Indexed Universal Life (IUL) Insurance: What It Is and Whether It's for You

What is indexed universal life (IUL) insurance?

What is an IUL? An IUL is a type of permanent life insurance, meaning it can accumulate cash value and provide a death benefit. Like other types of whole life policies -- including universal life insurance and variable universal life insurance -- index life insurance is sold as an insurance-investment hybrid.

How does IUL work?

Each time the policyholder makes a premium payment, part of the premium is used to cover the cost of life insurance, and the rest is unevenly split up to:

• Build cash value
• Pay premium expense charges and administrative expenses
• Pay fees and commissions

As cash value builds, insurance companies tie its value to a market index, like the Dow Jones Industrial Average or S&P 500. Or an insurer could decide to connect cash value to markets most everyday people have never heard of, like the Hang Seng Index. The insurance company decides which market the funds will be tied to, although they don't actually invest the money in the market. Instead, they use their chosen market to determine how much the money is worth at any given time -- up to a cap. The cap rate is normally somewhere around 10% to 12%, so if the market is enjoying a bull market and the value of stocks is soaring, money invested in an IUL will increase in value up to 10% to 12%.

If the market the insurance company has chosen tanks, IUL insurance typically includes a guaranteed rate of growth. The rate varies by insurance carrier.

Unlike term life insurance, an IUL policy lasts the policyholder's entire life, as long as premiums are kept up to date. That said, as a policyholder ages, the cost of the policy increases. A policyholder may be able to adjust their premium payment by lowering their death benefit.

After enough cash has accumulated, a policyholder can borrow from their IUL, although they can expect to pay interest on the loan. If they don't pay it back in full, the amount owed will be deducted from their death benefit.

When the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010, IUL policies were exempted from federal regulation. Unlike stocks and options, the U.S. Securities and Exchange Commission does not regulate IUL insurance. Further, agents who sell IUL insurance are rarely required to undergo the same training as a stock broker and may be less equipped to provide sound investment advice.

Indexed universal life pros

Like all financial products, IUL policies have some benefits. Here are a few worth knowing about.

Can act as "forced savings"

For someone who doesn't trust themselves to save money, an IUL acts as a forced savings account. Because part of each premium goes toward cash value, once the premium is out of their hands, the insurance company does the rest.

Offers some tax benefits

IUL death benefits are distributed tax free to beneficiaries. In addition, the policyholder can withdraw up to the amount they have contributed toward cash accumulated tax free. Once they begin withdrawing earnings on the money, funds are taxed as regular income.

Allows access to cash value

If a policyholder needs money and their IUL has accumulated enough cash, they may borrow against that money. If they fail to repay the loan with interest, the outstanding cash value will be subtracted from the policy death benefit.

Provides lifelong death benefit

Say a person purchases an IUL in their early 30s but is diagnosed with a rare disease 30 years later. As long as that person pays their premiums, they continue to be covered, regardless of their health.

Indexed universal life cons

Unfortunately, IUL insurance also has more than its fair share of disadvantages. Here are a few to be aware of.

Premiums increase with age

As a person grows older, the odds of dying increase. For that reason, insurance companies raise the cost of IUL insurance premiums by as much as 8% to 10% annually after the age of 50.

Fees can erode growth

From the moment a policyholder pays their first premium, fees nibble away at any profits they may gain. To understand how, it helps to understand how a premium load works. According to the International Risk Management Institute, Inc., a premium load is the percentage of a policyholder's premium that is deducted to cover policy expenses.

Here's a sampling of the types of fees a policyholder can expect to pay:

• Sales commission: The agent who sells the policy collects a commission from their company and that commission comes out of the policyholder's premium.
• Sales charges: Fees are charged for how much it costs the insurance company to sell the policy and to cover state and local taxes.
• Administration fee: This covers the cost of maintaining the policy and pays for everything from accounting to recordkeeping.
• Mortality charge: When a person buys a policy, the insurance company estimates they will live to be a specific age, and they count on collecting premiums for at least that long. If a policyholder dies before that, the company sees it as losing out on potential premiums. To protect itself, it collects another fee called a mortality charge.
• Surrender charge: This fee is deducted from cash value if a policyholder terminates their policy during the surrender charge period.

According to LIMRA -- the not-for-profit research association for the financial services industry -- sales of IULs are predicted to be up 11% in 2021. While there could be many reasons for the increase, one reason may be the tremendous fees collected by the insurance industry each time an IUL policy is sold and maintained.

Withdrawals can cause the policy to lapse

Imagine someone purchases an IUL policy in their 30s or 40s, hoping it will help fund their retirement one day. In their 50s, they lose their job and can't pay the premium. They contact their insurance company and are happy to learn that their premiums can be paid from the cash accumulated in their account. The following year, they become ill and are never able to return to work full-time. The policy lapses, and the policyholder is not only without death benefit protection, but they lose everything they have paid into the policy.

IUL vs. 401(k)

One of the best ways to determine whether an IUL is a good use of money is to compare it to other standard investment vehicles, like 401(k)s. Here's a quick breakdown of how they compare:

IUL vs. whole life

While both IUL and whole life are types of permanent policies, they do have some differences. For example:

• IUL insurance is tied to market value, while whole life is not.
• Cash accumulated in an IUL policy may grow at a faster rate than cash accumulated in whole life.
• Premiums on IUL policies are more expensive than whole life policy premiums.
• IUL policies are more complicated to understand and manage than whole life policies.

Learn more: What Is Whole Life Insurance?

Should you get IUL?

Committing to a permanent life insurance policy of any kind is rarely the best financial move.

Most financial experts advise against high-cost whole life insurance and recommend that individuals purchase low-cost term life insurance and invest the savings.

Life insurance is certainly not a one-size-fits-all subject, though. Take a deeper dive into the types of policies available. For example, compare whole vs. term life insurance. We've mentioned that whole life is rarely recommended by financial experts, but that doesn't mean it won't work for some. For example, a person who is concerned about estate planning and needs another place to leave tax-free funds for their beneficiaries may prefer a whole life policy.

Another thing insurance shoppers should consider is whether they're comfortable with premiums that increase with age. For example, the premiums on universal life insurance products -- like guaranteed universal, variable universal, and indexed universal -- all increase as the policyholder gets older. If that's a game-changer, it may be a better idea to check into life insurance with premiums that remain the same throughout the life of the policy.

Shopping for life insurance may be one of the least exciting products a person ever shops for. But by taking the time necessary to understand the different options, a person is more likely to end up with the kind of policy that offers a little peace of mind.