Indexed universal life insurance

There are two main types of permanent life insurance that, unlike term life insurance, provide permanent death benefit protection coupled with a cash value component that grows tax-efficiently. Whole life insurance offers more guarantees, with premiums and a death benefit that are fixed for life, along with a guaranteed rate of cash value growth.^1,2 However, universal life insurance (or UL) can be a more cost-efficient alternative, because premiums are flexible: you can raise or lower your payments within certain limits set by the policy (which can also impact the death benefit amount).³

Indexed universal life (or IUL) is a variation of universal life for those who want premium flexibility with the potential for greater cash value growth that’s tied to a market index, unlike regular UL, which can grow at a guaranteed crediting rate.⁴ Indexed UL also offers more downside risk protection compared to another type of policy called variable universal life or VUL, which lets policyholders invest more directly in market-type securities while assuming all investment risk.⁵ Indexed UL balances protection, risk, and reward in a way that works for many, but is it right for you? This article can help by answering key questions:

• What is indexed universal life insurance?

• How does cash value grow?

• What are the pros and cons of indexed universal life?

• How do you buy it?

What is indexed universal life insurance?

To better understand how this type of UL works and the benefits it can provide, it helps to get some context by reviewing the other main types of universal policies – standard and variable UL.

As we’ve noted, a standard universal life policy (sometimes called fixed-rate UL) provides permanent, lifelong death benefit protection plus a cash value component. It also lets you to raise or lower your premium payments within a certain range – and at the low end of that range, premiums may be comparable to term policy premiums. The death benefit is also adjustable. Flexible premiums may have appeal for people with fluctuating incomes, because it makes the advantages of permanent coverage more easily attainable. These UL policies can provide guaranteed cash value growth similar to a whole life policy, while providing the same kinds of tax deferral, policy loan features, and death benefit.⁶ But it’s also important to note that minimum premium payments means less cash value for growth, and expenses can ultimately erode its value, resulting in a need to pay higher premiums in later years and/or death benefit reductions to keep the policy in force.

The key difference between standard UL, Indexed UL and Variable UL lies in how cash value accumulation is calculated. In a standard UL policy, the cash value is guaranteed to grow at an interest rate based on either the current market or a minimum interest rate, whichever is higher. So, for example, in a standard Guardian UL policy, the annual interest rate will never go lower than the current minimum rate, 2%, but it can go higher.

People looking for potentially higher returns sometimes choose a variable universal life (VUL) policy instead. These policies give you the option to tie cash value growth to “subaccount” investment funds. These policies are sold by prospectus and the insurance company gives you the performance history and fee information, and you can decide how much of your cash value to invest in each option.

With potential reward comes risk: growth in a variable UL policy is not guaranteed the way it is in a standard UL policy. With VUL, funds in your subaccounts are subject to market risk: In a good year for the market, the value of your subaccounts (and cash value) can rise. In a bad year, the subaccount value can and will decrease.

Indexed UL splits the difference: it provides more growth potential than standard UL, with less investment risk than VUL

These 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.⁷ 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 losses either. Since the floor is usually set at 0%, in a down year for the markets your cash value amount will remain steady or even grow slightly (because some policies set the floor above 0%).

Key features of an indexed universal life policy

• Permanent, lifelong coverage, as long as premiums are up to date)

• Flexible premiums, within limits defined by the policy

• Income tax-free death benefit for beneficiaries, which may adjust in value⁸

• Tax-efficient cash value growth, tied to the performance of a market index

• Cash value allocation options, for example, in different indexes as well as a fixed interest option

• Minimum interest rate guarantees, also called a "floor" that limits risk

• Caps on gains, typically around 8%-12%, sometimes combined with a “participation rate” limit

How cash value grows in an indexed UL life insurance policy

First of all, you have to choose how you want your cash account to be allocated for growth. Each insurance company has its own selection of indices available, 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.

The cap is usually max credit for a specified segment of index participation. Most policies have annual caps, but some policies may have monthly caps. Caps can change at the end of any segment.

Additionally, upside performance can be impacted by a “participation rate” set as a percentage of the index’s gain. For example, if the reference index rises 10%, and the policy’s participation rate is 50%, the amount allocated to the index would grow by 5%. Most Indexed UL policies have a participation rate set at 100% (meaning you realize all gains up to the cap), but that can change.

