Think Outside The Stocks

Think Outside The Stocks Logo

Indexed universal life (IUL) insurance combines the death benefit of a life insurance policy with the cash value of an asset and the investment options of an index—plus flexible premiums—all into one product. IUL policies are sold as financial multi-tools with an array of benefits. But before you decide if it’s the right type of life insurance for you, here are the risks you need to know.

What is Indexed Universal Life Insurance?

Indexed universal life insurance is a type of permanent life insurance. It offers a death benefit and earns cash value the policyholder can use as a living benefit via policy loans during their lifetime. When a premium is paid, part goes toward the death benefit and policy fees and part goes toward the policy’s cash value.

Beyond the portion of the premium that goes toward cash value, an indexed universal life insurance policy can accumulate wealth in one of two ways:

1.     The policyholder can keep funds in the cash value portion of the policy where it may earn a low, fixed rate of return. 

2.     The policyholder can invest funds in the cash value portion of the policy in indexes offered by the insurance company, where its rate of return will vary depending on the performance of the index.

An indexed universal life policyholder may choose to invest a portion or all of their cash value. IUL policies are tied to the performance of indexes like the S&P 500, Nasdaq 100, or Dow Jones Industrial Average. Cash value is not directly invested in the market, but the performance of the market does influence the index, which determines the amount of interest credited back to the policy.

Growth of Cash Value

At regular intervals, typically month over month, index performance is evaluated. Gains in the index are credited as interest back to the policy. If the index decreases, the cash value will remain unchanged. For example, if an index grows 8% from January 1 to February 1, the cash value in an IUL policy is multiplied by 8% and that amount is credited to the policy, so if you have $100,000 in cash value multiplied by 8%, your value would increase by $8,000, resulting in a new cash value of $108,000.

Unfortunately, most insurance companies complicate indexed universal life policies by adding participation rates that cap a policy’s growth potential. If your insurer’s participation rate is 50%, using the example above, your $100,000 cash value would be multiplied by 8% at 50%, so your value only increases by $4,000—not $8,000. 

Insurers may also place index caps and floors. For example, if your insurance company places an index cap of 10%, the maximum growth that will be credited to your cash value is 10%, regardless of how well the index performs. Alternately, an index floor of 2% means your cash value will consistently be credited 2% even if the index performs poorly.

Index Rate Index Cap Index Floor Credited Rate
8% 10% 0% 8%
20% 10% 0% 10%
-5% 10% 0% 0%
-5% 10% 2% 2%

An index floor may make an IUL policy seem like a win-win; you’re guaranteed a minimum interest rate regardless of market performance, and in good investment periods you capitalize on index gains. But with fluctuating premiums and fees, even the minimal return guaranteed by an index floor may not provide enough growth of cash value to keep the policy in force without additional funding.

Some insurance companies utilize threshold rates and spread rates, which further limit your upside potential. A threshold rate means that your cash value won’t be credited unless the index reaches a certain growth percentage. For example, a threshold rate of 10% would indicate the index must grow by at least a 10% period over a period for you to see any return.

Index Rate Threshold Rate Credited Rate
15% 10% 5%
10% 10% 0%
5% 10% 0%

Due to caps and participation, threshold, and spread rates, as well as high management fees, indexed universal life insurance can become an expensive insurance product with less upside than other traditional investment options.

How Risky is Indexed Universal Life Insurance?

Indexed universal life insurance is one of the riskier types of life insurance you can purchase. Here’s how it stacks up against other permanent life insurance policies:

  Whole Life Fixed Universal Life Indexed Universal Life Variable Universal Life
Policy duration Permanent Permanent Permanent Permanent
Cash value Yes Yes Yes Yes
Rate of return The guaranteed rate of return (not tied to market performance) + non-guaranteed dividends Non-guaranteed rate of return (depends on bond performance), may offer minimum fixed rate Non-guaranteed rate of return (depends on index performance), may offer minimum fixed rate Non-guaranteed rate of return (depends on stock performance), may offer minimum fixed rate
Flexible premiums No Yes Yes Yes
The cash account value can decline No Yes, if bond rates are low and premiums high Yes, if index growth is low and premiums are high Yes, if stocks perform poorly
Risk ranked lowest (1) to highest (4) 1 2 3 4

In general, all types of universal life insurance carry more risk than whole life insurance or term life insurance. The reason they are riskier is there are more variables in play.

For example, universal life policy premiums aren’t fixed—and the flexibility of premiums applies not only to you but also to your insurance company.

  • Your insurer may choose to raise premiums and fees at their discretion, making the policy more expensive down the road. 
  • If you rely on your cash value to help fund premium payments and fees, and the investment portion of your policy underperforms, you can deplete your cash value and void your policy. 
  • You can choose to lower your death benefit with universal life insurance, which could mean cheaper premiums now but can leave your family unprotected in the future.

Of all types of life insurance, variable universal life policies are the riskiest because your cash value is directly tied to the stock market. Indexed universal life policies offer slightly more protection by tying cash value to the performance of an index, but are exempt from federal regulation by the SEC. Fixed universal life policies tend to be the safest of the three.

However, if you compare all permanent life insurance products, whole life insurance offers the least amount of risk. 

  • Fixed premiums never go up; purchasing a policy while you’re young and healthy can secure a low premium for life.
  • Cash value earns a guaranteed rate of return plus potential dividends (top-rated mutual insurance companies have consistently paid out dividends for over 100 years), regardless of market performance.
  • The death benefit is guaranteed, provided premiums are paid.

Rewards of Indexed Universal Life Insurance

For all the risks associated with an indexed universal life policy, they remain one of the more popular types of universal life insurance. In fact, according to financial research company LIMRA, over 20% of new life insurance policies sold in 2019 were IUL policies. 

Although not for everyone, people looking for alternatives to a 401(k) or another qualified retirement plan may find an IUL policy advantageous. Here’s why:

  • IUL insurance policies offer tax-deferred cash flow that can be used for retirement with greater growth potential than fixed universal or whole life insurance.
  • Cash value in an IUL policy can be accessed at any time, for any reason, and isn’t subject to penalties for early distributions. (Qualified retirement plans penalize you for distributions before 59 ½) 

Unlike qualified retirement plans, IUL policies don’t have a limit on contributions, provided the policy maintains a certain ratio of cash value to the death benefit.

  • For some policyholders, the flexibility of an IUL and the ability to choose between fixed interest or variable interest based on an index are appealing options.

Is Indexed Universal Life Insurance Right for You?

To decide if indexed universal life insurance is right for you, examine your risk tolerance, define your financial goals, and determine how involved you want to be with your insurance product.

If you’re currently maximizing your retirement contributions and willing to assume some risk while taking an active role in managing your policy, IUL insurance can be an interesting long-term option for generating wealth with the bonus of a death benefit. 

For financial security or a source of retirement income not tied to the market, whole life insurance is easier to understand and offers more guarantees than IUL insurance while also providing tax-deferred and tax-free cash flow, liquidity at any age, and a guaranteed death benefit. 

Buying Permanent Life Insurance

Regardless of the type of permanent life insurance you choose, it’s important to work with an insurance broker or Wealth Strategist that prioritizes your and your family’s best interests. Unfortunately, many of the insurance companies and agents who sell indexed universal life insurance prioritize their commissions over your needs.

Educating clients is our top priority.

Here we can customize a policy to fit your financial situation. Our expert Wealth Strategists are available to answer your questions and show you customized illustrations, outlining an individual plan of action to help you achieve your goals.