Indexed universal life insurance

Key takeaways

• Indexed universal life insurance (IUL) is permanent life insurance with flexible premiums and cash value growth tied to a market index.

• Downside risk protection is provided by a loss-protecting floor, while upside growth is limited via a cap or participation rate.

• Key features include lifelong coverage, flexible premiums, adjustable death benefits, tax-advantaged cash value growth, and a choice of cash allocation options.

• Compared with whole and universal life (UL), IUL offers more upside potential, but greater complexity, fees, and non‑guaranteed growth; but compared with variable universal life (VUL) there is less investment risk.

• IUL is often used by higher earners who have maxed traditional retirement accounts.

Indexed universal life insurance is a type of permanent life insurance that offers a unique combination of advantages: lifelong death benefit protection; flexible premiums; tax benefits; the potential to accelerate cash value growth by tracking stock market gains; valuable protection against cash value losses.

IUL is a form of life insurance that, unlike term life, provides permanent death benefit protection and a cash value component that grows tax-efficiently. However, compared with whole life insurance — which offers a fixed premium and death benefit and a guaranteed rate of cash value growth — and universal life insurance, which also offers flexible premiums, IUL is more of a niche product that works very well for some, but not all, individuals.

How an indexed universal life insurance policy works

There are three types of universal life insurance: standard universal life; variable universal life (VUL); and indexed universal. All are designed to provide lifelong death benefit protection and offer the flexibility of premiums that can be adjusted within a certain range. The key difference between them lies in how cash value accumulation is calculated:

• In a standard UL policy, the cash value is guaranteed to grow at a minimum guaranteed interest rate (e.g., at least 2% annually) and may credit a higher rate depending on conditions.

• A variable universal life policy offers the potential for higher returns, as well as the risk of losses: These policies give you the option to tie cash value growth to a choice of “subaccount” investment funds. But growth in a variable UL policy is not guaranteed: In a good year, the value of your subaccounts (and cash value) can rise; in a bad year, the subaccount value can and will decrease.¹

• Indexed UL splits the difference: It provides more growth potential than standard UL, with less investment risk than VUL. IUL policies let you allocate all or part of your cash value growth to the performance of a broad securities index such as the S&P 500 index.² However, unlike VUL, your money is not actually invested in the market — the index just provides a reference for how much interest the insurance credits to your account, with a floor and a cap for the minimum and maximum rates of return. While you won’t realize all the gains of your reference index, you won’t suffer any of the investment losses either. Since the floor is usually set at 0%, in a down year for the markets your cash value amount will typically remain steady (however, policy values could still decline due to loans, withdrawals, cost of insurance charges, or fees, or it could grow slightly because some policies set the floor above 0%).

How cash value grows in an indexed UL policy

First of all, your cash value growth will depend on how you allocate your cash account. You’ll choose from a selection of market indices, and you may be able to choose more than one. Generally, you’ll also be able to allocate a portion to a fixed-rate interest account.

Three key mechanisms determine how much is credited to your cash value account:

1. A cap: This is the maximum interest rate your cash value can grow by in a specific period, regardless of how high the underlying market index rises. If your cap is 5% and your underlying market index rises by 10% your cash value will grow by 5%.

2. A participation rate: This is the percentage of the underlying market index's gain credited to your cash value. Rates usually range from 50% to over 100%. If your participation rate is 50% and the market index rises by 10%, your cash value will grow by half of 10%, or 5%. If your participation rate is 100%, your cash value will grow by the full 10%. Some insurers choose not to use this upside-limiting feature, and have their IUL policy participation rate set at 100% (meaning the index’s entire gain — up to the cap — is credited to your account.

3. A floor: This is a guaranteed minimum interest rate — commonly set at 0% — applied to the cash value. The floor ensures that even if the underlying market index has negative returns, the cash value will not decrease due to index performance — it will just deliver 0% growth.*

It’s important to note that the protection from market losses in an IUL policy comes at a cost: The insurance company uses what they earn by limiting your gains via caps and/or participation rates to pay for your policy’s downside loss protection.

So what happens in a good or bad year? Here are two examples based on how the S&P 500 did in 2022 and 2023:

The 2020s have seen one of the worst years for the S&P 500 this century — as well as one of the best. In 2022, the index dropped 18.1%, its worst performance since 2008; the next year, 2023, the index gained it all back and then some with an overall rise of 24.2%.^4,5

We’ll assume you started with $10,000 in your cash account on January. 1, 2022, and you allocated 80% to the S&P 500 with an 11% cap, a participation rate of 100% and a floor of 0%; to hedge your bets, you put the other 20% in the fixed-interest account which paid 3%. To simplify things, we’ll assume nothing else was added via premium contributions.

2022 IUL cash value performance (S&P 500 down 18.1%)

In a down year like this, you likely wouldn’t be happy with the results: Your cash value grew by about 0.6%. In this hypothetical example, a standard UL or whole life policy that can pay dividends would typically provide more cash value growth.⁶ At the same time, you had no risk of loss in a terrible year for the market, so even 0.6% growth was likely better than other market investments you may have held. Assuming you made no adjustments to your allocation, here’s what would have happened the next year:

2023 IUL cash value performance (S&P 500 up 24.2%)

Over this unusually volatile two-year span, your average cash value growth rate would have been close to 5%. That’s still typically better than a standard universal life policy, with much less investment risk than a variable universal life policy.

