Pros and Cons of Indexed Universal Life Insurance

According to LIMRA, indexed universal life insurance policy premiums increased 23% in 2014. But financial experts warn this product, which was first introduced in 1997, is not for everyone.

Robert Quinlan, the managing member of Quinlan Care LLC, an insurance agency/brokerage firm based in New York, discussed with me the pros and cons of this type of life insurance.

Boomer: What is indexed universal life insurance?

Quinlan: It has captured more attention today from insurance agents, brokers and consumers.  So what is indexed universal life insurance? Let’s first look at an earlier hybrid form of this life insurance: universal life insurance (UL for short and still around).

UL is a permanent form of life insurance where the excess of the premiums above the current cost of life insurance (the cost of term insurance today) is credited to the policy. The cash account is credited each month with interest that is declared by the insurance company on an annual basis. There is also a guaranteed minimum interest rate, like 2 or 3%. Each month the cash account is also debited for the current cost of the life insurance to cover when you die. Monthly fees are also withdrawn from the cash account.

Indexed Universal life insurance is not similar to UL because instead of crediting money to the cash account based on a carrier’s declared interest rate, Indexed UL’s earnings rate is pegged to a financial index such as a stock index. What is a stock index? It is a way to measure the value of the stock market by computing the prices of selected stocks. It also allows investors and financial professionals to compare the value of specific investments. A commonly used one is the Standard and Poor’s 500 stock index, which is the value of 500 stocks that is tracked every day on the financial markets.

Indexed UL policies aren’t directly invested in the stock market like a variable universal life insurance policy. Instead, the financial value of the index is used to calculate how much interest is credited to your policy’s cash account. The carrier will cap or limit the upside amount that can be credited to your account. The carrier will also buffer your downside with a guaranteed interest rate if the stock market declines in value. The insurance company’s ability to credit your account depends on how well the carrier’s investment portfolio (largely invested in bonds) performs.

Boomer: What are the advantages of this product for baby boomers?

Quinlan: Advantages may include above averages returns when the selected index does well.  Policy loans are allowed and generally free of income taxes. The loan does not have to be repaid.  However, if a policy is surrendered, any loan outstanding is subject to income taxes in the year that the policy lapsed. The death benefits are income tax free. And cash values account will grow tax deferred of income taxes like an IRA. There are no limits on the amount of money that you can contribute each year. The death benefits are not subject to a lengthy probate process like some wills; the face amount is paid directly to the policy beneficiary. Finally, IULs permit tax free exchange of one policy to another.

Boomer: What areas are state insurance regulators looking at?

Quinlan: There are several areas that the state insurance regulators are examining today, and ones that consumers should be also looking carefully at. You are sitting across from your insurance agent or financial advisor going over the policy illustration.  Does the illustration have sufficient disclosure to properly educate you about the policy’s upside, downside, policy fees, withdrawal situations and tax considerations? Does the policy illustration adequately show you how your policy will perform today and into the future, tell you about how your interest is credited to your cash value account and the fees that will be debited from your cash value?  You may be shown an illustration with a crediting rate of say 10% or 12% based using the stock index.  Your cash account may be bulging with cash in 30 years according to the projections. However, where is the insurance company going to find investments that will consistently return 10%, or even higher at 12% every year for the next 30 years?

Boomer: What should baby boomers carefully look at prior to purchasing this type of coverage?

Quinlan: Today we are at historically low interest rates. Yes, the stock market has recovered from the 2008 crash record lows. Look at an illustration that is run by your financial advisor or insurance agent/broker that shows you how your policy will perform at a more conservative return at say 6%. Now, how does it perform in 30 years at 6%? Does the policy still meet your goals? Some life insurance groups that represent the industry are proposing these illustrations show three different returns: low (based on the minimum guaranteed rate stated in the policy), medium and high levels of cash value. Other features are important. Carriers can change their crediting rates at any time. And you will not find an indexed universal policy paying you an annual dividend nor guaranteeing cash value like you would find in a whole life insurance policy.

Boomer: What are some tax advantages of indexed universal insurance?

Quinlan: While you cannot deduct the policy premiums from your income taxes, the death benefit, face amount of the policy is almost always free of federal or state income taxes. If you borrow cash from your policy, the loan will be generally free of income taxes.  The inside cash value of your policy will grow on a tax deferred basis like an IRA or your 401(k). You can access your money in the policy without an IRS penalty, regardless of your age. You don’t have to wait to age 59-1/2 to access the cash value.

Boomer: What are the costs and administrative charges associated with these policies?

Quinlan:  Costs can include mortality and expense risk charges (to compensate the carrier if a person does not live to their life expectancy), cost of insurance (the cost of having insurance protection), a surrender charge if you terminate your policy during the surrender charge period during the first years of your policy. There will be a charge if you add a rider, additional features to your policy like a waiver of the premium in the event you become disabled.

Boomer: Who should purchase an indexed universal insurance policy?

Quinlan: Indexed UL should be purchased by someone who is financially sophisticated and understands the policy’s pros and cons. You should also have a need for permanent life insurance protection like leaving money to your children or grandchildren, supplement your retirement income or to maintain your spouse’s life style at your death. You have also heard repeatedly: one size does not fit all. These words are still true with IUL and other financial services products. Shop around as carefully as when you bought your home.