Can you name an investment that offers tax-deferred returns on stock investments . . . lets you take cash out at any time . . . AND includes life insurance coverage!? The correct answer is . . . an indexed universal life (IUL) insurance policy.
Like any financial product, an IUL has advantages and disadvantages. However, its unique set of features can make it appealing to investors looking for insurance coverage combined with the ability to invest and grow their capital.
This article takes an in-depth look at how IUL works and who can benefit from it.
IUL is a Type of Universal Life Insurance
Because indexed universal life is a type of universal life insurance, it’s important to understand the main characteristics of this type of insurance before we dig into the intricacies of IUL. Like whole life insurance, universal life is a form of permanent life insurance.
This means, as you might have guessed, that it is designed to last a lifetime. Term life, the other major type of life insurance, is purchased for a specific period of time, such as five or ten years.
While term life is much cheaper than most permanent life policies when you are young, it becomes increasingly expensive as you get older.
This means that those who continue to pay ever-higher prices for term life as they age can end up paying more than if they had purchased permanent insurance at a young age.
Besides being designed to last a lifetime, both whole life and universal life differ from term life in that a portion of the premiums are used to fund a cash value account that can grow over time.
This growth is generally guaranteed in a whole life policy and based on the interest rate offered by the insurance company in a universal life policy.
Some of the main features of permanent life insurance policies are summarized below:
- The death benefit is guaranteed to remain in effect as long as premiums are paid.
- A portion of your premiums go to pay for insurance coverage and the remainder go to build up the value of the policy’s cash account.
- Growth in the cash account is tax-deferred.
- Funds can be withdrawn from the cash account via a policy loan or partial surrender.
Universal life offers more flexibility than whole life when it comes to making changes to the policy’s premium and death benefit amounts. With universal life, as you age, the portion of your premiums devoted to paying for the cost of insurance (COI) will rise.
This reflects the higher mortality risk to the insurance company. Accumulated funds in the cash account can be used to pay these premiums.
As long as premiums are paid, excess funds in the cash account can be withdrawn by the policyholder without affecting the amount of the death benefit.
What is Variable Universal Life Insurance?
To understand the appeal of IUL, it helps to first take a look at another form of universal life known as variable universal life (VUL). These policies allow you to invest your cash account funds in subaccounts that invest in stocks or bonds like mutual funds or exchange-traded funds (ETFs).
Rather than the fixed interest rate paid by traditional universal life or the guaranteed growth rate offered by whole life, these subaccounts offer you the chance to earn higher returns by investing in riskier investments.
The downside of investing in variable universal life is that if the market crashes, or even declines modestly, it can put your cash value in a downward spiral that is hard to get out of.
When the fees of a VUL policy are added to negative returns, it can take time, sometimes many years, for your cash account to recover.
What is IUL?
Indexed universal life enables you to avoid this danger of investing in a subaccount linked to the performance of a stock market index. It does this by putting a floor, typically 0%, on subaccount performance. IUL subaccounts are usually linked to major indexes such as the S&P 500 or NASDAQ 100.
The performance floor for subaccounts gives you the ability to participate in the market’s upside while being protected from downside exposure. If this sounds too good to be true, it should be mentioned that in most cases these subaccounts don’t allow you to benefit from the full extent of the market’s upside.
IUL policies typically feature a cap rate that limits your potential upside as well as a participation rate that specifies what percentage of the market’s return in any given period will be credited to your account.
For instance, if your IUL policy’s cap rate is 10% and the market index tracked by the subaccount rises 12%, you would only earn 10%.
Similarly, if the participation rate is 80% and the market rises 10% for the period, even if the cap rate is 10% your account would only be credited 8%.
Despite these limitations, the opportunity to earn some portion of the market’s upside while being protected from a market crash has made these policies attractive to investors looking for growth potential without market risk.
IUL policies can offer this feature because rather than investing your funds in stocks or other equity investments such as mutual funds or ETFs, they purchase call options on the related index.
This enables them to generate the funds necessary to credit your account if the market rises, while avoiding taking any losses (other than the cost to acquire the options) if the market falls.
By protecting your subaccount’s value on the downside, IUL features less investment risk than variable universal life while offering a bit less upside. When compared to a traditional fixed universal life policy, it offers greater upside along with higher volatility.
Many IUL policies allow you to divide your cash value between indexed subaccounts and a fixed account that earns a specified amount of interest.
The Pros of IUL
The primary benefits of IUL are as follows.
Tax Free Withdrawals
Funds in the cash account of an IUL can be withdrawn free of taxes up to the amount you have contributed to the policy.
The tax-favored status of insurance enables your cash value account to grow faster than it would if you had to pay taxes on the growth each year.
Greater Growth Potential Than Traditional Whole And Universal Life Insurance
Because an IUL offers the potential to earn returns linked to the performance of the stock market, it can provide greater returns than traditional whole life or universal life policies.
Less Downside Risk Than Variable Universal Life
Because IUL subaccounts aren’t directly invested in equity investments such as mutual funds or ETFs, these policies can offer a guarantee against loss of capital if the stock market declines over a crediting period.
You can not only adjust premium payments and insurance coverage amounts as with other forms of universal life, but also the allocation of your cash value funds between the fixed account and the equity subaccounts offered in the IUL. You can also use your cash value to pay insurance premiums.
