Indexed Universal Life Insurance (IUL) Explained

Indexed universal life insurance contains the following components:

  1. Cost of Insurance
  2. Set or “Target” premium
  3. Fees
  4. Cash Value Components
  5. Death Benefit Options

Cost of Insurance

When you compare an indexed universal life Insurance vs term life insurance (the most commonly purchased level premium version), or Whole Life Insurance, you will notice one major standout is that the cost of insurance rises on a year to year basis.

In this article, we cover in depth the difference between a rising premium term policy and a level premium term.

Since the cost of insurance is lower in earlier years, it allows more of the premiums paid, to be allotted toward cash value growth. Ideally, that growth will outpace the rising cost of insurance in the later years.

Set or “Target” Premium

The cost of insurance of an indexed universal life insurance policy rises every year. If all you were to do is pay that cost, also known as the “Minimum Premium,” you would most likely be better off purchasing an Annual Renewable term, due to the lower overall price. Additionally, if nothing above the minimum premium is deposited into the policy, the cash value will never get a chance to develop. It will most definitely never outpace the rising insurance costs either.

For this reason, the Target premium was created, this amount is the optimal or ideal amount, at a minimum anyway, of where your premiums should be. If you hit your target, the cash value will most likely outpace the rising cost of insurance.

Insurance companies encourage you to pay more than the target, all the way up to the maximum amount allowed for tax purposes so that the policy does not become a Modified Endowment Contract. Read our explanation of the taxation of life insurance policies and modified endowment contracts.

Paying more than the target allows for more of your money to grow based on your index choices. Keep in mind that the premium charges may vary for the monies below and up to target and those above the target amount.

Fees

Here is an example fee schedule for an index universal life Insurance policy:

Policy and surrender charges

Life insurance policies charge a hefty premium for the services they provide. The difference between term or whole life insurance and universal life insurance is that a universal life insurance policy fully discloses those fees.

Here is a list of typical fees that you may find on an index universal life insurance policy:

  • Administrative Charge 
  • Face Amount Charge Per $1,000. A small fee per $1,000 of life insurance coverage,  an example insurer would charge 12 cents per $1,000 of insurance a year. The total annual cost for a $1,000,000 policy would be $120 a year.
    $1,000,000 / 1,000 = 100 x $0.12 = $120
  • Cost of Insurance. Based on the insurance company’s experience but not to exceed CSO mortality tables, this is a rising cost as previously discussed. However, there are strategies to lower these costs, which will be discussed in the death benefits section of this article.
  • Indexed performance charge. Essentially a “funds under management” fee. Where you get charged based on the index you choose to have your cash value based on.
  • Premium Charge In other words a “load fee.”
  • Surrender Charge.
    If you surrender your policy for its cash value, the surrender charge will be deducted from the total cash value amount. Depending on the insurance carrier, this will usually fall off between years 10 and 15.

Here is an example of surrender charges on one of the large indexed universal life insurance carrier’s policies:

Year in Surrender Charge PeriodMaximum Percentage of Surrender Charge
1100%
299%
397%
496%
584%
681%
777%
873%
969%
1062%
1159%
1255%
13+0%

Cash Value Components

Cash value has a few features and limitations that one must be aware of prior to purchasing an indexed universal life insurance policy:

  1. Interest Rate Floor
  2. Growth Rate Cap
  3. Participation Rate
  4. Indexes

Interest Rate Floor

This is perhaps the most enticing feature of an indexed universal life insurance policy. It guarantees that your policy will always have a “positive year.” In other words, you only experience the upside of the market and no downside. If the market dips—even to 2008 levels of close to 40%—your indexed universal life policy will still grow (or, at least, not lose) based on the minimum floor amount.

This amount is usually 0%-3% and varies from carrier to carrier.

It’s important to note that while the cash value amount does not go down during a bad year in the market, you will still be charged all of the built-in policy charges. Which means that your overall policy may still decrease in value, especially if this down market year happens later in the policy when the cost of insurance is substantial.

Growth Rate Cap

Likely the most limiting feature of an indexed universal life insurance policy, a cap rate limits the maximum amount of growth you will get based on the index you choose. For example, if you have a 14% cap and the market earns a 22% return, you will still only get a maximum of 14%.

Participation Rate

Aside from the cap rate, some companies also limit what percentage of the overall index you get to participate in. For example, if the index returns 10% in a given year, if your policy has an 80% participation rate, you will only receive an 8% return.

Indexes

You will usually have the option to choose between different common indexes such as the S&P 500, Russell 2000, etc. There are also fixed accounts within an indexed universal life insurance policy, but if you’re looking for a fixed growth rate, traditional universal life or whole life will probably be a better bet.

