Understanding indexed universal life insurance
Some buyers of cash value life insurance are disappointed with the slow rate of account value growth offered by fixed-rate policies. At the same time, many of these consumers don’t want to risk their cash value in the stock market as they would have to with a variable life policy.
The answer to this dilemma is a hybrid policy called indexed universal life (IUL) insurance.
Life other forms of universal life insurance, IUL allows you to vary your premium payments as long as there exists enough cash value to support the policy. The death benefit can change over time, depending on the performance of the index or indices you allocate your premium to.
What sets IUL policies apart from other types of cash value life insurance is the method of crediting interest. They earn interest based on the movement of a market index, giving them the ability to grow higher in value than fixed interest rate policies or whole life policies that charge a flat rate of interest. However, you are not actually invested in the market or in any index. The insurance company simply uses the index as a measuring stick for how much to credit to your contract.
IUL policies also have a provision whereby the account value cannot lose value based on how the corresponding index performs. If the index loses 5 percent, 15 percent or even 75 percent in a given period, the policy’s account value remains steady. Zero interest is the worst your contract can return in a given period. This makes it a safer alternative to variable life insurance.
Indexed life insurance policies use a variety of market indices. Some will even offer you choices on what indices you want your contract to be based upon. The most common index used as a benchmark is the Standard & Poor’s 500 (S&P 500), which is a widely used index to measure the U.S. stock market. Other options include the Russell 2000, the Wilshire 5000 and some international market indices.
Insurers offer several formulas for crediting interest, often called strategies. Some use monthly index movements while others calculate an average movement over a given period. The most common strategy is a one-year point-to-point strategy. This strategy measures the one-year growth of an index and applies that percentage to the policy’s account value. If the index declined in value during that one-year period, the account value will not lose any principal.
Caps and spreads
Because indexed life does not lose principal based on the market, there has to be a limit on its upside. Insurers have two methods of limiting an IUL policy’s upside: caps and spreads.
A cap is a ceiling on interest rate growth. If the policy has a 10 percent cap on interest growth during a policy period, the policy will not credit interest beyond 10 percent, regardless of how much the benchmark index increases. If the index increases 5 percent, your account value will increase 5 percent. If the index climbs 12 percent, the account value will be limited to 10 percent.
A spread, on the other hand, acts more like a floor. If your policy strategy has a 5 percent spread, your account value will increase by whatever percentage above 5 percent the corresponding index goes up. If the index increases 7 percent, your account value will grow 2 percent (7 – 5). If the index climbs 15 percent, your account value will earn 10 percent. But if the index only increases 3 percent, your account value will earn nothing for that period.
Whether it’s more advantageous to be subject to a cap or spread depends on how the index performs over time. If the index has several large increases, then a spread will likely provide a better return since there is no upside limit. If the index has more moderate increases, then a strategy with a cap rate will likely do better.
Why zero is your hero
Let’s say you invest $100,000 in a regular investment that immediately loses 10 percent, taking the value down to $90,000. The investment will then have to gain 11 percent just to get you back to even.
Using that same scenario with an indexed life insurance policy, the 10 percent loss does not impact your policy’s account value. If your cash value were $100,000 before the index loss, it would still have $100,000 less any charges during the period.
Like other types of cash value life insurance, indexed universal policies provide the ability to access the cash value and use it for a variety of needs. Some people use their life insurance policy cash value to help fund a child’s college education, others use it for supplemental retirement income, and it can even be used for home improvement or medical expenses.
IUL also offers the same tax-deferred growth as annuities and qualified retirement plans, meaning you do not have to pay taxes on the policy’s interest growth each year.
Life insurance also has special tax treatment that allows you under some circumstances to loan yourself part of your cash value without owing taxes on the proceeds. Depending on the provisions of your contract, you can often take as long as you wish to pay back the policy loan, or you can choose not to repay the loan and accept a lower death benefit. If you choose to repay the loan, you will often receive a more favorable interest rate than you would through traditional lenders, and the loaned funds will continue to earn interest as if they were never withdrawn.
Also, because life insurance withdrawals are not taxable, they don’t impact the formula the IRS uses to determine whether to tax your Social Security benefits.
At the same time, there are no IRS contribution limits on life insurance, so it’s potentially a way to save large sums on a tax-advantaged basis. Also, you don’t have to wait until you’re 59 1/2 to access the funds in your life insurance policy like you do for annuities and 401(k)s.
Indexed life insurance is also fairly liquid. Many life insurance policies allow you to withdraw up to 90 percent of the cash value. And like most life insurance policies, an IUL insurance policy provides a tax-free death benefit to the beneficiaries.