Comparing IUL Insurance to IRAs and 401(k)s

Whenever the stock market experiences a growth spurt, it’s hard for even the most conservative investors to sit on the sidelines. That phenomenon, no doubt, explains the dramatic rise in something called indexed universal life (IUL) insurance over the past few years.

Like other permanent life insurance products, IUL features an insurance component as well as a cash benefit that holders can tap when the need arises. But there’s a key difference. Instead of crediting a policyholder’s account based on conservative bond funds, insurers tie it to a stock index like the S&P 500.

Unquestionably, indexed universal life policies are one of the hottest offerings in the financial sector. According to the research firm LIMRA, IUL premiums rose by a staggering 23% in 2014 alone.

But they’re also one of the most contentious. Now, some financial gurus urge investors to steer clear of whole life policies altogether, repeating the old maxim “buy term and invest the rest.” With IUL, however, the debate is particularly fiery. Even New York’s top insurance regulator has called into question the sales practices surrounding this trendy form of insurance.

Regardless of whether you happen to be a believer in this specialized insurance product, it’s almost always a good idea to maximize your 401(k) and IRA before putting any money into an IUL policy.

Inside IUL Policies

One of the main selling points for indexed universal life is that it gives the policyholder exposure to the stock market while protecting against losses. If the underlying stock market index goes up in a given year, owners will see their account increase by a proportional amount.

The word “proportional” here is key. Insurers use a formula for determining how much to credit your cash balance. And while that formula is tied to the performance of an index, the amount of the credit is almost always going to be less. If the market increases 10% over the course of a year, your cash amount may only go up by, say, 7% or 8%.

There’s also a cap on the amount of the credit, which limits your account’s growth if stocks have a banner year. According to Moore Market Intelligence, the average upper limit on account credits is 12%. So even if a benchmark like the S&P 500 shoots up 20%, your gain could be a fraction of that amount.

For some consumers, that could be a price they’re willing to pay in order to mitigate their downside risk when the market heads in the other direction. Most IUL policies have a 0% guaranteed minimum credit rate, which means – hypothetically, anyway – that your account won’t lose value if stocks take a sudden dive.

However, potential policyholders also have think about the notoriously high expenses – including administrative fees and surrender charges – associated with permanent life insurance. The commission paid to sales reps is particularly steep, often swallowing up the entire first year of premiums. From there, sales fees frequently continue at around 5% annually before tapering off. As a result, the cash balance of your account may not start to show any substantial growth for years.

Reps make much less by selling term policies, which offer a death benefit without the cash component. That’s one of the reasons that some agents – although certainly not all – are more apt to push universal life policies. (For more, see What Your Life Insurance Agent Makes – On You.)

In comparison, 401(k) and IRA accounts with no-load funds, and typical annual expense ratios of around 1.5%, start to look like a much cheaper alternative.

Lack of Transparency

Another factor to consider when it comes to IUL policies is the complexity of the contracts you’re signing. What many investors don’t realize is that they often contain provisions that let the insurer change the rules of the game at a later date. For example, some policies allow the company to lower the cap on returns in order to strengthen its balance sheet.

According to some critics, the sales pitch to get clients interested in indexed products can be equally confusing. Reps will sometimes use illustrations that show how much policyholders can potentially earn under certain market conditions. But the industry has come under fire for relying too heavily on rosy projections that will almost certainly never happen.

That’s drawn the attention of Benjamin M. Lawsky, New York State’s Superintendent of Financial Services, who has expressed concern that issuer forecasts are “wildly inaccurate.” A top official of the American Council of Life Insurers, a trade association, has acknowledged that the industry needs to improve standards for how equity-indexed policies are sold.

A Good Tax Shelter?

So is there anyone who would clearly be better off with an indexed universal life policy? There’s an argument to be made for having one if you’re a high net worth individual and don’t want your family to face a giant tax bill after your death (see Cut Your Tax Bill With Permanent Life Insurance). Irrevocable life insurance trusts have long been a popular tax shelter for such individuals. If you fall into this category, you probably want to talk with a fee-only financial advisor to discuss whether buying permanent insurance fits your overall strategy (see Indexed Universal Life: Cash, Flexibility And Safety).

For just about everyone else, though, it’s hard to find a compelling reason to choose IUL over term insurance, especially if you haven’t maxed out on contributions to your retirement accounts. For more information, read Is Life Insurance A Smart Investment? and Strategies To Use Life Insurance For Retirement.

The Bottom Line

For most folks saving for retirement, buying a less expensive term life policy – and investing the remainder in a 401(k) or IRA – is a smart move. In most cases, you’ll have much lower fees to eat away at your return. Plus, you won’t have to worry about the fine print in your IUL contract.