Indexed Universal Life Insurance Pros and Cons

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There are so many questions floating around the internet that center around indexed universal life insurance pros and cons. Indexed universal life insurance is the hottest thing going in the life insurance industry at the moment, tough to deny that.  Sales continue to lead all other categories, and it's safe to assume this product is now a mainstay in the quiver of most U.S. life insurers.

Given the apparent interest, you're probably wondering if this product is right for you?  To help you drive further at an answer to that question, we prepared a comprehensive pros and cons list for indexed universal life insurance.

The Pros of Indexed Universal Life Insurance

There are six key benefits for IUL that everyone should understand; the benefits are:

  1. Potential for above average interest earnings
  2. Principal protection
  3. Interest rate swap protection
  4. Anytime access to your cash value
  5. Solid income producing potential
  6. Incredible tax efficiency

Very High Potential Interest Earnings

Indexed universal life insurance is a fixed insurance product.  This means that you pay your premium to the insurance company and they promise some sort of benefit in return.  Besides the death benefit, indexed universal life insurance policies promise to pay interest on cash values held inside the life insurance policy.

This interest rate has the potential to be very high by today's standards in any given year.  For most indexed universal life insurance policies, that potential is low double digits.  We're talking 10-12% paid on cash value annually.

It’s possible because the interest rate paid depends on the movement in an index. Usually, a stock index like the S&P 500.  The interest rate paid is the movement (or percentage change) in the index for a given period (most commonly a one year period).

So, if the S&P 500 (for example) increases by 10% this year, the interest rate paid on your cash value is 10%. You’re asking yourself, “how’s that possible?”.

There are no other fixed savings options (issued by insurance companies or otherwise) available in the United States that offer that same level of potential with any guarantees. This definitely puts a checkmark in the “pro” column for indexed universal life insurance.

Principal Protection

The interest rate paid on the indexed universal life insurance policy may come from the movement of a stock index, but indexed universal life insurance does not participate in stock market crashes or declines.  Instead, indexed universal life insurance policies have a floor, which is the lowest amount of interest the insurer can pay on the cash value in your policy.  For most policies, this floor is zero.

This means no matter how bad the stock market gets; your indexed universal life insurance policy will never earn anything less than zero.

Even better, some indexed universal life insurance policies have a floor that pays a small guaranteed interest rate on the cash value, perhaps 1%.  In this case, no matter how bad the stock market, your indexed universal life insurance policy can do no worse than 1% interest paid on your cash value.

Interest Rate Swap Option

While the indexing feature of indexed universal life insurance can provide, superior interest earning in today's economy, you'd be wise to wonder how this might work long term if interest rates rise.

Would this feature still be attractive to you if fixed interest rates were to return to the double digits (10%+) as they did in the early 1980’s?  Could rising interest rates stall out the stock market and force it down for several years?

Well, if that happens, your IUL policy still has a way to earn a nice return.

Indexed universal life insurance is a fixed life insurance contract, meaning that it does not have any direct investment in the stock market. Simply put, if it allowed for direct investment in the market, it would be considered a “variable contract”.  IUL also provides a fixed interest rate option (in addition to the index options), which likely would pay a competitive market interest rate in the event we see increasing long-term interest rates across the economy.

If that scenario comes to fruition, everyone who owns an indexed universal life insurance policy has the option to swap strategies and move to a fixed interest rate account option with their cash values and simply earn the interest rate that is being paid in the fixed interest account.

To be perfectly clear, choosing the fixed interest account is always an option. It just becomes much more attractive if interest rates continue to rise.

For example, if interest rates rise to a level where the fixed account on an indexed universal life insurance policy is 8% annually, you might opt to forgo the indexing feature and simply earn the 8% interest rate that you know is being paid on the fixed account.

You don't need a new life insurance policy to do this, you just call your insurance company and let them know that you want to move your cash value from the index account into the fixed account.

Access to Your Cash

Indexed universal life insurance policies often come with a non-direct recognition style loan option known most commonly as an indexed loan.  This loan option allows the policyholder to take loans against cash values without sacrificing the incredibly high-interest rate paid on cash values from the policy.

In other words, you can take an indexed loan from your policy and still earn the same interest rate (potentially double digits) on the cash value as if you had never taken the loan. The goal when using this type of indexed loan is to maintain a positive spread on what your cash value earns versus the interest paid on the loan(s).

Additionally, most indexed universal life insurance policies offer multiple loan options that might be attractive given various economic conditions.  If circumstances change and one type of loan is no longer the way to go, you have the option to switch loan options from one to another to take advantage of that loan options unique features during different circumstances.

Solid Income Producing Potential

Indexed universal life insurance can provide substantial retirement income to policyholders.  The income generated by indexed universal life insurance is quite remarkable.

According to one top life insurer, a healthy 40-year-old male who buys an indexed universal life insurance policy and contributes just $10,000 per year to the policy through age 65 could potentially generate nearly $32,500 per year through age 100 with the same indexed universal life insurance policy.  That's a sizable return on your money.

Incredible Tax Efficiency

Indexed universal life insurance comes with several tax advantages.  It has a death benefit that can go to heirs tax-free.

Cash value accumulates inside the policy with no tax implication.

You can take money out the policy also without tax liability provided you follow the right process.

This all makes indexed universal life insurance incredible tax efficient.  You don't need an attorney or a fancy array of trusts and LLC's established to free your money from Uncle Sam's cold grasp.  You simply need an indexed universal life insurance contract.

