As it stands today, you might feel like you need an entire college course on life insurance to simply understand all the available options you have to consider.
From navigating the pros and cons of policies to understanding the terms and fine print, knowing what to select for your needs isn’t quite so simple. Conceptualizing life insurance is simple:
- You select a policy
- You pay the premium
- If you die while the policy is active, your beneficiary receives a death benefit
Typically, to receive coverage most will elect to enroll in a term life insurance policy with protection lasting somewhere in the neighborhood of 20-30 years. Selecting term life insurance is straightforward in most cases, but what about other life insurance plans such as indexed universal life insurance?
Knowing the basics of indexed universal life insurance (IUL) in addition to the pros, cons, and alternatives is key to seeing if it is a right fit for your portfolio!
Key Takeaways from this article:
- Indexed universal life insurance pays interest based on the performance (up or down) of the stock market
- Based on stock indexes, IUL can be seen as a flexible and high reward life insurance investment option
- The policy includes both a death benefit and cash value
- Is a type of permanent life insurance plan generally used to diversify and for tax-advantages
- Can often be viewed as more complex and confusing, not recommended as the primary form of life insurance for most
What is Indexed Universal Life Insurance anyway?
Commonly referred to as IUL, indexed universal life insurance is life insurance with a cash value, meaning a portion of the policy has a cash value that can earn interest so long as premiums are paid.
The upside to IUL is the potential for interest gains in addition to the policy having tax-free advantages. The keyword to understand is “Indexed” meaning the cash value for the policy owner is determined by the stock index, such as the Dow Jones or NASDAQ (examples of indexes).
Additionally, flexibility is another advantage to consider as consumers are granted permission to adjust the death benefit and pay premiums with the cash value. Deciphering how it all works and its pros and cons are vital before deciding to move forward with an indexed universal life policy.
A quick list of pros of indexed universal life insurance:
- Tax-free gains
- Higher rate of return potential
- No Social Security impact
Where there is a greater risk, sometimes there is a greater reward. Not to call IUL risky by any means, but the higher rate of return on the cash value is attributed to the no guarantee on the interest rate. Based on the performance of the index (more on that later), there is the potential for greater returns based on the index’s performance.
Flexibility is often attributed as one of the pros to enrolling in an IUL plan in that you can customize the death benefit while also deciding how aggressive in the market you would like to be.
Most view IUL as an investment vehicle with coverage, not the other way around, making flexibility key. You can also pick numerous riders (insurance provisions) for your policy.
Unlike term insurance or even whole life insurance policies, the tax advantages offered by IUL can be seen as one of the biggest advantages.
Based on your individual financial needs, deciding to enroll in a permanent policy such as indexed life insurance means you can take advantage of tax-free returns over a certain period of time.
A quick list of the cons of indexed universal life insurance includes:
- More expensive
- No guarantees
Most people don’t need their life insurance to last their entire life, but instead just a period of their life. Once you have paid off your debts and reached a certain age, life insurance isn’t necessary for most which is why many planners recommend term life over whole life insurance.
One of the negatives surrounding IUL is that it is permanent life insurance with higher premiums, and it is only good when those premiums are being paid.
Often the major drawback to any permanent life insurance plan is the expenses, fees, and complexity. IUL has gotten a reputation as being a complex life insurance plan due to all the subtle nuances associated with the index portion of the policies.
Where some may view the flexibility of indexed universal as a pro, for the average consumer this can lead to confusion.
Cons also included capped earnings and IUL policies don’t take into account dividend yields meaning these restrictions can actually limit the rate of return. Without understanding this, you can easily miss out on potential earnings had this money simply just been in the market.
Another drawback or term to familiarize yourself with is participation rates or “point to point” timeframes. These fine-print terms can negatively impact your cash value accumulation because of restrictive periods of growth based on the timeframes. Your planner and tax advisor might even recommend stashing the money in a savings account depending on the investment advice you receive.
Lastly, a variety of fees and other seemingly hidden costs including premium expense charges tacked on administrative fees, commissions, surrender charges, and rider fees can make IUL a more costly than advantageous plan for some.
How does IUL differ from whole life insurance?
Indexed universal life insurance is similar to whole life insurance, universal life insurance, and variable life insurance in that they are all permanent life insurance policies, meaning they last the entirety of your life as long as you pay the premium.
Unlike term life insurance – which ends after a specified term – permanent life insurance coverage has both a death benefit and a cash value.
How the cash value is structured is the key difference between whole life insurance and an IUL policy. The cash value of your indexed universal life insurance plan has a minimum guarantee on the return, however, the rate of return is not fixed, it is instead “indexed.”
Unlike whole life insurance where there is a fixed rate of return, indexed universal life insurance is based on the index chosen by the insurer.
Often, this is where most consumers get lost in the fine print, an index is a group of investments such as stocks or bonds. The interest rate is based on the performance of a specific index.
Other types of life insurance policies you can consider include:
- A universal life insurance policy
- Whole life
- Term life
- Indexed universal life
The best way to find out whether you need permanent coverage and whether or not IUL is a good fit is to start by speaking with a non-bias financial professional.
This means your financial advisor should not make any commission off recommending a life insurance policy. Be sure to ask if they are respective affiliates for the insurance company and if so how they are compensated.
You will want to understand the difference between IUL insurance policies and other whole life insurance policy factors before making your determination.
Why have I heard negative things about Indexed Universal Life Insurance?
Mention the words “Sub-prime mortgage” and you will see people squirm in their seats.
Designed to offer financing to those with impacted credit records, sub-prime mortgages were a large contributing factor to the 2008 mortgage crisis because of predatory lending techniques and an overextension of lending.
The point being, the sub-prime mortgage vehicle when used appropriately was actually designed to help provide lending to those with credit woes – but in many cases, it was a bad fit for most and caused more harm than good. The same can be said for indexed universal life insurance.
While we are certainly not comparing IUL to sub-prime mortgages and predatory lending, the negative that often surrounds indexed universal life insurance stems from consumers not fully understanding the advantages of disadvantages. Most people do not need indexed universal life insurance (yet) even though it can provide both coverage and diversification.
The complexity of these policies combined with the fees means IUL needs to be the best fit, not a one size fits all approach. Negativity surrounding IUL stems from consumers not fully understanding the basics nor needing IUL, only to be roped into paying high premiums. Indexed universal life insurance should not be the first investment vehicle most consider.
The Verdict –
Do what is best for you and your needs. Like anything, IUL is a great fit for some, but that doesn’t mean it is a great fit for everyone. A key takeaways to always factor when looking for life insurance of any kind include:
- What type of coverage do I need?
- What is the purpose of life insurance (retirement, tax-free investing, coverage, etc)?
- What is my budget?
If you’re someone who has a large amount of money to invest and you’re looking for tax-free retirement options, indexed universal life insurance is worth the consideration in order to diversify your assets!
As you age, your tax deductions are limited (no more kid deductions, mortgage paid off, etc) making IUL a great vehicle for those looking into tax-free investments.