Who should buy indexed universal life insurance?

Why you can trust Insure.com

Quality Verified

At Insure.com, we are committed to providing the timely, accurate and expert information consumers need to make smart insurance decisions. All our content is written and reviewed by industry professionals and insurance experts. Our team carefully vets our rate data to ensure we only provide reliable and up-to-date insurance pricing. We follow the highest editorial standards. Our content is based solely on objective research and data gathering. We maintain strict editorial independence to ensure unbiased coverage of the insurance industry.

Getting the right life insurance policy is pivotal to protecting your family’s financial health. While a traditional term life insurance policy is the best option for people needing maximum protection for a limited period of time, others with a high net worth or who have maxed out other investments may want to consider permanent policies with an investment-like component. Indexed universal life insurance is one of these permanent policies – which last your entire life – that can provide some supplemental gains alongside the death benefit. 

These policies can be complicated, and it’s not always easy to figure out the pros and cons of indexed universal life coverage.

Let me start out by explaining what indexed universal life insurance is and how it works. 

Indexed universal life (IUL) is known as cash-value life insurance, meaning you pay your premiums and the policy builds up a cash value you can withdraw or borrow against. 

Just like in other cash‑value life insurance products, such as fixed-rate universal life and whole life, account values are allocated to high‑grade bonds and government‑backed mortgages. 

But IUL products are distinguished from other types of cash‑value life insurance products because the interest from those bonds and mortgages can be allocated to an indexed account. These indexed accounts purchase options on an equity‑based index, such as the S&P 500. 

The indexed crediting rate, or the expected rate of return, therefore depends on the performance of various equities indexes, but with some limit to your returns and some protection against loss to reduce volatility. 

Indexed accounts differ from the underlying index, so be careful not to confuse indexed accounts with index funds. For instance, index funds fully experience both gains and losses, whereas an indexed account is protected against loss and credits only a portion of the gain. IUL policies also differ from universal life and whole life products where you’ll always receive some interest credited directly to the policy account in the form of a dividend or interest crediting rate.

So, what type of returns can a policyholder see from indexed universal life insurance?  

Because IUL account values must be allocated to high‑grade bonds and government‑backed mortgages, you can expect the rate of return to be similar to prevailing rates of return from high‑grade bonds and government‑backed mortgages. 

In addition, you can expect some upside when the underlying index produces a gain, but you can also lose all the interest you would otherwise have received when the underlying index experiences a loss. For example, you’ll receive a higher indexed crediting rate when the rate of return of the S&P 500 is greater than prevailing interest rates, but receive a lower rate or no indexed crediting rate if the return of the S&P 500 is less than prevailing interest rates. Other indexed accounts derived from other indexes can offer the promise of more upside but also charge more. This increases the risk of loss of interest and some of your policy account due to the higher charges.

Policyholders can take steps to maximize the benefits of an indexed universal life insurance policy: 

Look for indexed universal life insurance products that offer three things. The first is policies with low internal policy costs compared to the alternatives. Costs charged in IUL products vary by as much as 80% — more from product to product than any other product type. 

The second is insurers with a track record of superior performance from their portfolio of bonds and mortgages. The greater the interest from these bonds and mortgages, the more options the insurer can purchase on the underlying index, which means it is reasonable to expect a higher rate of return on the indexed account. 

The third is policies that offer an indexed strategy that is consistent with your risk tolerance. Some IUL policies offer exotic indexed strategies, offering the promise of more upside, but this also means a greater risk of loss.  

Policyholders who will benefit from this policy have a moderate risk tolerance and are willing to accept the risk of loss of interest. Ideally, they’re also eager to earn an equity‑indexed crediting rate that could be higher than the interest otherwise received from bonds and mortgages.

But some people should avoid these type of policies. 

Consumers with a conservative risk tolerance who are willing to accept lower rates of return in exchange for greater certainty of return should avoid indexed universal life insurance. Also, because indexed crediting rates are derivatives of other indexes, indexed crediting strategies are different from the underlying indexes, and are thus more complicated. In some cases, considerably more complicated, so those seeking a simple‑to‑understand product should instead shop for universal life or whole life type products. 

Additionally, people with a more aggressive risk tolerance should also avoid indexed universal life insurance. Because IUL account values are only credited with a portion of the gain in exchange for protection against loss, those seeking maximum return over the long term, albeit with greater volatility over the short term, should consider variable life products, where account values can be allocated directly into various mutual-fund-like accounts, including directly into indexes like the S&P 500. This means they will receive all the return over the long term, albeit also with all the risk of loss over the short term.  

A few words of caution:

Current state regulations for most product types permit agents, brokers, and insurers to “quote” low premiums or project high growth while charging high costs. When they do this, they don’t have to disclose the high costs or the risks of underperformance. Such underperformance can result in paying more than the “quoted” premium to match the originally expected/illustrated results. If you don’t pay the premium, your policy will lapse and all premiums and account values will be lost. As such, it’s important to inspect what to expect — meaning you should do your own research to see what rate of return to expect.  

Indexed universal life insurance products are particularly susceptible to such misleading sales and marketing practices. As such, consumers should only consider an indexed universal life insurance from agents, brokers or insurers that provide complete year‑by‑year disclosure of all internal policy charges and performance requirements, ideally without you having to ask for it. In addition, work with an advisor who benchmarks the competitiveness of internal policy costs,  evaluates if the performance requirements are achievable, and assesses the risk of underperformance relative to your risk tolerance. This will improve the likelihood that your expectations will be met. 

If your advisor isn’t already providing you with such benchmarking of costs and performance, ask them for a Veralytic report or click here to connect with a Veralytic advisor.  

Barry Flagg

Expert Advisor

 

 . .

Barry D. Flagg is the inventor and founder of Veralytic®, the leading online publisher of life insurance pricing and performance research and product competitiveness ratings. Veralytic is the result of his unique background in both the fiduciary investment business where he became the now oldest, youngest Certified Financial Planner (CFP®) in history, and as a life insurance expert consistently recognized in the top 1% of the industry. He’s renowned for applying Prudent Investor Principles to life insurance product selection or retention and portfolio management. As a result, he serves as sub-advisor to thousands of irrevocable life insurance trusts (ILITs) as well as RIAs and wealth managers, is a regular contributor to Forbes for articles about life insurance, leads curriculum development and instruction for Applied Fiduciary Practices involving life insurance for The Center of Board Certified Fiduciaries at Wake Forest University, and serves as a volunteer to the CFP Board Professional Standards and Legal Department for complaints involving life insurance. Barry has authored numerous articles for national publications on managing life insurance as an asset according to established and proven asset management principles and frequently teaches continuing education courses about the same to attorneys, CFP®s, CPAs, and CTFAs.