6 min read

What Is Indexed Universal Life?

Over the last several years, sales have dramatically increased for indexed universal life (IUL); this is both good and bad. A quick Google search will yield two different groups with polar opposite arguments.

  1. Insurance agents who believe IUL is the best (or only) option.
  2. Investment advisors don’t understand it and rip it apart based on the actions of insurance agents.

These two groups leave you helplessly in the middle, trying to decide where the truth lies. This article intends to cut through the noise and misinformation about indexed universal life and will serve as a guide to help you understand your next step.

Today, IUL is positioned as the financial savior to all your financial needs; no investment or financial product can accomplish what this product can. This is both true and false. What works for one person could be a terrible mistake for another (more on this below).

 

What is Indexed Universal Life?

Indexed universal life (IUL) is an insurance contract that offers death benefit protection and the ability to accumulate cash value. The cash value increase mainly comes from an underlying index like the S&P 500, Nasdaq 100, etc. The cash value inside the contract participates in the growth of an underlying index; however, it’s not invested directly into the index therefore it cannot lose money when the market goes down. Unlike term insurance (temporary coverage), indexed universal life is permanent.

Like every product on the market, whether financial, apparel, or electronics, IUL has undergone several iterations. The first-generation IULs were built in a higher interest rate environment (the 1980s), and the assumptions used by the insurance companies weren’t sustainable to meet both the client's and insurance company's goals. Over the last decade, insurance companies have built better products using lower assumed interest rates. Combined with better index options, policy benefits, and products is a core reason IUL is becoming more popular.

 

What Are The Primary Uses for Indexed Universal Life?

Of course, all life insurance requires a financial need for the death benefit. Aside from the death benefit, there are a few key scenarios where IUL would be beneficial, I will focus on the 50,000-foot view and not get too weeded.

  1. Death benefit - this could be income replacement, buy-sell agreements, estate planning, etc.
  2. Living benefits and long-term care. IUL can be a suitable addition for long-term care; however, it’s not a complete replacement. 
  3. Potentially tax-free income in retirement. 

When IUL is presented, it’s most often used for supplemental and potentially tax-free income, and it has become a favorite for the dinner seminar crowd.

 

Is Indexed Universal Life an Investment?

As mentioned above, the primary use for IUL today is for tax-free income. So, is life insurance an investment? For compliance purposes, no. Life insurance is life insurance, and you need to have a reason for the death benefit.

So, could life insurance be used as an investment? It depends on how you intend to utilize its benefits and how the policy is structured.

If used correctly, it can be a great additional income source in retirement that’s not correlated to your other investments. If you have traditionally beaten the S&P 500 over the last 15-20 years, expect lower returns with IUL. Most people have not come close to the S&P returns with the average investor earning around 5% after any and all applicable fees, so IUL may offer a higher return (especially on a tax and risk-adjusted basis).

If your primary goal is a death benefit, it’s nearly impossible to out-invest a death benefit offered by an insurance company relative to the premium required to fund the contract.

As with any financial product or strategy, the tool must always fit the need.

 

Who Does IUL Best Serve?

I’ve never met a beneficiary who received a death benefit that cared about the type of life insurance or the cost. The fact is most people are underinsured based on LIMRA stats, and what’s sad is most people aren’t adequately insured because they;

  1. drastically overestimate the cost of insurance
  2. rely solely on employer-sponsored plans (which is never enough)
  3. are intimidated by the process to obtain coverage

If you are currently searching for life insurance, here is what you need to know if IUL was recommended for cash accumulation and tax-free retirement.

 

When IUL Is Not The Best Fit

IUL is probably not your best option if you are paycheck to paycheck. It would be better to contribute to an IRA and use term insurance to maximize the benefit to your family should you unexpectedly pass away (Dave Ramsey got something right with this one).

If you expect your income to increase, make sure to choose a term life insurance policy that can convert to a current permanent product offered by the insurance company. The logic behind this is twofold:

  1. You may want/need to convert in the future for other reasons.
  2. Life insurance is an asset that you own. If your ability to obtain life insurance changes in the future, this may be your only option.

Additional scenarios

  • You don’t need the death benefit
  • You are just starting to save with no investable assets
  • Premiums (policy contributions) must be made monthly (annual is always better)
  • You are in a low tax bracket with not a lot of upward mobility in your professional life
  • You don’t understand the product or strategy. If your agent/advisor can’t articulate why you need it, it’s better to pass.
Who Can Benefit from IUL
  • High-income households ($200,000+)
  • You are maximizing your current retirement accounts
  • Steady income with the ability to make annual contributions
  • You have a need the death benefit
  • You are worried about future tax rates

One of the best benefits, which is rarely discussed, is how IUL can hedge market fluctuations and minimize sequence of return risks in retirement.

