Indexed universal life (IUL) insurance is often pitched as a cash value insurance policy that benefits from the market’s gains – tax free – without the risk of loss during a market downturn. While the sales pitch certainly sounds compelling on the surface, critics warn that market returns are far from guaranteed and the term nature of the insurance could make it expensive to maintain the policy later in life when premiums tend to rise sharply. In this article, we’ll take a look at the pros and cons of IUL policies and some other options that might be worth considering as alternatives.
Indexed universal life policies put a portion of the policyholder’s premium payments toward annual renewable term insurance with the remainder added to the cash value of the policy after fees are deducted. On a monthly or annual basis, the cash value is credited with interest based on increases in an equity index. The gains are applied based on a participation rate that’s set by the insurance company, which can be anywhere from 25% to over 100%. (For more, see: The Best Type of Life Insurance for You Right Now.)
Let’s take a look at some typical marketing material for an IUL policy:
“Indexed universal life insurance provides death benefit protection and the opportunity to build money inside your policy, called cash value, based in part on the increases of market indexes. Even if these indexes dip, you’re still safe with a guaranteed minimum interest rate.” – Voya Financial
“Indexed universal life insurance combines life insurance protection with equity-linked accumulation potential. It has some of the same features as universal life, like premium flexibility, and offers more growth potential, but with potentially less risk than variable universal life insurance.” – AXA
Key benefits of these policies include:
- Higher Return Potential – These policies leverage call options to gain upside exposure to equity indexes without the risk of losses, while whole life policies provide only a small interest rate that may not even be guaranteed. (For more, see: see Indexed Universal Life Policies: Watch These Risks.)
- Greater Flexibility – Policyholders can decide how much risk they’d like to take in the market, adjust death benefit amounts as needed, and choose between a number of riders that make the policy customizable to their needs.
- Tax-Free Capital Gains – Policyholders do not pay capital gains on the increase in cash value over time unless they abandon the policy before it matures, whereas other types of financial accounts may tax capital gains upon withdrawal.
There are several gotchas that are associated with indexed universal life insurance policies that critics are quick to point out. For instance, someone that establishes the policy over a time when the market is performing poorly could end up with high premium payments that don’t contribute at all to cash value. The policy could then potentially lapse if the premium payments aren’t made on time later in life, which could negate the point of life insurance altogether. (For more, see Comparing IUL Insurance to IRAs and 401(k)s.)
Drawbacks of these policies include:
- Caps on Returns – Insurance companies often set maximum participation rates of less than 100% and as low as 25% in some cases, while returns on equity indexes are often capped at certain amounts during good years.
- No Guarantees – Whole life policies often include a guaranteed interest rate with predictable premium amounts throughout the life of the policy, whereas IUL policies have variable returns based on an index and have variable premiums over time.
The Bottom Line
Indexed universal life insurance provides a number of advantages and disadvantages to consider before purchasing a policy. While the policies provide greater upside potential, flexibility, and tax-free gains, there are caps on returns and no guarantees as to the premium amounts or market returns. These policies are generally best for those with a large upfront investment that are planning for tax-free retirement. (For more, see: What is Indexed Universal Life Insurance?)