Notes on Cash Value Growth 

Indexed universal life is not an investment in the market. You are not purchasing shares in an index fund or any individual stocks. If you want to have an actual investment with the no-cap upside while taking on the full risk of the market (no floor), within your life insurance policy, you need to purchase a Variable Universal Life Insurance policy.

An indexed universal life insurance policy’s cash value growth only tracks the selected indexes and grows based on the pre-set limitations. It is, therefore, not considered a securities product, unregulated by the SEC, and can be sold by unregistered advisors.

Dividends, which historically provide a large amount of index growth, are also not usually included in the overall growth of an index universal life insurance policy.

The premiums and cash value of your index universal life policy are actually invested in the insurance company’s general account similar to a whole life policy. If the index performs too well, the insurance company stands to lose a large amount of money since life insurance companies are very regulated as to what they can invest in within their general accounts.

To offset this risk, insurance companies will take out an insurance policy on the up side of the index. Another way to manage this risk is that insurance companies leave themselves leaway on the cap rate. For example, they may say the current cap rate is 10% with the guaranteed minimum of 3% so that they can lower the cap if they come under too much pressure.

Death Benefit Options

Like most universal life insurance policies, indexed universal life insurance policies have three death benefit options:

Level

The death benefit stays the same throughout the policy years. Or at least until the cash value catches up to the death benefit. In this option, the total amount of the insurance benefit actually goes down as the cash value rises because cash value fills  the gap. This helps offset the rising cost of insurance in later years when this benefit option is selected. Many people will choose option 2 and then switch to option 1 when they age in order to manage costs.

Increasing

The amount at risk stays the same throughout all policy years. The cash value amount adds to the death benefit, dollar for dollar. Because the death benefit amount never changes, the cost of insurance constantly rises.

Return of Premium

This option gives the death benefit plus all premiums paid upon the passing of the insured. In terms of cost, it is midway between level and increasing benefit options.

Summary

By definition, an indexed universal life insurance is a universal life policy where its cash value tracks a specific index or combination of indexes. If you are aware of the costs of indexed universal life insurance (and its shortcomings), you can also make use of its advantages.

There are many companies that offer indexed universal life insurance. Prior to purchasing, make sure to delve into the details and fine print.

Listed above are 5 or more reasons not to buy indexed universal life insurance, but also many reasons why someone might.

 

FAQs

Can you lose money in an IUL?

Yes, even though IUL provides an interest rate floor, the fees can be more than the minimal growth in a bear market.

Is an IUL better than a 401k?

An IUL is an insurance policy, and a 401k is a qualified retirement account that can hold all types of investments and interest-bearing instruments. Kind of like apples and oranges, both fruit but a very different taste.

Is indexed life insurance a good investment?

Indexed universal life is actually not technically an investment in the market. It is a life insurance policy that has a cash value which tracks an index.

Is Indexed Universal Life Insurance A Good Investment?

Indexed Universal Life is not truly an investment in the market. It is a life insurance policy that has a cash value which tracks an index.

Is Indexed universal life insurance good for retirement?

You can use an IUL for retirement. Depending on the structure and strategy, it may or may not be the correct tool. it does have the tax benefits of a life insurance policy, so that is definitely a plus.

What are the pros and cons of indexed universal life insurance?

The advantage of an IUL is a favorable tax and interest rate floor. Unfortunately, there is also a growth cap and participation rate. Moreover, it’s not an actual investment in the market and has no dividends while still levying fees.

What company has the best IUL?

Many companies offer great IUL policies, and no single company is the global indexed universal life insurance leader. A responsible customer will research the various policies offered and make an intelligent decision. Reach out to Sproutt life Insurance for an expert advisor’s assistance in your research.

What is indexed whole life insurance?

Read the article above for a full picture.

What is the average cost of universal life insurance?

The cost of insurance depends on many factors including, but not limited to, age, health, amount of coverage, and many more factors.

What is the difference between universal life and indexed universal life?

Universal life’s cash value grows based on the interest rate market. Indexed universal life growth based on indexes.

Which is better, term or universal life insurance?

Term and universal policies are very different, suiting different people with unique advantages. Since each policy has positive and negative elements, learn about both kinds of policies to decide if you only need coverage for a matter of years or for the rest of your life (plus added perks).

Who has the best IUL policy?

Many companies offer great IUL policies, and no single company offers the absolute best indexed universal life insurance policy. Every policy has it’s pros and cons. A responsible customer will research the various policies offered and make an informed choice. Reach out to Sproutt life Insurance for an expert advisor’s assistance in your research.

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