However, it’s important to remember that this example shouldn’t be taken as “typical.” There are a large number of variables that would have altered the 2-year performance outcome, including but not limited to the policyholder’s decisions regarding premium amounts and cash value allocation; the policy’s cap, floor, participation rate, and fixed interest rate; and of course, the performance of the reference index, not to mention the expenses deducted for the cost of insurance.

Index universal life insurance pros and cons

Index universal life offers flexible premiums, permanent protection, and the potential for accelerated cash value growth because gains are tied to a market index instead of a fixed interest rate. At the same time, downside protection is provided by minimum crediting guarantees. Those advantages come with trade-offs: growth is not guaranteed, upside is capped, policy charges and required minimum premiums can constrain cash value accumulation, and the death benefit can be adjusted down if the contract is underfunded or performs below expectations. These are not “set-it-and-forget-it” financial instruments: Diligent long‑term funding and monitoring are essential.

How indexed universal life compares to other options

Indexed universal life versus term life insurance

Term life is the simplest form of life insurance. With a typical term policy, you pay a set monthly premium for 10, 20, or 30 years, and if you pass away during that term a death benefit is paid to your family. The downside is that the coverage is temporary, with little flexibility to deal with changing circumstances, and there’s no cash value. Bottom line: Term life and IUL policies are designed to meet very different coverage needs.

Indexed universal life insurance versus whole life insurance

Both types of policies provide permanent life insurance protection with a cash value component that can grow over time, but indexed UL (like other UL policies) provides more flexibility by allowing you to raise or lower your premium payments. In addition, IUL policies let you link your cash value growth to one or more market indices to speed growth while still limiting downside risk. These are positives, but there are downsides also: IUL policies are much more complex and need to be actively managed by the policyholder. Whole life insurance policies are much simpler in comparison, with level premiums, more cash growth guarantees and fewer (if any) investing options. However, whole life policy premiums tend to be more expensive, especially compared to the minimum amounts in an IUL policy.

IUL versus standard universal life and variable universal life

IUL policies offer the same permanent coverage and premium flexibility as the other types of universal policies, and all can be customized with valuable riders that can add living benefits, premium waivers, accidental death protection, and more. The difference comes down to how cash value grows. Indexed UL offers more growth potential than a standard UL policy, but less growth potential than a VUL policy.

However, protection from downside risk is another matter. A standard UL policy guarantees cash value growth, but in an IUL policy only the amount allocated to a fixed-value option is guaranteed to grow; the amount linked to a market index won’t grow if the market performs poorly. Finally, an IUL policy has less downside risk than variable UL which has no performance floor to limit losses.

Indexed universal life versus 401(k) plans

Like all other forms of life insurance, the primary purpose of an indexed UL policy is to provide the financial protection of a death benefit if the policyholder passes away unexpectedly. So while the comparison to 401(k) plans (and IRAs) isn’t exact, indexed UL policies can be attractive for high-income individuals who have maxed out their 401(k) or other retirement account contributions: because these policies don't have contribution limits, they can provide additional tax-deferred growth potential with market-based returns — and some insulation from market volatility.

Some tax implications to consider

Indexed UL policies offer several tax advantages, starting with the fact that cash value grows on a tax-deferred basis, allowing for greater growth over time. You also get tax-efficient access to cash value through withdrawals or policy loans, which are generally income tax-free. Also, the death benefit is generally income tax-free to the beneficiaries, which can be a significant advantage for estate planning purposes.

There are also important tax downsides that policyholders should be aware of. For one, if the policy lapses or is surrendered with an outstanding loan, the loan amount may become taxable. You should also know about the “IRS 7-Pay Test.” If the cumulative premiums paid during the first seven years exceed the amount needed to have the policy paid up in seven level annual payments, the policy becomes a Modified Endowment Contract (MEC). If that happens, it loses some of the tax advantages with respect to loans and withdrawals. Bottom line: If you choose to purchase an IUL policy it’s important to consult a financial advisor who can help you maximize the tax benefits while complying with IRS regulations.

Is indexed universal life insurance right for you?

Many people consider indexed universal life insurance to be a “hybrid” financial product, part life insurance policy, part investment vehicle. It has distinct advantages — including premium flexibility, tax-deferred growth, and the potential for faster cash value appreciation than some other policy types — and drawbacks, including complex structure, multiple fees, and the need for active management by the policyholder.

An IUL policy can be an excellent fit if you’re interested in permanent life insurance coverage coupled with an opportunity for above-average cash value growth. If you’ve already maxed out your 401(k) or IRA contributions and want another tax-friendly way to grow your assets, an IUL can be an advantageous vehicle for doing so — and down the road it can also help with your estate planning or wealth transfer goals.

That said, IUL policies aren’t for everyone. If you want straightforward asset growth or low cost life insurance, an IUL policy probably isn’t the right choice. Investors who prefer simple, low-fee vehicles may do better with index funds. And someone who’s looking for the largest death benefit at the lowest price will likely find term life a better deal. Plus, an IUL policy requires ongoing attention, so it isn’t a good fit for anyone who’d rather “set-it-and-forget-it.”

Guardian can help

If you think the advantages of an IUL policy could be a good fit for your needs, you should explore your options with a professional who specializes in permanent life insurance. If you don’t know such a person, consider asking a friend or colleague for a recommendation. Or, Guardian can put you in touch with a nearby financial advisor who will listen to your needs and help guide you to a solution that fits your goals.