At its core, life insurance is simple. You pay premiums for a policy, and a death benefit is paid out if you die during the course of the policy.
But in practice, term life insurance is the only type of life insurance that keeps it simple. Other types of life insurance complicate matters by adding investment components, enacting age restrictions, or introducing customization of premium payments and death benefits. That can help a policyholder tailor a plan to fit their needs, but it also adds a lot of layers to the one thing you really need a life insurance policy to do: provide a financial safety net for your loved ones.
Indexed universal life insurance is one of those insurance types that provides more for a policyholder but can quickly get complicated in the process. There’s potential for big gains with an indexed universal life insurance policy, but when it comes to the concerns it adds, it may not be worth the trade off.
What is indexed universal life insurance?
Indexed universal life insurance is a type of permanent life insurance – a life insurance policy that stays in effect for your whole life as long as the premiums are paid (as opposed to a term life insurance policy, which expires after a set amount of time). Other types of permanent life insurance include whole life insurance, variable life insurance, and universal life insurance.
All permanent life insurance policies are split into two parts: the death benefit (which pays out a sum if you die), and cash value portion that can gain value over time. With universal policies, policyholders can adjust the death benefit within limits, and can use gains from the cash value to pay for premiums.
What makes indexed universal life insurance unique is the "indexed" part. These policies have a minimum guaranteed interest rate (so you won’t lose money), but the interest rates aren’t fixed; instead, they’re based on an index chosen by the insurer.
An index is essentially a group of investments like stocks or bonds. The S&P; 500 and the Nasdaq 100 are examples of indexes. The insurer doesn’t directly invest in the market, but uses the interest rate of a determined index to settle on the interest rate for your policy based on the performance of the index.
Alternatives to indexed universal life insurance
If that all sounds like a lot to handle, there are alternatives to indexed universal life insurance that might be a better option.
First, there’s a basic term life insurance policy. More affordable and more easily understood, a term life insurance policy should serve anyone who just wants financial peace of mind in the form of a death benefit – no indexes or cash values or interest rates to worry about.
Then there’s whole life insurance, another type of permanent life insurance. Whole life insurance is like a stripped-down version of indexed universal life insurance; there’s a cash value component that acts as a forced savings vehicle, but it’s a lot simpler.
Then there are other types of universal life insurance policies. The main difference between indexed universal life insurance and, say, variable universal life insurance is how the cash value gains are realized, but both offer the same benefits in terms of the flexibility of the premiums and death benefit.
What’s good about indexed universal life insurance?
A majority of people don’t need their life insurance policy to stay in place for their entire lives; once they pay off debts, have fewer dependents, and become self-insured, it’s usually not worth paying for a policy. But there are some cases in which the cash value component of a permanent life insurance policy can be useful (to pay off large estate costs, for instance, or as a means to pass tax-free inheritance if other assets are large enough to trigger estate taxes) and something like an indexed universal life insurance policy can come in handy.
With an indexed universal life insurance policy in particular, policyholders can see decent growth depending on the index that the interest rate is set against, and the minimum interest rate means that the risk is minimal if the market falls. The policyholder also has the advantage of a flexible death benefit and premium payment plan if needed,
What’s bad about indexed universal life insurance?
There are downsides to permanent life insurance policies in general, which we’ve talked about in depth elsewhere. Essentially, permanent life insurance policies like whole life insurance are more expensive than term life insurance policies.
When it comes to indexed universal life insurance, though, the primary downside is that it’s a really confusing product. Term life insurance is very straightforward: the policyholder pays the premiums, and the death benefit is paid out if they die. Even whole life insurance is understandable once you wrap your brain around how the cash value component works.
But consider how one CFP thinks about indexed universal life insurance:
To truly understand this will require you to either spend ample time studying the policy you are considering purchasing inside and out or have an enormous amount of trust in the person recommending it.
Why is it so confusing? Because there are a lot of complications and nuances about the index and the growth of the cash value.
For instance, earnings may be capped; if the S&P; 500 earns 8% but your policy is capped at 4%, you won’t see the full growth. Indexed universal policies don’t take into account dividend yields, which presents another situation in which your interest rate wouldn’t meet the index growth. There can be participation rates, or "point to point" timeframes that limit when interest is calculated and applied to your cash value.
Plus, late into the policy’s timeline, you may end up paying a lot for little protection.
Is indexed universal life insurance worth it?
Like other permanent life insurance policies, it’s hard to justify the extra costs associated with an indexed universal life insurance policy, when a term life insurance policy paired with an outside investment plan is more affordable and can provide a better return.
Indexed universal life insurance has the added drawback of being convoluted; there are so many details specific to every policy that it can be hard to know exactly how well it will work out for the policyholder.
Overall, indexed universal life insurance isn’t the best option for most people, and a more straightforward term life insurance policy will provide the protection needed at a lower price.