Indexed Universal Life vs. IRA and 401(k)

The Debate Over Indexed Universal Life Insurance Policies

Even the most cautious investors find it difficult to remain on the sidelines when the stock market is experiencing a bull run. This could explain why indexed universal life (IUL) insurance is becoming more popular. While indexed universal life insurance is popular, it is also one of the most divisive.

IUL, like other permanent life insurance plans, includes both an insurance component and a cash payout that policyholders can use as needed. However, there is a significant distinction. Rather than crediting a policyholder's account with conservative bond funds, insurers link it to a stock index such as the S&P 500.

Some financial experts advise clients to avoid buying whole life insurance altogether, citing the ancient adage "purchase term and invest the remainder." The dispute about IUL, on the other hand, is very heated. The sales techniques surrounding this type of insurance have even been brought into question by New York's top insurance regulator.

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TAKEAWAYS IMPORTANT

• IUL contracts give some equity risk premium while protecting against losses.
• Although there is no cap on returns, IRAs and 401(k)s do not provide the same downside protection.
• IULs feature perplexing terms and alarmingly hefty fees (which eat away at returns significantly over time).
• IULs may not be a suitable fit for anyone who isn't a high-net-worth individual trying to save money on taxes.
• Rather than buying IULs, many investors would be better served buying term insurance and maximizing their retirement plan contributions.

What Makes IUL Policies Work?

One of the key benefits of indexed universal life is that it allows policyholders to participate in the stock market while also protecting them from losses. Owners will see a proportional increase in their account if the underlying stock market index rises in a given year.

The phrase "proportional" is crucial here. Insurance companies utilize a formula to determine how much to credit your cash balance, and while that formula is linked to the performance of an index, the credit amount is usually always smaller. If the market rises 10% over the course of a year, your cash balance may only rise by 7% or 8%.

The Expensiveness of IUL Policies

There's also a credit limit, which means your account can't increase too much if stocks have a good year. The normal upper limit on account credits is 12 percent, according to Sheryl Moore Moore Market Intelligence. So, even if a benchmark index like the S&P 500 rises 20%, your gain could be a fraction of that.

For some consumers, that may be a price they are ready to pay in order to reduce their risk of losing money if the market turns against them. Many IUL plans feature a guaranteed minimum credit rate of 0%, which indicates that your account will not lose value if equities take a sharp drop (at least theoretically).

However, prospective policyholders should consider the famously high costs of permanent life insurance, such as administration fees and surrender charges. Sales commissions are exceptionally high, potentially absorbing the entire first year's premiums. Following that, sales commissions are often maintained at roughly 5% each year until dropping off. As a result, it's possible that your account's cash balance won't start to rise for years.

Salespeople make far less money selling term plans, which provide a death benefit but no cash value. One of the reasons why some agents are more likely to promote universal life policies is because of this.

IUL Contracts: An Overview

When it comes to IUL rules, you should also examine the complexity of the contracts you're signing. Many investors are unaware that they frequently include terms that allow the insurer to change the rules of the game at any time. Some rules, for example, allow a corporation to lower its return cap in order to strengthen its balance sheet.

Some critics claim that the sales pitch used to entice clients to buy indexed items might be as perplexing. Illustrations showing how much policyholders could gain under different market situations are sometimes used by sales people. However, the business has been chastised for depending too heavily on optimistic forecasts that will almost definitely never materialize.

Is IUL Really Worth It?

Is there anyone who would plainly benefit from a universal life policy that is indexed? If you have a high net worth and don't want your family to incur a large tax burden after your death, there is a case to be made for having one. For such people, irrevocable life insurance trusts have long been a favorite tax shelter. 6 If you fall into this category, you should see a fee-only financial counselor to see if permanent insurance is a good fit for your entire strategy.

For almost everyone else, however, there are few compelling reasons to pick IUL over term insurance, especially if you haven't yet reached your retirement contribution limit.

IRAs and 401(k)s

IRAs and 401(k)s are two different types of retirement savings accounts. Pre-tax or post-tax money is deposited into the accounts and invested to build a retirement nest egg. 401(k) and some types of IRA earnings grow tax-free, but taxes must be paid when the money is withdrawn.

Contribution matching from a participant's employer is occasionally available with retirement savings accounts. 401(k) and IRA accounts with no-load funds and typical annual expense ratios of approximately 1.5 percent start to look like a considerably cheaper alternative to IULs when compared to the high fees of IULs. Because the fees are negotiated by a major firm sponsor on behalf of multiple members, some investment options within retirement plans may have even lower fees.

The Bottom Line 

Investment income does not have a maximum, but it also does not have a set floor. Smart investment with adequately diversified assets, on the other hand, can drastically lower the risks.

Saving for retirement, purchasing a less expensive term life insurance policy, and investing the remainder in a 401(k) or IRA is a wise choice for most people. In most circumstances, the fees that chip away at your return will be significantly lower. Plus, with an IUL contract, you won't have to worry about the fine print.