Indexed Universal Life Insurance (IUL) consists of two parts. Term coverage, to provide a death benefit, and a cash account, to provide cash value.
There are two types of term insurance, Renewable Term and Level Term.
Renewable term is the most expensive way to buy insurance. The Insurance Company looks at your age and health and offers to give you a certain amount of death benefit in return for X amount of premium. This premium will provide you with coverage for one term. The length of the term will be specified in the policy’s contract. Many renewable policies have a one-year term, but some are longer.
If you would still like coverage once your term has expired, your policy may be renewed. Your new premium will be higher as your age has increased and you represent a greater risk to the Insurance Company.
The premiums on Renewable Term policies rises quickly. Most term policies never pay a death benefit, as either the cost of insurance becomes unaffordable to the owners and they quit paying the premiums causing the policies to lapse. Or the Term is converted to a permanent policy.
Level Term Insurance is very similar to Renewable Term, but with a key difference. With Level Term, the insurance company guarantees your premium to be fixed or level for a set period of years. The length of the period varies from product to product but 10, 15 and 20-year terms are common lengths for a policy. Once this level period has expired you may be able to renew, but the premiums will be comparable to those of a Renewable Term policy since your age and risk to the insurance company have increased.
The type of term coverage that provides the death benefit of an Indexed Universal life policy is the most expensive type…renewable term. The cost of insurance starts out low but rises quickly over the years. This works to the detriment of Indexed Universal life policies as we will see later on.
The premiums on IUL policies are flexible. You can pay less or more in premium as you please. We will see how this works in just a bit.
When you pay a premium on an Indexed Universal Life Policy, your money
The death benefit is the amount of money the Insurance Company agrees to pay to your beneficiaries if you should die while the policy is inforce. Since IUL is based on renewable term insurance, the cost of buying a death benefit will rise. As the cost rises, more of your premium dollars will go to pay the increasing cost of your death benefit and less of your premiums will make it into your cash account.
Fees are typical with all Insurance Policies. With traditional policies, there is one flat annual fee known as the Policy Fee. Indexed Universal Life has other fees in addition to the flat annual policy fee such as:
These additional fees can be annoying and expensive.
The Cash Account is where the Indexed Universal Life policies are really supposed to shine.
After paying the cost of insurance and the fees associated with the policy, the remaining dollars of your premium are deposited into your cash account. The amount of money you have in your cash account is the cash value of your policy. Some people regard this cash value as equity, but this is wrong. In reality, the cash value of an IUL policy represents how much you have overpaid for your insurance. The cash value is generated by paying more in premium then is required to pay for coverage.
The money accumulated in the cash account from excess premium payments is set to mirror a certain index such as the Dow Jones or Nasdaq. Whether or not you have a say in which index your policy mirrors, is dependent upon the insurance company. Some companies allow you to choose from a select list of indexes. Others don’t.
One of the many hailed qualities of the cash account is that you can never lose money! Indexed Universal life policies generally guarantee the minimum return on the money inside the cash account to be no less than zero. Some policies even guarantee a small positive return.
But Indexed policies also have a policy cap. No matter how well an index performs, your return will be capped at whatever percentage is specified in your contract. This cap rate is non-guaranteed, and the insurance company may adjust this policy cap once each year to any rate they please. The amount of control this gives the insurance company over the performance of IUL policies should be frightening to any who have purchased, or are looking to purchase, these products.
Also, be aware that, while the cash account does mirror an index, the dividends of the index are not included! The difference in the return on an index with and without a dividend can be substantial.
Flexible premiums allow you to pay more, less or even skip a premium each year. Flexible premiums also allow you to overfund an IUL.
When you choose to pay more in premium than required to purchase the death benefit, part of your premium will still go to pay for the ever-increasing cost of insurance. Part of the premium goes to pay the fees associated with the policy, and the remaining dollars will be deposited in your cash account.
Paying excess premiums or “overfunding” the policy, will result in more money accumulating in the cash account than originally depicted. But Like any other life insurance policy, Indexed Universal Life products are subject to the IRS seven-pay test. The seven-pay test defines how much you are allowed to overfund a policy without it becoming a M.E.C. (Modified Endowment Contract)
If a policy becomes a MEC, it loses its tax favorable treatment, and the growth in the policy becomes taxable. Once a policy becomes a MEC it remains a MEC. If you are considering overfunding a policy, you will want to consider staying under the IRS seven-pay test, or your policy will become taxable.
