It’s a question we hear a lot from clients when we first meet to discuss life insurance policies: “What’s the difference between universal life (UL) and index universal life (IUL) insurance?” Well, there’s a big difference. The “index” policy allows your cash value to grow if a linked market index, such as the S&P 500, grows. But before we jump into all of those juicy details, let’s first look at why people buy UL policies in the first place.
UL policies are flexible. Did your need for insurance just decrease? Not a problem. You can adjust your death benefit down from $2 million to $1 million. Did you just come into some money, and now you can afford to buy more insurance? Great. Assuming your health hasn’t changed, UL allows you to increase the size of your policy if you qualify medically. Your ability to control these policy features is something missing from traditional whole life insurance, in which you set terms on day one and that is what stands for the life of the policy.
In addition, both UL and IUL policies allow for premium flexibility. As long as the cash value exceeds the cost of insurance needed to sustain the policy, premiums can be skipped. Additional money can be deposited into the policy when it is convenient, or if the goal is simply to build as much tax-free withdrawal capability in the future as possible.
So how exactly do traditional UL policies operate? In a nutshell, your policy has a cash component and an insurance component. The cash component increases when the premium payments exceed the current cost of insurance. That cash value is then credited interest based on prevailing interest rates in the economy, but often with a guaranteed minimum.
What Is Index Universal Life Insurance?
IUL policies still have the flexibility associated with UL policies in that the contract components, particularly the premium and death benefit, are adjustable. The index portion refers to the fact that your cash value can be linked to a market index, such as the S&P 500. Let’s look at an example.
Mike is a 60-year old man who places $1 million into an IUL policy. Based on his age and health, the $1 million premium will buy him an initial death benefit of $3 million. However, if the market performs as projected, that death benefit should exceed $4 million. The policy terms include a minimum 1% interest rate and a maximum of 12% if the S&P 500 performs at the top end of the range.
The actual calculation is a little more complicated and involves caps, participation rates, and policy fees, but historically speaking, your index returns can be very respectable. In a persistently low interest rate environment, such as the one we’re currently in, it is possible that opting for IUL over UL may work out better for your heirs.
What Are the Disadvantages of Index Universal Life Insurance?
One disadvantage of IUL is that your index returns do not include dividend payments like dividend-paying stocks. The reason for this is that your market exposure is actually captured through derivative market products, such as options, and not through direct market participation. Because reinvested dividends have historically been an important component of market returns, the lack of dividend distributions is noteworthy. However, IUL is not subject to the risk of market loss common to other securities. In addition, compared to UL which pays an interest rate declared by the company but not based on a market index, IUL is usually a bit more costly, yet much less expensive than traditional whole life insurance.
The other main risks are that the market simply doesn’t perform and your cash value is credited at a slow rate, or that the insurance carrier raises its charges or lowers your index cap in a way that inhibits your cash build-up. Reducing the index cap is specific to IUL policies, but increasing costs can be a risk with many different types of life insurance policies.
The Estate Planning Advantage of Universal Life Policies Over Whole Life Policies
When it comes to preserving and transferring wealth from one generation to the next, UL policies really do the job well. When these policies are purchased inside irrevocable life insurance trusts, it is generally the death benefit — not the cash value — that matters. As such, much lower premium payments can be made to support the same death benefit. For this same reason, you’ll often find UL policies used for business succession planning, estate liquidity, and income replacement.
The advisors at Howard Kaye can show you how to maximize the benefits of your life insurance policy and transfer more money from one generation to the next. Depending on your specific needs, a UL or IUL policy may the right solution for you. Contact us today at 800-DIE-RICH and let’s start working on a custom estate plan for you.