No Contribution Limits
Unlike retirement plans such as IRAs or 401(k)s, there is generally no limit to the amount you can contribute to an IUL, other than any restrictions imposed by the insurance company offering the policy.
No Minimum Withdrawal Age Requirements
Again, unlike retirement plans such as IRAs or 401(k)s, IULs don’t require you to reach a certain age before withdrawing funds.
These policies feature a permanent death benefit that is distributed tax-free to the recipient or recipients.
Subject to your particular policy and available cash, you can take a loan from your IUL with no need to pay taxes (as long as the loan does not exceed the amount you have contributed to the policy), penalties or face a credit check. You are not required to pay the loan back. The insurance company will charge interest on the loan.
The Cons of IUL
Greater Performance Risk Than Traditional Insurance Policies
While IUL policies protect your cash account funds against market declines, they don’t provide the same type of guaranteed growth provided by traditional permanent insurance policies. If the stock market performs poorly over the period you own an IUL, the growth of your policy’s cash value may underperform that of a traditional policy.
Cap And Participation Rates
Most IUL policies have cap and/or participation rates that limit how much of an index’s performance a subaccount can benefit from.
Subaccounts Aren’t Actively Managed
IUL subaccounts are linked to stock market indexes, so you miss out on the chance to outperform the market when investing in these accounts.
Higher Fees Than Non-Insurance Investment Accounts
Due to insurance company administrative costs, fees for these accounts are typically higher than investment-only accounts placed in mutual funds or ETFs.
Potential Tax Consequences
If you surrender your policy or it lapses, there may be taxes on money you’ve taken out of the policy.
Your account is credited based on the performance of the index the subaccount is based on, excluding any dividends.
Consistently poor subaccount performance can eat up your cash value.
Who Can Benefit From IUL?
Generally speaking, anyone who is looking for both the potential for investment growth and insurance coverage can benefit from owning indexed universal life.
More specifically, these policies are aimed at investors who want to participate at least to some degree in the expected growth of the stock market while taking less risk than they would by investing directly in the market.
While IUL is not right for everyone, there are certain circumstances where these policies can be particularly attractive, including:
Estate Planning Purposes
Because insurance benefits pass to your beneficiaries tax free and avoid probate, life insurance is often used in estate planning strategies. An IUL policy can serve the dual purpose of a savings vehicle for retirement or some other goal while also passing on wealth to your heirs when you are gone.
Tapped Out Retirement Plan Contribution Eligibility
If you have reached the limit of what you can contribute to retirement plans such as 401(k)s and IRAs, an IUL can enable you to set aside even more money for retirement in a tax-favored account.
Funding Early Retirement
Retirement plans such as 401(k)s and IRAs typically require you to be 59 ½ before you begin withdrawing funds. Because IUL doesn’t have the same age restrictions, it can be used as a means of funding early retirement.
People Looking For Both Insurance Coverage And Investment Growth
IUL can be used as part of a long-term strategy emphasizing insurance coverage initially and retirement savings further down the road.
IUL Investment Strategies
While IUL offers you the chance to grow the funds in your cash account along with the growth of the stock market, all market movement is not created equal as far as these policies are concerned.
For instance, because most IUL policies cap the growth of their subaccounts, if the market index your subaccount tracks rose 40% in one year while your cap was 10%, the result would be the same as if the market rose just 10% during that period.
Consider the following scenarios:
- The index rises 40% in the first year after you purchase the IUL, then is flat for the next three years. While the total increase of the index over those four years is 40%, in an IUL you would only earn 10% (assuming a 100% participation rate) over the same period, or 8% at an 80% participation rate.
- Now consider a scenario in which the market rises 10% each year for four years in a row. In such a case your IUL, using compound interest, would earn just above 40% for that period, or just above 32% at an 80% participation rate.
- In a scenario where the market went up 10% in year one, then down 10% in year two, up 10% in year three, then down 10% in year four, the value of an IUL becomes especially evident. An investor with direct exposure to the market would earn essentially nothing over those four years, while an IUL investor would earn just above 20%, or 16% at an 80% participation rate, over the same time period.
These scenarios demonstrate why IUL has become such a popular option in recent years. While there are certain cases, such as the first scenario, where its crediting mechanism causes its returns to significantly trail the market, in other scenarios it can deliver close to average market returns without downside risk.
In some cases, as in the third scenario, it can even outperform the average performance of the index over a period of time due to the 0% floor most policies feature.
Sophisticated investors could pursue a strategy of using the policy’s fixed rate subaccount during times when the market appears topped out, while moving more funds to the index-linked subaccounts when the market appears more likely to rise.
Of course, the protection offered by the subaccount floor of 0% means that you can always just let your cash value ride in these subaccounts without worrying whether the market will crash.
Overall, IUL is a niche product that can meet the needs of investors looking for insurance coverage along with tax-favored growth of capital without the risk of suffering from a market decline.
Indexed Universal Life is not the perfect solution for everyone, but it can be a fitting addition to your overall financial product mix if you can benefit from its particular characteristics.
Joshua Iversen is the President and Chief Investment Officer of Syzygy Financial Services LLC