IUL vs. Whole Life: An Overview
Those shopping for the right life insurance policy have a wide array of choices, ranging from cheap term life insurance to expensive permanent life insurance policies. When it comes to the latter, two popular options are whole life insurance and index universal life insurance (IUL). Individuals deciding between these options should carefully examine their needs before committing to a life-long decision.
In this article, we’ll take a look at the key differences between these policies and some tips for individuals trying to decide between them. (For background, see "Life Insurance: Putting a Price on Peace of Mind.")
- Permanent life insurance provides death benefit coverage for the life of the insured.
- Permanent policies accrue cash value that can be used for disbursements such as retirement income or emergency savings.
- Whole life policies guarantee benefits with fixed premiums and known minimum growth.
- Indexed universal life (IUL) policies have flexible payments with cash accumulation pegged to the performance of an equity index.
Whole Life Insurance
Whole life insurance policies have been around for decades. In general, these policies are considered the safest option for those looking to provide for their family after death.
- Guaranteed death benefits
- Fixed premiums that don’t increase with age
- Option to pay up face value in 10 years, 20 years, or at age 65
- Option to borrow against cash value if needed later in life
- Interest and cash disbursements may be income-tax-free
- The interest rate may not be guaranteed (although often there will be a minimum floor rate)
- Potential opportunity cost with low relative interest rates
- Premiums aren’t flexible and must be paid consistently
Indexed Universal Life Insurance
Indexed universal life insurance policies give policyholders the option to allocate all or a portion of their net premiums (after paying for the insurance coverage and expenses) to a cash account. This account credits interest based on the performance of an underlying index with a floor of 0% return and a cap rate and/or participation cap on the return.
The dynamics begin to get a bit murkier when looking at how the index exposure is built. Rather than purchasing equities outright, the insurance company typically enters into options contracts using some portion of the policy premium, which enables them to pass on the upside gains without the downside losses—but at the cost of additional counterparty risk.
Many insurance companies provide minimum cap rates of between 1% and 4% and participation rates of around 50%, although some provide non-guaranteed cap rates of around 10% to 14% and participation rates in excess of 100% in sales materials, according to a The Bishop Company LLC report. If an underlying index returns 20%, a policyholder may only realize a 10% to 12% return with these caps in place. The use of stock options also eliminates dividends from any index return calculation, which usually accounts for 2% to 4% of the total market return. Without these returns, policyholders may generate a lower return than the benchmark indexes.
- Guaranteed benefits
- Flexible premium payments
- Potential for higher interest earnings
- Option to borrow against policy later in life
- Earnings depend on equity performance
- If the index falls, returns can be inferior, although there are often floors to prevent extreme losses.
- Potential for premiums to rise over time
- Use of complex derivative investments
- Higher expenses
- The death benefit may be reduced or forfeited if premium payments lag behind performance.
Deciding Between the Two
Whole life insurance is designed to be exactly that—life insurance. In contrast, indexed universal life insurance policies are more like retirement-income vehicles. Cash inside of these policies grows on a tax-deferred basis and can be used to pay premiums. Plus, during retirement, policyholders can take tax-free distributions from the accrued cash value to help cover any sort of expenses—useful for those who have already maxed out their Roth IRA and other options. In fact, many policies are sold based on the concept of accumulating cash value rather than a guaranteed death benefit.
It’s also important to consider the use of derivatives by indexed universal life insurers. Since a call option is inherently capped at a certain level or expires worthless, IUL policies have limitations to the maximum returns during good years and limit the downside to 0% returns during bad years. Insurance providers touting high returns for IUL policies may be trying to take advantage of “recency bias” if equity indexes have been performing well as of late.
Some IULs also come with guaranteed contractual benefits through riders, which can actually provide guaranteed benefits that are comparable to general account products. Still, IUL policyholders should not rely on high equity index returns to fund their life insurance over time. High returns in some years can lead to policyholders neglecting to fund the cash value of the policy, which could lead to a lapse in coverage later in life if returns aren’t quite as good. Taking policy loans from the cash value and paying interest can also be a risky endeavor if the credited interest doesn’t cover the costs of the loan.
The Bottom Line
Individuals shopping for permanent life insurance, which offers a cash component as well as insurance coverage, have a number of different options. Whole life is generally the safest route for those looking for something predictable and reliable, while IUL policies provide an interesting retirement- planning vehicle with greater upside potential and tax advantages. (For more, see "5 Life Insurance Questions You Should Ask.")
Related: The Best Whole Life Insurance