
Increased growth potential: IUL policies may have a higher growth potential than whole life policies if the underlying index performs well. If your index returns are favorable, they can quickly outpace a whole life policy's guaranteed but often lower rate of return.
Market downside protection: IUL policies generally have an interest rate cap set at 0% — if the underlying index has negative movement, then your index credit account will experience zero growth instead of losing money. Variable life insurance policies, on the other hand, can result in financial loss if your invested securities perform poorly.
Lifelong coverage: Your beneficiaries are entitled to death benefits at any age you die (typically up to 121 years) so long as you continue paying your premiums.
Flexible premiums: Your insurer may allow you to increase or decrease your life insurance premiums, which can be useful if your income regularly fluctuates or a life event is temporarily affecting your finances (e.g., job loss, paying for a wedding).
Cash value is tax-deferred: The cash value in your account is not taxed until it is issued to your beneficiaries after you die or if you cash it out early. Tax-deferred growth generally grows at a higher rate over time than if you made contributions with after-tax dollars.
Some investment risk: Interest rate floors are typically set at 0%, which means your cash value will experience no growth if the underlying index experiences a dip. While this helps mitigate financial loss, it is a tradeoff of not choosing another life insurance policy (e.g., whole life) that offers a guaranteed, albeit lower, return rate.
Complex: The investment component, fixed-rate savings account and flexible premiums are all additional layers that can make an IUL policy complicated when compared to a term life policy.
Indexed Universal Life Insurance Alternatives
If an IUL policy is not for you, consider other forms of permanent life insurance or temporary coverage with term life insurance.
Whole Life Insurance
Best for: Individuals that are content with their cash value growing at a guaranteed but lower rate
Also a form of permanent life insurance, whole life insurance offers a simplified option for cash value growth. Instead of tying cash value growth to the performance of an underlying index, cash value on whole life policies grow at a guaranteed rate. For instance, a whole life interest rate of 2.5% will always earn 2.5% interest regardless of current market conditions.
Whole life insurance policies, however, have lower growth potential. While whole life cash accounts are guaranteed to grow over time, it typically does so at a more conservative rate.
Variable Life Insurance
Best for: Individuals that have investing experience and want the highest growth potential for their cash value account
Variable life policies have a higher growth potential than IUL policies because there is no interest rate cap. If the interest rate cap on an IUL policy is 10%, then you only earn 10% even if the index performs at +21%. If it was a variable life insurance policy, you can earn the full +21%.
Variable life insurance policies do not have interest rate floors, like IUL policies. If the market performs poorly, then you risk financial loss that can result in your policy lapsing if you cannot cover your policy fees. Therefore, variable life insurance is better suited for those with investment experience.
Term Life Insurance
Best for: Individuals with coverage needs that are temporary and specific
Term life policies of five- to 30-year terms can be useful if you need coverage for a specific period and purpose. For example, buying a 25-year term life policy when your child is born will offer them some financial support if you die before the projection that they will be financially independent at age 25.
Term life policies do not have a cash value component. With permanent life policies, you have a portion of your premium payments working for you by accumulating cash value over time. There is no such feature available in a term life policy.
Want Lifelong Coverage and To Build Cash Value?
The right life insurance policy will depend on your coverage needs, budget and comfort with investment risk. Permanent life insurance is ideal if you want permanent coverage, while also accumulating cash value with each premium payment. IUL policies, specifically, have higher growth potential than whole life policies with less risk than a variable life insurance policy. But if your coverage needs are temporary, then a term life policy may be a better fit.
SmartFinancial can help you narrow down your options to the best life insurance option for your needs and budget. Just answer a few questions and enter your zip code below to receive your free quotes. You can also call 855.214.2291.