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Indexed universal life (IUL), explained plainly

Life insurance

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Permanent coverage with index-linked interest, and enough moving parts to deserve a slow explanation

Indexed universal life (IUL) is a permanent life insurance policy with a flexible premium and a cash value that earns interest linked to the movement of a market index, subject to a cap, a participation rate and a floor. It is not an investment in the index; the money is never in the market. It is a life insurance policy with a crediting formula, and a set of policy charges that come out of the cash value every month whether the index rose or fell. Understanding both halves of that sentence is the whole job of this page.

Next Wave Options is an independent agency in Salinas appointed with several carriers. We place IUL for people who need permanent coverage and understand what they are buying, and we decline to place it when a simpler, cheaper policy would do the job.

How the crediting works

  • The index. The policy tracks a published index over a crediting period, commonly one year, and credits interest based on its change. Dividends on the index's stocks are not included.
  • The cap. The maximum interest the policy will credit in a period no matter how far the index rose. Caps are set by the carrier and can be changed, within contractual limits, after the policy is issued.
  • The participation rate. The share of the index's gain that counts before the cap is applied. A rate below 100 percent reduces the credit; some designs use a rate above 100 percent with a lower cap.
  • The floor. The minimum credit in a period, often zero. The floor protects the credited interest from a falling index; it does not protect the cash value from the policy's charges, which continue in a zero-credit year.

Every one of those terms is a lever the carrier controls, and the combination determines what the policy actually credits over time. Illustrations use assumed credits; the guaranteed column in an illustration, which regulators require the carrier to show, assumes the guaranteed minimum and is the only column that is promised.

The charges, which are the half that gets skipped

Each month the policy deducts the cost of insurance for the death benefit, which rises every year as you age, plus administrative and expense charges and, in the early years, a surrender charge if you cancel. If the premiums you pay plus the interest credited do not keep pace with those charges, the cash value falls, and a policy that is underfunded for long enough can lapse in your 70s or 80s, when replacing it is expensive or impossible. The single most important question to ask about any IUL is not "what does it credit?" but "what happens to this policy if it credits the floor for five years?", and a good illustration answers it.

Who an IUL fits

  • Someone who needs a permanent death benefit, has a long time horizon, and can fund the policy well above the minimum premium for many years.
  • Someone who has already filled their workplace retirement plan and IRA and wants an additional place to hold long-term savings inside a policy, understanding that policy loans and withdrawals reduce the death benefit and can have tax consequences if the policy lapses.
  • Someone who will read the illustration, including the guaranteed column, and review the policy every year.

Who it does not fit, and what fits instead

  • A family that needs the largest possible death benefit for the years the children are at home. Term life buys many times the coverage per dollar.
  • Anyone who cannot comfortably pay well above the minimum premium for decades. An underfunded IUL is the policy most likely to lapse when it is needed.
  • Anyone who was told it replaces a 401(k) or an IRA. It does not. An IUL is a life insurance policy; retirement plans have contribution limits, employer matches and tax rules that a policy does not replicate. We do not recommend reducing retirement plan contributions to fund a policy.
  • A senior who wants a simple permanent policy. Whole life has a level premium and a guaranteed cash value schedule, with far less to monitor.

How to read an IUL illustration

  1. Find the guaranteed column. It assumes the minimum crediting rate and the maximum charges the contract allows. If the policy lapses in that column before age 90 at the premium you plan to pay, the premium is too low.
  2. Check the assumed rate in the non-guaranteed column against the current cap and participation rate. Regulators limit how optimistic the assumed rate can be, but it is still an assumption, not a forecast.
  3. Look at the charges by year, especially the cost of insurance in the later decades, and the surrender charge schedule in the first ten to fifteen years.
  4. Ask for the same illustration at a lower assumed rate. A carrier that will not provide one is telling you something.

The California Department of Insurance's Life Series consumer guides cover permanent insurance in neutral terms and are worth reading before any IUL conversation, including one with us.

How we handle an IUL conversation

  1. We start with the need, not the product. If the need ends, we will recommend term. If it is a simple permanent need, we will show whole life next to the IUL.
  2. We show the guaranteed column first and the charges by year, and we run the illustration at more than one assumed rate.
  3. We compare carriers on caps, participation rates, floors, the carrier's history of changing them, charges and financial strength, listed on our carriers page.

Questions people ask about IUL

It is not an investment; it is a life insurance policy whose cash value is credited with interest linked to an index, after policy charges. Compared with a retirement account it has higher costs and different tax rules, and it should be funded only after workplace plans and IRAs, if at all.

The crediting floor protects the interest credited from a falling index, but policy charges are deducted every month regardless, so the cash value can fall in a year with a zero credit, and an underfunded policy can lapse. The guaranteed column of the illustration shows the worst case the contract allows.

The maximum interest credited in a crediting period regardless of how far the index rose. Caps are set by the carrier and can be lowered after issue within the contract's limits, which is why a carrier's history of cap changes is part of our comparison.

Whole life has a fixed premium, a guaranteed cash value schedule and, for participating policies, non-guaranteed dividends. IUL has a flexible premium, index-linked crediting subject to caps and floors, and charges that rise with age. Whole life is simpler and more predictable; IUL has more upside and more ways to go wrong.

Policy loans and withdrawals can provide cash in retirement, but they reduce the death benefit, carry interest and, if the policy lapses with a loan outstanding, can create a taxable event. It is a supplement for people who have already funded their retirement plans, not a substitute for them.

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Reviewed by Roberto Morales, California Insurance License #0G97165. Next Wave Options is licensed for life and annuity products only and does not provide investment, tax or legal advice.