Indexed universal life (IUL) is a type of permanent life insurance wherein interest credited to the cash value component is linked to a market index, such as the S&P 500. These policies can provide life insurance that lasts for your entire life, and depending on how the policy performs, your cash value might grow at a higher rate relative to a non-indexed universal life policy.
Learn how indexed universal life insurance works, what to watch out for, and its alternatives.
Definition of Indexed Universal Life (IUL) Insurance
Like any life insurance policy, indexed universal life provides a death benefit if the insured person passes while the policy is in force. As a universal life insurance policy, the premiums are flexible—you can potentially delay or skip premiums as long as your cash value continues to pay your policy’s internal costs—and you may be able to increase the death benefit.
Unlike a “regular” universal life insurance policy, the cash value is linked to a market index, such as the S&P 500, and movements in that index determine how much growth (if any) the insurance company credits to your account.
- Alternate name: Equity-indexed universal life insurance
- Acronym: IUL
How Does Indexed Universal Life Insurance Work?
To get coverage, you apply for a policy and pay premiums to a life insurance company. Your premium payments go into the policy’s cash account, and the policy’s expenses are paid out of those funds. What sets IUL apart is that the cash value earns interest according to one or more market indexes.
To better understand how IUL works, it helps to look at the mechanics of permanent insurance and universal life insurance policies in general. With permanent insurance policies, you typically pay premiums that exceed the policy’s costs in the early years. As a result, you build up a cash value inside of the policy that, if all goes well, can help pay insurance costs for the rest of your life.
Universal life insurance is a subset of permanent or cash value life insurance that provides various options for managing the policy (and IUL is a subset of that). For example, if you own a universal life insurance policy, you don’t necessarily have to follow a rigid premium payment schedule. (On the other hand, you typically do if you own a whole life insurance policy.) You might even be able to skip premium payments when money is tight or your policy’s cash value is sufficient to cover the policy’s costs.
If your life insurance policy runs out of money—due to loans, withdrawals, or insufficient premiums—you risk losing coverage and potential tax consequences.
As with other cash value life insurance policies, you may be able to withdraw from or take a loan against the cash value of the policy. Bear in mind, however, that most permanent life insurance policies have surrender periods that can range up to 20 years, during which you may be assessed a surrender charge (or penalty) on withdrawals.
The "Indexed" Feature
Within an IUL policy, the cash value can experience investment-like returns while not being directly invested in the market. You can choose to designate the cash value among different accounts, which include fixed accounts (these offer a guaranteed minimum interest rate, such as 2%) and accounts linked to market indexes (such as the S&P 500 and MSCI Emerging Markets indexes). And you might be able to select a combination of investments/accounts inside one policy.
To illustrate how this works, you could buy a policy with exposure to the S&P 500 index, which is different from owning an S&P 500 index fund in several ways. If the index rises, the insurance company may credit your cash value with additional earnings based, in part, on how much the index gained.
If the index falls, your cash value generally receives zero earnings or a guaranteed minimum amount but does not lose value. Also, an index-linked account does not include dividends, making it distinct from mutual funds that might be linked to the same index.
Index calculations can be incredibly complicated, and the details are different at every insurance company. However, it’s essential to know that you typically don’t get 100% of the growth in the markets. Insurance companies set limits on how you participate in any upside. Common features used to limit gains (and losses) include the following, and one or more may apply to the same account:
- Cap: This rate limits your earnings up to a specific amount—8.5% per year, for instance, although higher and lower caps are possible. In this case, if the index gained 11%, the amount credited would top out at 8.5%.
- Participation rate: This specifies how much of the index’s growth may be credited to your policy. With an 80% participation rate, you would receive up to 8% when the index gains 10% (80% of that 10% gain). Some participation rates may exceed 100%.
- Threshold rate: This is a rate above which gains are credited to your account. In other words, it requires that the index grows by a certain amount before you begin participating in gains. For example, the index might need to increase by 10%. Any growth above and beyond that may be credited to your account, but if the index does not reach the threshold, you might receive zero crediting in your indexed account.
- Spread rate: This is an amount that the insurance company subtracts from any index growth you’re participating in. For example, if you have a spread rate of 2%, an index growth of 8% would result in a maximum of 6% being credited to your account.
