What is indexed universal life insurance?
Cash-value life insurance (variable, indexed, or fixed) are some of the most complex financial products in the market today. Many different things factor into a properly structured indexed universal life insurance policy. Client health ratings, insurance carrier solvency, cost and fees in the policy, index options, persistency bonuses, loan rates, product features, rider options, term insurance riders, and so much more. As with many other things in life, good things don't come easy. While indexed universal life insurance policies are rather complicated, there are many advantages associated with this type of insurance product.
One of the most important benefits of using indexed universal life (IUL) is the tax advantage of this type of investment. The money contributed to the policy is usually post-tax money. But any growth associated to the cash value of the policy based on the index allocations are tax-deferred. The money can be accessed via a tax-free loan while the insured is alive or a tax-free death benefit when the insured passes away. In many ways, this is similar to making a Roth IRA contribution except for the fact that the contributions and distributions have a lot less restrictions associated.
Another important benefit of and IUL is the fact that the cash-value can not be reduced by negative index performance. The cash-value CAN be reduced by fees, expenses, loan interest, cost of insurance, premium loads, and many other charges. However, one of things that will not cause the cash value to be reduced is the negative performance of the index allocation.
It is important to be educated on all the pros and cons of putting money into and IUL policy before purchasing a contract. Also, the right financial advisor can really help in exploring the different options, applying for different policies, navigating health underwriting with the carriers, and maintaining the policy after it is issued. Nonetheless, these insurance policies can be very advantageous if they are properly set up and used.
This is a great question. In fact, because of how complex indexed universal life policies can be, I've even heard this question asked by other advisors. If I may, I'd like to give my true and honest assessment of indexed universal life policies.
Indexed Universal life (IULs) are a type of universal life policy. The universal portion means that premiums are flexible and the components of the life insurance policy (death benefit, savings element and premium) can be altered throughout the contract. Universal policies are also permanent insurance policies, like a whole life policy, although there are some major differences between universal life and whole life. One difference lies in the flexibility of universal life and the inflexibility of whole life.
Within universal life policies, there is a cash component as well as an insurance component. It is the cash component that makes IULs differ from VULs (Variable Universal life) and ULs (Universal life). The cash bucket inside of a indexed universal life policy grows as a result of index performance (and the indexes are usually selected by the client or advisor each year). The indexes will usually reflect broad market indexes like the S&P 500, DJIA, etc. This all seems pretty simple.
HOWEVER, the complex part kicks in when you start to study how the "interest" or "cash growth" is calculated on these policies. To truly understand this will require you to either spend ample time studying the policy you are considering purchasing inside and out or have an enormous amount of trust in the person recommending it. However, even if you trust your advisor, I would advise you to do the studying yourself. The reason is that these products all work differently and even advisors with the best intentions can overlook how these work. Let me provide some examples of what I'm talking about.
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.
Since this has turned into a long-winded response already, let me just say these final thoughts:
1. Understand how the indexes work. Ask a lot of questions. Ask if you can choose your issue date. Know your best and worst case scenario.
2. Make sure that the illustrations that are shown to you reflect a realistic rate of return. If you the illustrations you are looking at assume a 7% annual rate of return, you need to ask them to re-run at something more conservative. Is it possible to get 7% on average over a long period of time? Yes. BUT, that is without caps and participation rates involved. To be safe and to make sure your policy does not lapse, I would suggest projecting a more conservative return (like 4%).
3. Explore other alternatives to IULs. GUL (Guaranteed Universal Life) policies, for example, are incredibly straight forward and are backed by a guarantee from the insurance company. That leaves little room for misunderstandings or misleading life insurance illustrations. UL policies are also easier to understand in my opinion. This doesn't mean GULs and ULs are better the IULs, but it means if you're unfamiliar with how IULs work, you should either do your homework or consider choosing a different policy type.
Joe Allaria, CFP®
In the answers from the other advisors, you have some good background on how this product works. I would like to take this opportunity to explain how I use universal life insurance, to broaden your understanding of the product.
Universal life is a very flexible product. You can employ different strategies for funding it. For example, you can design a policy to maximize cash accumulation. Alternatively, you can design the policy to secure long-term guarantees.
I personally believe that life insurance should be the most secure part of your financial portfolio. It serves as a foundation that protects the viability of your other products. If the life insurance policy collapses, or is insufficient, then you might have to liquidate other assets prematurely. But if the coverage is sufficient, and the guarantees long enough, then your other products are free to provide optimum value.
For this reason, I frequently like to use universal life insurance as almost “permanent term insurance.” The goal is to get the lowest annual premium that would guarantee the coverage for the rest of your life. Like conventional term insurance, no cash is built up. But like permanent insurance, you never have to worry about the price going up. When designed this way, life insurance serves as a very strong foundation for your finances, at the lowest possible cost. The key is getting prequalified for coverage before you apply, so you could be sure that the price you are paying indeed will be the lowest the market offers.
Indexed universal life insurance is a lot like universal life insurance, however it does have a couple of wrinkles not found in traditional universal insurance policies. Universal life insurance comes in many different forms, from your basic fixed-rate policy to variable models that allow the policy holder to select various equity accounts in which they can invest. An indexed universal life insurance policy gives the policy holder the opportunity to allocate cash value amounts to either a fixed account or an equity index account. Indexed policies offer a variety of popular indexes to choose from, such as the S&P 500 and the Nasdaq 100.
Indexed policies allow policy holders to decide the percentage of their funds that they wish to allocate to fixed and indexed portions. Also, these types of universal insurance policies typically guarantee the principal amount in the indexed portion, but cap the maximum return that a policy holder can receive in said account. Since these policies are seen as a "hybrid" universal life insurance policy, they are usually not very expensive (due to lack of mangement), and are safer than an average variable universal life insurance policy. However, the upside potential is also limited when compared to variable policies.
To learn more, read Intro To Insurance: Types Of Life Insurance.
Universal life insurance (often shortened to UL) is a type of permanent life insurance, primarily in the United States of America. Under the terms of the policy, the excess of premium payments above the current cost of insurance is credited to the cash value of the policy.
The cash value of the policy can have a minimum fixed rate, or often equity indexed.
Many companies are also often additional rider or benefits to these policies for things like Long Term Care, Lifetime Income, Critical Illness or Injury, as well as Chronic Illnesses.
I’ve found these policies to be useful for people who make too much for a regular ROTH IRA, and can build to function like a “Rich People ROTH.(click here to read full article from Financial Planner LA)
People often claim that these policies are more expensive than term, over the long term they can actually end up being cheaper, with a great chance of actually getting some type of benefit from the policy.
Yours in Success,
Securities and advisory services offered through National Planning Corporation (NPC), Member FINRA, SIPC, a Registered Investment Advisor. Trilogy Capital Trilogy Financial and NPC are separate and unrelated entities. The opinions voiced in this article are for general information only and do not constitute an endorsement by NPC. NPC does not provide tax advice. Financial Planner LA Blog