Indexed Universal Life Insurance

What Is Indexed Universal Life Insurance?

An indexed universal life insurance policy is similar to other types of life insurance, such as traditional universal life. It is a permanent policy that will last your entire life, and features both a death benefit and cash value that can build up over time.

The key difference in an indexed universal life policy from other life insurance is how that cash value is built. According to the National Association of Insurance Commissioners, in an indexed policy, the interest of the cash value component is tied to an index such as the S&P 500.

Indexed policies feature some of the other typical benefits included in a standard universal policy, such as flexible premiums and death benefits. In fact, part of the potential upside of an indexed universal life policy is the cash value growing to the point that it can handle some or all of the premiums of the policy, leaving you with fewer expenses while keeping the death benefit active.

The policy remains active as long as its premiums continue to be paid.

Indexed universal life policies provide the flexibility offered by all universal life insurance while striking a balance between the fixed return on standard universal life and the full market participation of variable universal life. It is vital to understand the fees, costs and conditions that dictate your indexed universal life policy because they will be more complex than standard policies.

— Stephen Kates, CFP®

How Does Indexed Universal Life Insurance Work?

An indexed universal life insurance policy features the same basic functions you will find from most permanent life policies: You pay regular premiums on the policy in perpetuity, and when you die, the policy pays out a death benefit to your beneficiaries. The policy will be canceled if you stop paying your premiums.

The difference is that the cash value can build up over time. It can be borrowed against and even used to help pay your premiums once it has accrued enough value, which is achieved by tying the cash value to an index.

Say, for example, that you have a policy that is tied to the S&P 500. The interest on your cash value will grow with that index. So if the S&P 500 sees a big leap, your cash value will benefit.

But an added factor to be aware of is that the interest on an indexed universal life policy is typically capped in both directions. This can provide stability by protecting you from suffering serious losses and helping to ensure your cash value isn’t exhausted.

However, it also means your potential gains are limited. Say that you have a cap on your policy of 10% and a floor of 0%. If the S&P 500 dropped by 10%, you would be protected by the floor and not see a similar drop in your cash value.

But if the index jumped by 15%, you would not see all of that increase reflected in your cash value.

Most indexed universal life policies use “participation rates” in addition to hard caps to govern the growth of the cash value. For instance, if the participation rate was 75% and the cap was 10%, the growth of the policy in a year the market grew 15% would be 10% (the cap). In a year when the market grew by 10%, the policy would only return 7.5%.

Participation rates and caps can vary between policies and will impact the fees and terms of the policy.

Pros and Cons of Indexed Universal Life Insurance

As with any life insurance policy, there are both advantages and disadvantages to opting for an indexed universal life policy. Your personal circumstances and what you are looking for from a policy will help to determine if a permanent, indexed version makes sense for you.

Pros

As with other forms of universal life, one of the pros of an indexed policy is flexibility. Your death benefit can typically be adjusted, and your premium can also change if you build up enough cash value to cover that cost.

An indexed policy also allows you the ability to steadily grow your cash value, taking advantage of the growth of an index without having to worry as much about the downsides of a decrease in value since your policy will likely have a floor.

Similar to other forms of universal life, another added benefit is that the policy will last for as long as you keep paying your premiums. You don’t have to worry about a set term running out and ending up leaving your beneficiaries with nothing.

Cons

One of the major cons of an indexed universal life policy is the flip side of the floor: the ceiling. A cap on the potential growth of your cash value is a tradeoff for less risk but also means that there is a very good chance of you missing out on potential growth.

Even if the index your policy is tied to sees consistent and dramatic gains, you will never see it reflected in your cash value beyond the set cap.

Another downside of indexed universal life is the inherent risk of tying your life insurance policy to an index. Markets can be volatile, and growth is not guaranteed.

Indexed Universal Life vs. 401(k) Plan

A 401(k) plan and an indexed universal life policy are sometimes compared as different ways to accumulate retirement savings. But they are so different that one over the other may not necessarily always make sense.

If you have a 401(k) plan, you deposit money each year that goes towards your retirement savings that will grow over time. This money, which is tax-deferred, can be invested in a variety of different ways to help accelerate growth.

When you are past the minimum age and are retiring, you can withdraw the money from your 401(k). Your contributions can also often be matched by your employer.

An indexed universal life policy, on the other hand, is more limited in how it can grow since its interest is tied directly to an index. In addition to the cash value it accumulates, it pays out a death benefit to your beneficiaries when you die.

But you also have to continuously pay premiums on the policy to keep it active. If you cease to pay premiums, then the policy will be canceled.

Read More: Annuities vs. IUL