When you choose to pay less in premium than illustrated for your policy, your premium will still go to pay for the ever-increasing cost of insurance and the fees associated with your policy. Whether or not there will be any money left over to be deposited into your cash account is dependent on how much you pay.
Now here’s where things get interesting. If the money you paid in premium is not enough to cover the cost of insurance and the policy’s fees, or if you decide to skip a premium, the insurance company will make up the difference by withdrawing funds from your cash account. If there is not enough money in your cash account to make up the difference, your policy will lapse.
Never assume that just because you don’t pay the premium out of pocket that premium isn’t required. You will always pay your entire premium. It’s just whether it comes from your bank account, from the funds in your cash account, or a bit of both.
A worrisome aspect of IUL is the fact it is built upon renewable term. Due to this poor structuring, the premiums of IUL products will rise with the cost of insurance. If you are unable to keep up with the rising premiums, the insurance company will withdraw the necessary funds from your cash account. Unless the indexed funds perform in such a way that allows the cash account to increase to cover the ever-increasing cost of the term insurance, it is only a matter of time before the policy has eaten up all the value and the policy lapses.
Once a policy lapses, there is no coverage and hence no cash value and no death benefit. Unfortunately, this often happens when the insured is older and is more likely to utilize the death benefit.
Indexed Universal Life policies are often depicted as a part of retirement income strategies. Most times these strategies involve overfunding the policy to boost the cash value (money in the cash account) so that the retiree can draw on the cash value for income in later years.
This is a poor strategy. The premiums on IUL products become so exorbitant that it is impossible or impractical to keep up with them. Either way, the policy will lapse and there will be nothing to draw income from.
The cash value and death benefit of Indexed Universal Life policies are often misunderstood. The cash value is the amount of money in your cash account. It represents the amount you could borrow or withdraw. If you were to surrender your IUL policy, you would receive the cash value minus any outstanding loans, and fees associated with surrendering your policy.
The death benefit is the amount the insurance company has agreed to pay your beneficiaries should you die while the policy is in force. If you should have a loan against your policy when you die, your beneficiaries will receive your death benefit minus the outstanding loan.
There are two options for how a death benefit is paid with an IUL policy. Under Option A, the death benefit of an IUL policy will equal the face amount of the policy. Under Option B, a more costly option, the death benefit of an IUL policy will equal the face amount of the policy plus the cash value in the cash account. This cash value isn’t free money, it represents how much you have overpaid for your insurance. Under either option, your beneficiaries will only receive a death benefit.
Average Rate of Return has become a popular way to measure investments, and it is often used to measure up the investment side of Indexed Universal Life.
While figuring out the average rate of return on an IUL can be straightforward enough, average rate of return can be tricky and downright misleading, since you can lose money while earning a positive average rate of return.
For example: You invest $100 with an investor of good esteem. The investor promises you an Average Rate of Return of 5% on your $100 over a two-year span.
The first year, your investor makes a poor investment and loses $$ 100 you invested with him, a loss of 50%. This leaves a balance of $50. The next year he makes a better investment and experiences a gain of $30, a gain of 60%. This leaves a balance of $80 ($50 + $30).
It has now been two years, and your investor hands you over your $80 and informs you your money has earned a 5% average rate of return. Adding the 50% loss plus the 60% gain equals an overall 10% “gain”. Divide this gain by 2, for the two-year time period, and this gives a 5% average rate of return. Your investor is, indeed, correct in stating your money has earned a 5% average rate of return. At this point, he will probably ask you to invest more money with him. But you can see, how misleading average rate of return can be.
A more meaningful calculation would be the Actual Rate of Return. The Actual Rate of Return looks at the return of your money compared to the original sum invested. In this case your final return of $80 minus the original amount, $100, would leave you $20 dollars in the hole. Considering 20 is 20% of 100, we see the actual annualized rate of return was -10% (20% divided by 2 years).
The only problem with figuring the Actual Rates of Return for IUL policies, is that the rates are seldom anything to write home about. In fact, most of the time, they stink. This is unsurprising, considering the premiums of IUL products rise with the cost of insurance, and whatever you could earn in your cash account is capped at whatever rate the insurance company chooses.
While IUL policies can be very profitable for insurance companies they are a risk for individuals to own.
If you have an Indexed Universal Life policy, or are considering purchasing one, request our complimentary insurance review. We will review the policy with you to help determine if it’s a good fit for you or not.
Call our office 702-660-7000 or email us [email protected] to request your free insurance review.