- Floor rate: Instead of limiting gains, this rate limits losses. Typically the floor is set at 0%, meaning that 0% is the lowest interest rate that can be credited to your account. This is an important feature if the underlying market index performance has a negative return.
These features may work in tandem with each other to modify the interest credited to the cash value. For example, a high participation rate might suggest the potential for significant gains, but if there’s a low cap or a large spread, those gains will ultimately be limited. Likewise, a high participation rate helps only after the index passes your threshold rate (if any).
The limitations above make it possible for insurance companies to offer potential growth while providing protection against market losses. It’s critical to acknowledge that there’s no free lunch with any financial product, and with that understanding, you can decide what’s best for your money.
Alternatives to Indexed Universal Life Insurance
Depending on your needs, other forms of insurance might serve you better.
A standard universal life insurance policy is similar to IUL without the index-linked investment component. Your earnings may depend on the current crediting interest rate offered by the insurance company, and you can’t know exactly how much you’ll receive over the years, though policies will have a minimum guaranteed interest rate, such as 2%. As with IUL, premium payments are flexible, but you need to pay enough to keep the policy in force.
Whole life insurance is another form of permanent insurance with a cash value. With whole life insurance, you have a defined cash value, premium schedule, and death benefit. The outcome is more certain with whole life than with IUL or UL, but whole life does not include potential market exposure.
Variable Universal Life
Variable universal life (VUL) insurance policies are universal life policies with direct exposure to investment markets. If you have an appetite for risk, you can select investments similar to mutual funds inside of your policy. Unlike IULs, you can lose money in VULs, but they typically don’t limit your upside with caps or other features.
Term life insurance provides temporary coverage, so it might be appropriate if you need insurance only for a certain number of years. For example, you might buy 20-year term life coverage to ensure that family members have enough time to become self-sufficient and financially stable. Unlike IUL or whole life, term life insurance does not include a death benefit that is guaranteed for your entire life.
Pros and Cons of Indexed Universal Life Insurance
Permanent life insurance coverage
No negative returns
Difficult to understand
Can be expensive
Limits on upside returns
- Permanent life insurance coverage: IUL policies can provide permanent life insurance for those who need it. While most families are well-served by term coverage, you may need to guarantee that a death benefit remains in place for your entire life. The death benefit is generally tax-free for beneficiaries, and the funds do not go through probate.
- Market participation: If your index performs well, your policy might grow at a rate that’s faster than whole life or universal life policies. If that happens, you might be able to pay less into the policy or provide a bigger than expected death benefit to beneficiaries.
- No negative returns: IUL policies generally do not allow you to lose money when your index loses value. Instead, you might receive no earnings for the period or receive a minimum guaranteed credit to your cash value.
- Difficult to understand: IUL policies are notoriously confusing. People are often intrigued by the idea of participating in gains and avoiding losses. But there’s a lot more to it than that. If you don’t have a handle on the index calculations, caps, participation, and spreads, you might not be getting what you think. Plus, if the policy doesn’t perform as illustrated, you may need to pay more into your policy or risk a loss of coverage and tax consequences.
- Can be expensive: Some IUL policies can get expensive, especially when you add optional riders that enhance your coverage. Administrative fees, premium charges, costs of insurance, and other fees can eat into your cash value. And if the markets don’t produce returns, you may be unable to pay the internal costs. Plus, you may face surrender charges if you try to cash out your policy.
- Limits on upside returns: If you’re buying IUL hoping for long-term growth, you may be disappointed. With caps and other features that limit your growth, you could miss out on some of the market’s biggest gains. Plus, fees can put an additional drag on your performance. Evaluate options like buying pure insurance for insurance coverage and investing in other vehicles.
- Buying an indexed universal life insurance policy can satisfy a need for permanent life insurance and provide exposure to equity markets via the cash value.
- IUL is a type of universal life insurance, which means premium payments and the death benefit are flexible.
- Cash values in IUL policies are not typically credited with negative interest, meaning they do not participate in market losses, but gains are also limited.
- Determining how index gains will be credited to your cash value can be complicated. Be sure to understand how features that limit gains, such as caps, spreads, thresholds, and participation rates, apply to index-linked accounts in the policy.