Markets are volatile and have become even more so in the last few years. You don’t fully recognize this until you stop contributing and begin withdrawing from your account(s). The highs aren’t as high, and the lows become much lower. IUL can provide another bucket of money you can pull from when your portfolio has suffered a loss. This strategy will allow your portfolio to weather different market cycles more efficiently. Due to the ability to have some growth without market losses, many agents & advisors have positioned IUL to act more like a bond portfolio.

 

What are the cost?

There are three core expenses within IUL policies.

  1. Premium load: covers things like commissions, doctor records, medical exams, and acquisition costs.
  2. Per thousand charge or unit charges are for policy administration (comes out monthly)
  3. COI: the cost of insurance charge (comes out monthly)

Some policies have an account value charge used to buy more expensive options to earn more money in the cash accumulation account.  I believe that policies with an account value charge aren’t needed for a few reasons;

  • The added expense isn’t worth the potential benefit or risk.
  • This additional charge can cause the policy to lose money in a down year. Some policies with account value charges have been as high as 6% (recent regulations have attempted to solve this).

Since IUL is coverage you own until you pass away, try to examine the total cost of ownership of a policy over your lifetime. In most cases, the total cost is less than you pay to manage your investments (sometimes dramatically lower).

 

Cost of Insurance Optimization

The best way to fund a policy for retirement is to ensure you are purchasing the minimum death benefit for the dollars you contribute. Cost of insurance (COI) charges are based on the net amount at risk (NAR) or the difference between the cash value and the death benefit. In most cases, the longer you own the contract, the more efficient it becomes from a cost and performance perspective.

Net Amount at Risk

What Are The Risks with IUL

  • Incorrect funding
  • Incorrect product design
  • Selecting the wrong insurance company
  • Insurance companies decreasing crediting rates
  • Unrealistic assumptions used by agents and advisors
I will be writing about each of the above bullet points in the near future. If you would like to be notified when we publish these articles, click the link below.

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Optimal Way To Fund IUL for Income

IUL policy funding should align with the end goal. If you fund too quickly, cost increases eating into growth; however, fund too slowly and you erode potential gains. When funding for income, a good rule of thumb is no shorter than five years but not longer than ten. Annual contributions position the policy to receive preferable index crediting compared to monthly, quarterly, or semi-annual. 

Self-funding a policy is typically the only option presented to consumers, but the methods used to fund policies vary depending on the situation. If you are planning on contributing more than $20,000 per year or if you are already doing so, you should consider financing as a funding option.

To learn more about how financing indexed universal life works, we have a 20-minute webinar discussing the strategy in detail.

Watch Now

Understanding how to correctly fund your IUL will ultimately reduce the risks discussed above and increase your plan’s probability of success.

 

Taking Income from IUL

If you are looking at IUL as a source of additional income, there are a few things you need to understand at a high level.

There are two main ways to receive income, either withdrawals or loans. For withdrawals, you are simply withdrawing your contributions (called withdraw to basis). When you withdraw all of your contributions, you can switch to loans (if needed). Different loan types are available based on the carrier; the main two are fixed and variable. A fixed loan is just that, fixed. That may sound nice; however, with fixed loans, you don’t have the ability to earn index credits on the loaned portion — this is only available through variable loans. 

With loans, income is tax-free from life insurance contracts because you do not pay tax on a loan (think of a mortgage or home equity loan). The insurance company uses your account value as collateral and lends you their money. The insurance company will charge you an interest rate for access to the funds to be classified as a loan. 

Example: you have an $800,000 account balance and want to access $70,000 as income. The $70,000 will be charged a loan rate of 4%; however, you still can earn interest on the money you took as income. If the loan rate is 4% and the index crediting rate is 7%, you have a +3% spread on the $70,000 you took as income via a policy loan. Over time, you will have separate index credits for the loaned (income) and the unloaned portion of the account value.

Structured the correct way, you do not need to pay interest payments, this can be handled internally within the policy, and ultimately the loan is paid off at your death using the death benefit.

 

Additional Resources

Book - The New Rules of Retirement Savings

Movie: The Power of Zero


Disclosure: This information is for general purposes only. Specific actions should only be taken after consulting with a qualified advisor. Nothing in this article is intended to be tax or legal advice.

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