Indexed Universal Life Insurance
Indexed universal life insurance is permanent life insurance that possesses the same features as universal life insurance but adds one additional feature – the investment performance within the cash account is tied to a financial index. Most often, the index will be based on equity performance, although there is no reason why any financial index could not be used.
Basic Features of Indexed Universal Life Insurance
Universal life insurance differs from other forms of permanent insurance, such as whole life insurance, in providing a great deal of flexibility in the timing and amount of premiums. Once value begins to accumulate in the cash account (which may take two or three years), the policyowner can use accumulated cash to pay premiums. The death benefit is also flexible. If the policyowner chooses to draw down the cash account, this will reduce the amount of the death benefit. Alternatively, the policyowner can augment cash value by paying additional premium and add value to the death benefit as well. Premiums can be paid monthly, quarterly, or annually.
Unlike whole life and regular universal life insurance, indexed universal life insurance allows the interest credited to the cash account to fluctuate in accordance with a market index of financial performance such as the Standard & Poor’s 500. Changes in the index are not fully reflected in the credited interest rate; the amount of index change transmitted to the cash account is determined by a parameter called the participation rate. For a 10% increase in the index, a participation rate of 75% would yield a credited interest rate of 7.5%. The participation rate is one of several key features of indexation, all of which are specified in the insurance contract.
The credited interest rate may also be affected by the annual cap on earnings, which specifies a maximum allowable rate of return. The contract also specified a minimum rate of return – usually zero – which prevents a decrease in the index from reducing the principal value in the cash account. The contract usually allows these key parameters – participation rate, maximum and minimum rates of return – to be changed annually, at the discretion of the insurance company.
Advantages of Indexed Universal Life Insurance
Indexed universal life offers various advantages. Some derive from the indexing feature; others are common to all forms of universal life insurance.
Indexation developed as a way of benefitting from gains in market performance without assuming the burden of active management. An index is an average of the elements surveyed. The buyer of an equity index displays a willingness to settle for the average rate of return of the firms whose performance is captured in the index. Even professional managers find it difficult to pick stocks well enough to consistently beat the stock-market averages, so the purchase of an indexed security is a reasonable choice. On the risk/return spectrum, indexed assets are less risky than an actively managed portfolio but with less upside potential. Variable life insurance, in which the buyer selects and manages the investment portfolio, carries more risk and more potential gain than does indexed universal life. The buyer of indexed universal life does not receive a guaranteed return, as does the holder of a whole-life policy. Whole-life policies offer an internal rate of return roughly equal to that of fixed-income securities, so indexed universal life insurance falls in between variable and whole-life insurance on the risk/return spectrum.
Permanent insurance offers several tax-related advantages. The investment gains of indexed universal life insurance accrue tax-deferred. The death benefit is almost always tax-free to the beneficiary. (If the policy is part of the estate, estate taxes could be levied.) The policyowner can take out a loan against the cash value of the policy and receive the proceeds tax-free. The loan can either be repaid or liquidated by the death benefit.
The Security of Indexed Universal Life Insurance
Although the cash value account lacks the guaranteed return associated with whole life, the policy owner’s principal value is protected by the minimum guaranteed interest rate. Although the death benefit may fluctuate, it is guaranteed. As usual, all payout guarantees are backed by the financial strength of the insurance company. At least four major ratings agencies rate the financial strength of insurance companies and publish their results.
Suitable Candidates for Indexed Universal Life Insurance
Any candidate for permanent insurance might be a candidate for indexed universal life insurance. The best candidates are those who get the most value out of the special features that this insurance provides. Flexibility of premium is most valuable to those who would otherwise struggle to make the necessary premium payments. Young families - particularly large families – with relatively low incomes find universal life insurance attractive. Their insurance need is high and they are likely to want growth in their investment portfolio, so the indexation feature would be useful to them.
At the other end of the income spectrum, indexed universal life insurance is an attractive way of supplementing retirement income for high-income households nearing retirement. These households often need further tax shelter after maxing out contributions to qualified retirement plans. Life insurance contributions fit this bill, since their investment gains accumulate tax-deferred. (In order for them to escape taxation altogether, the estate tax must be surmounted; death benefits are included in an estate and may well be depleted by estate taxation.) Moreover, the IRS penalty on withdrawals prior to age 59 ½ and the requirement to take distributions no later than age 70 ½ also will probably not apply. The policy may also carry a total-disability benefit rider to reduce the risk of total income loss just prior to retirement. This strategy is diametrically opposite to that of the young, low-income households; the idea is to “overfund” insurance need to build the maximum cash value. This value can be tapped with eventual tax-free withdrawals and/or loans.
Several caveats accompany this strategy. Contributions should fall short of turning the policy into a modified endowment contract, which would greatly reduce its tax benefits. Surrender charges will likely apply to withdrawals in the first 10 years of the policy, so policyholders should plan on taking out the policy a decade or so prior to retirement and contributing long enough to outlive surrender charges. Lapse of the policy would convert outstand loans into taxable income, turning the tax shelter into a tax headache. The death benefit will be reduced by withdrawals and loans outstanding at death.
Drawbacks of Indexed Universal Life Insurance
Indexed Universal Life Insurance is permanent insurance and shares the drawbacks of that class, such as the high premiums necessary to keep the policy in force. As a species of universal life insurance, it has the capability to overcome some of these inherent limitations – but not all at the same time. The policyholder will typically face a choice between reducing cash value to pay premiums – fully funding insurance need and keeping the policy in force – and paying high premiums to maximize cash value. The policyowner should choose the higher priority – full satisfaction of insurance need or investment return.
Indexed universal life insurance exemplifies the unusual flexibility of universal life insurance in general. Its risk return properties make it attractive to both young policyholders and older ones nearing retirement. Premium flexibility is likewise beneficial to both young and old alike if they require either a secure satisfaction of insurance need or growth of cash value. Indexation is a means of enjoying potential market gains without bearing the burden of active investment management. Its minimum guarantees are in keeping with the philosophy of insurance-related products.
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