Choosing a type of life insurance can be complicated. There is term insurance and whole life insurance. Indexed Universal Life is a type of whole life insurance. It is sometimes presented by agents as a type of investment with market upside potential without downside loss. This is catchy because who would not want an investment that only has upside potential?
Most things you will read about Indexed Universal Life are negative and for good reasons. Furthermore, whole life insurance policies are generally a bad decision. I would be in agreement with this, but it is important to understand that if you are in a rare situation it may be useful.
There are pros and cons to having an Indexed Universal Life policy. I will cover both of them and concentrate on the con’s as this will apply to almost everyone, except those rare situations I mentioned. These scarce situations need to have all the stars aligned in the universe for it to be right and you will see why.
What is Indexed Universal Life?
First, I think it is important to explain what Indexed Universal Life Insurance is. To say the very least, it can be complicated. Even the people that sell it often do not have a firm grasp of how it entirely works. Here is a simple explanation.
Indexed Universal Life is a type of whole life insurance that has both a death benefit like life insurance and cash accumulation similar to investing. The index part has to do with cash in the policy tied to a market index, such as the S&P 500. Premiums are paid to the policy just like life insurance. Part of this premium goes to the cost of life insurance. The other portion used as investment savings. For example, a monthly premium of $400 one hundred of this may go into the insurance. The remaining $300 goes into the index (as well as expenses).
As cash value builds in an indexed policy it can be used to pay for the insurance premiums. This is partly how they are communicated to the buyer. This is great as long as there is sufficient cash accumulation. Also, these policies are often sold with the explanation of being taxed advantaged. This is true. Tax laws favor insurance premiums and it can be a good way to protect assets. Yet, these policies are only good for very few people and there are many reasons why.
Where does the upside potential come from with no downside that is communicated by buying one?
The return guarantees presented with Indexed Universal Life is true. They often have for example a guaranteed return of about 2% even in a down market. However, they also often have a cap at which they can gain in upmarket years. This is how they are able to offer the guarantee in a down market.
Having a guaranteed return on the cash accumulation sounds good right? Not really and here are reasons Universal Indexed Life is not a good choice for the majority of people.
Reasons Not to Buy Indexed Universal Life
It can be extremely expensive
The cost of the insurance in combination with administrative fees and commissions for the deal really add up. Depending on the premiums and the death benefit for the policy, the so-called cash accumulation may not even really begin to start until several years after the policy begins. The beginning years all of the fees eat away at the premiums.
If you decide you want to get out of the deal there most likely will be surrender charges. A lot of companies you may need to have a policy for at least ten years before there is no surrender charge. Again, there is a reason these life policies have guarantees. The insurance company is going to make sure they do not lose. With surrender charges, this ensures it will not happen.
The cost of the insurance portion will increase as a person gets older. Many times, the seller of these policies will state when the cash grows it can then be used to pay the premiums. This is true. But it can quickly deplete a policy depending on the cost of insurance and market performance over time.
Likely will not beat market returns
No one has a crystal ball on how the market is going to perform, although some people may claim to have one. However, statistically, over a long period, the market tends to average about 7%-9% conservatively. It could do better or worse. If there is a cap on a policy say at 8%, with the fees and expenses this will turn out to be much less.
You can take loans, but they are subject to interest
The cash accumulation is one of the selling points of an Indexed Universal policy. People are told they can take money out if needed. This is true, but it may be subject to interest. Withdrawals will also decrease the policy death benefit.
You are like most people and not extremely wealthy
Whole life policies, in general, are not designed for middle-class America. They favor the wealthy due to the tax advantage protections for assets so they are not subject to estate taxes. It would not surprise me if they were specifically designed for this, but that is another story.
As you can see, for most people Indexed Universal Life does not sound quite as good as it is often explained from the sales side. But it is made for more affluent people. The reasons to buy one is just not a category most normal people fall into.
When might it make sense to buy an Indexed Universal Life Policy?
There is a reason most smart financial gurus will tell people not to buy a whole life policy. The reason is the majority of people do not come close to even having to think about it or consider looking into it. There is really no cookie cutter math to consider a Universal Life Policy, but being wealthy with large assets is a qualification.
If you make for example 250 thousand dollars a year and expect to continue making this amount or it increasing, an Indexed Universal Life policy may be something to look into. This is after all other investment accounts have been maxed out that may have tax savings. Investors with really good cash flow in a high tax bracket can indeed benefit from the cash accumulation potential in a whole life policy. It would enable them to take advantage of the tax benefits at retirement. Being in a very high tax bracket at retirement the fees and expenses in an Indexed Universal Life policy would be the cost of saving at tax time.
What do you do if you are not wealthy?
The first thing you should never do if you do not have a cash accumulation problem is do not buy any type of whole life insurance policy. This includes an Indexed Universal Life policy. Do not fall for the sales tactics of buying one with the guarantees of only upside gains and no downside.
There is a reason that insurance companies own just about all of the tallest buildings in the world and sponsor what seems to be like every sporting event. They do not lose and they will always make a big profit. Their actuaries that calculate insurance probabilities may be close to having a crystal ball and telling the future.
If you need insurance, buy term insurance
Term insurance is just insurance. There is no cash value, but it is much less expensive than whole life insurance. Buy term insurance and then invest the difference. If you are looking for something tax-advantaged, invest the difference in a Roth IRA each year. There are income limits for this RothIRA.com, but they are higher than than the average income for most people.
The great thing about term insurance is not only the affordability, but there are no surrender charges. It can be canceled when you want to do so. Also, there are no startup costs. Unlike whole life insurance where the death benefit grows with the cash accumulation, the amount of insurance purchased is the amount you have for the term.
If the difference is invested in a Roth IRA, you can take out the original contributions at any time tax and penalty free. You can’t take the earnings unless you are 59 ½ and the account is five years old, but this is okay if it isn’t. Everyone has the possibility of running into a jam. This at least allows access to some of the money without interest or penalties compared to a whole life policy.
Save smart, become debt free, and build wealth
To sum it all up, Indexed Universal Life policies are not something the majority of people need. This holds true for whole life insurance policies in general. Buying term insurance and investing the difference is a better alternative for both insurance and saving money.
Hopefully, this information will help to better understand an Indexed Universal Life policy. As I previously mentioned, they can be complicated and often they are sold to unsuspecting buyers with statements of only upside earning potential with no downside. Also, they are tax-advantaged. These statements may be true, but keep in mind whole life policies were built for wealthy people. At least this is my opinion.
If you are ever considering an Indexed Universal Life policy or any whole life policy, make sure to seek financial professional advice. Do not just do it one time. Get some different opinions on it and at least three of them.
Having an Indexed Universal Life policy can be beneficial in the right circumstance. But it is important to max out all other alternatives first. Getting debt free and building wealth may just put a person in that rare circumstance to possibly consider whole life insurance. This would then be a good problem to have, but it should not be a problem even considering one for most people.