So, what would actually happen to the cash value in your account in a good year? And what about a bad year?

Here’s an example 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 2008⁹; the next year, 2023, the index gained it all back and then some with an overall rise of 24.2%.¹⁰

We’ll assume you started with $10,000 in your cash account on Jan. 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%. And 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 almost always provide more cash value growth.¹¹ 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

Compared to other universal life policies, an index policy offers the same permanent coverage and premium flexibility features, with the following basic differences based on the cash value growth calculation:

• Upside potential – Indexed UL offers more growth potential than a standard UL policy, but less growth potential than a variable UL policy without performance caps

• Downside risk – While a standard UL policy guarantees cash value growth, in an index UL policy only the amount allocated to a fixed-value option is guaranteed to grow – if the reference index drops, it won’t grow at all (assuming a 0% floor or guaranteed minimum interest rate); however, IUL has less downside risk than variable UL (and other variable life insurance policies) which have no performance floor to limit subaccount losses.

Indexed universal life insurance vs. whole life insurance

Both types of policies provide permanent life insurance protection with an cash value component that can grow over time, but indexed UL (like other UL policies) provides more flexibility to deal with changing circumstances by allowing you (the policyholder) the option of raising or lowering your premium payments. In addition, with most IUL policies, the life insurance company gives you one or more index-based options that can help your cash value grow faster while still limiting your downside risk. But there are downsides as well: IUL policies are more complex, the cash value growth and the expenses are decoupled, so the cash value needs to be managed to some degree, if only to ensure that your cash value doesn’t drop below a minimum threshold. Your cash value can stop growing and, in some cases even go down if the expenses exceed the cash value growth, especially if you only make minimum premium payments. This could force you to make higher payments later on, lower the death benefit amount, or forego your coverage altogether.

Whole life insurance policies are much simpler in comparison, with level premiums, more cash growth guarantees (albeit with less upside potential), 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.

Indexed universal life vs. term life insurance

Term life is the simplest form of life insurance protection: 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 the coverage is temporary, with little flexibility to deal with changing circumstances, and there’s no cash value. Typically, the only substantial change you can make after your term policy is in effect is to convert it to a permanent policy, which you can also do with UL policies.

By contrast, indexed UL gives you a more flexible – and complex – financial tool with benefits that can last a lifetime. You get permanent life insurance protection with the option to lower your premiums (within contract limits) to a level that may be comparable to a typical term premium. You get the advantages of cash value with the potential for greater growth (compared to other kinds of permanent life) along with the assurance of a performance floor that can help reduce risk. IUL (like a whole life policy) can also provide tax-efficient estate planning benefits not available with temporary term coverage.

Indexed universal life vs. 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. Having said that, indexed UL policies can be particularly attractive for high-income individuals who have maxed out other retirement accounts. IUL policies don't have contribution limits, allowing for additional tax-deferred growth potential with market based returns – and some insulation from market volatility.

Some cost and tax implications to consider

Indexed UL policies offer several tax advantages, starting with the fact that cash value grows on a tax-deferred basis, so you don't pay taxes on the gains as they accumulate within the policy, allowing for greater growth over time. You also get tax-efficient access to cash value through withdrawals (up to the amount of premiums paid into the policy) or policy loans, which are generally income tax-free. Also, the death benefit paid out is generally income tax-free to the beneficiaries, which can be a significant advantage for estate planning purposes.

However, there are also important tax implications 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 (or MEC). If that happens, it loses some of the tax advantages associated with life insurance policies with respect to loans and withdrawals. So it’s important to consult a financial or tax professional that can help ensure you maximize the benefits of your IUL policy while staying compliant with IRS regulations.

Also, because indexed UL policies are somewhat complex, there tend to be higher administrative fees and costs compared to other forms of permanent life insurance such as whole life. So make sure you understand all the costs – and potential advantages – before finalizing your policy.

Is indexed universal life insurance right for you?

An IUL policy can be a powerful addition to your overall financial strategy – especially if you are a high-earner looking for additional tax-efficient savings vehicles. If you think it could be the right life insurance policy for you, we suggest getting professional guidance. Discuss your situation with a financial professional experienced in helping people get permanent life protection. If you don’t know such a person, ask a friend or colleague for a recommendation; or Guardian can put you in touch with a nearby financial professional.