The Cons of Indexed Universal Life Insurance

There are a few drawbacks to indexed universal life insurance that you should know; they are:

  1. Most policies have a surrender charge for the first several years
  2. Reported account values not always accurate in real-time
  3. Poor customer service from the life insurer
  4. You must qualify for life insurance
  5. Some features may not be guaranteed

Surrender Charges Reduce Access to Cash in Early Years

Indexed universal life insurance contracts usually have surrender charges.  This is a contingent deferred sales charge-like feature that allows the life insurance company to keep some of your money if you cancel the contract within the first several years. In most cases, surrender charges range from 10-20 years.

The surrender charge is detailed in the policy contract.  Also, most insurers make life a bit easier by providing updated information regarding the current surrender charge through access to your policy online and in the annual statement that is mailed out at your policy anniversary.  This means you're able to look up the surrender charge through your personal online account access to see how much the surrender charge is (in real dollars) in any given year.

Like contingent deferred sales charges found on investment products, (b-share mutual funds, variable annuities, etc.) surrender charges only become a problem if you aren't planning on sticking with the contract through the surrender charge period.  You should probably not consider indexed universal life insurance if you are unable to commit to funding it over an extended period of time.

Account Value Information Not Always Clear

The banking industry has trained us to think everyone can give us 24-hour real-time access to all account values all the time.  This is something the life insurance industry would love to accomplish but sadly has not been able to pull off successfully.

Yes, as mentioned a few paragraphs ago, every life insurance company that I’m aware of grants online access to policy information to their policyholders. However, the accuracy of cash values tends to be less than perfect.

Indexed universal life insurance has a few moving parts. That’s not a bad thing, just means that the insurer’s ability to accurately report the interest credited to the policy at all times is nearly impossible.  Unfortunately, the information provided isn't always readily available to the policyholder or his/her agent in its most accurate form.

There's also a lot of insurance jargon to learn, and this isn't necessarily industry standard (i.e., it can change from company to company).  This takes some getting used to.

The good news is, with insurance contracts, nothing can happen that can't be later corrected, and serious mistakes are few and far between.

Still, values are not always immediately accessible, and at times specific information available says a lot without saying anything at all.

Not Everyone is Committed to Customer Service

This is by far our biggest frustration.  Not all insurers believe customer service concerning cash values is a top priority.  This looks like situations were account values are missing or incomplete, loan requests appear to take a long time to process, and payments are applied strangely.

I should be clear in pointing out that we've never had a situation where one of these problems wasn't ultimately corrected (mostly), but there have been times when the solution took an excruciatingly long amount time to come.

You should weigh contract features against company competence because some insurers can undoubtedly woo with great promises, but fail to deliver on the most fundamental of policy management.  Caveat emptor, my friends.

You Have to Qualify for Life Insurance

You might find all or most of these features of indexed universal life insurance tremendously valuable and be ready to move forward purchasing your very own policy.  There's just one hurdle you must clear at the very beginning.  You have to be healthy enough to qualify for life insurance.

We should also mention that you need to have financial justification to actually buy life insurance (this is sometimes a little more nuanced than people realize).

If your health history has some blemishes, there's the possibility that perhaps a spouse could be the insured.  Some inexperienced agents will suggest that you can have your kids or grandkids “stand in” as the insured for a policy if you aren’t able to qualify.

However, …if you're thinking about doing that, please pump the brakes. It turns out that life insurance companies aren’t in love with issuing $1+ Million policies on three-year-olds. Go figure.

Contractual Features Aren't Always Guaranteed

While indexed universal life, insurance comes with more than a few attractive features, you should understand that there is quite a bit of variation regarding the specifics. The feature that allows you to earn double-digit interest is subject to a cap rate that might decline meaning your highest potential is now only 9% instead of 11%.

The expenses charged against the policy could increase meaning there will be less cash value in your policy because the life insurance component took some of it.  It's rare for expenses to increase, but it's not unheard of.

You have to look at the policy you are considering and understand what is and what is not guaranteed to stay the same after the policy is issued.  The key distinction here is what the industry refers to as “current company practice” versus “contractual guarantees.”

However, don’t be alarmed, just because something can change doesn't make it bad.  In fact, most policies guarantee only a handful of terms against change. All we’re saying here is that you simply want to know what can change and get some understanding as to how drastic the changes can be.

Index Universal Life Insurance Pros and Cons

That is our list of pros and cons for indexed universal life insurance.  The product comes with many highlights.  Some aspects will certainly make indexed universal life insurance inappropriate for some people.  Understanding the good and the bad will help you navigate your buying decisions a little better.

We have decades of experience in the life insurance industry and a plethora of first-hand experience designing, implementing, and servicing indexed universal life insurance products.  That's not to brag in any way, but to let you know, we know what we're talking about. It's not theory.

Moreover,… this information comes from our collective experience as the knowledge bank we have compiled over the years on indexed universal life insurance.

Please reach out to us for more information on indexed universal life insurance and how it might work for you.

About the Author Brandon Roberts

Brandon launched the Insurance Pro Blog in July of 2011 as a project to de-mystify the life insurance industry. Brandon was born in Northern New England, and he currently calls VT home. He attended Syracuse University and graduated with a triple major in Economics, Public Administration, and Political Science.

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