Index Universal Life Pros and Cons – You’ve maxed out your 401(k) or IRA. Now what? You need additional retirement funds, but you don’t know what you can contribute to. Sure you could go through the complicated process of making non-qualified contributions to your IRA, but that comes with extra paperwork and the risk that you’ll lose the documentation you need to prove that you already paid tax on those extra contributions. Yuck.
At the same time, you desperately need life insurance – your term policy is about to expire and renewal rates look a little scary. What do you do? Well, assuming that you meet certain criteria, indexed universal life might just solve the majority of your problems.
How Indexed UL Policies Work
Indexed universal life insurance is a special type of universal life. You don’t know what universal life is? OK, here’s the short version. Universal life, sometimes referred to as “UL,” is a life insurance policy that combined elements of term insurance with elements of permanent (sometimes called “whole life”) insurance.
Premiums are paid into a cash account. From there, the insurance company deducts the cost of insurance and sets up a death benefit for you. The remaining funds are invested into the insurer’s general investment account, which typically pays a low fixed rate of return. Each month, you pay a premium, the insurer deducts the cost of insurance, and then invests the rest.
Over time, your cash value account grows as long as the cost of insurance doesn’t exceed your premium payments plus any interest credited to your account by the insurance company. If there’s ever a time when the cash account balance drops to zero, your insurance policy terminates. Otherwise, there are no strict premium payment schedules. You can increase premium payments (within certain limits), decrease payments, or even stop payments altogether.
Index Universal Life Pros and Cons
With indexed universal life, the insurer doesn’t invest your premium dollars into the general investment account. Instead, it uses a very precise mix of bond investments and index call options to pay interest based on the upward movement of a stock market index.
A call option is the right, but not the obligation, to buy a specific number of shares of a specific stock for a specific price within a specific time frame. For example, a stock option may give you the right to purchase 1,000 shares of Microsoft stock at $10 per share for the next three months. This contractual right to buy Microsoft may only cost you $500. So, instead of paying $10,000 for 1,000 shares of stock (i.e. 1,000 shares at $10 per share = $10,000) and hoping the price increases, you pay a paltry $500 for control over that stock for the next three months.
If Microsoft shares were trading for $9 per share, but jumped to $11 within the next three months, you would either exercise your option or sell it. With a right to buy the stock at $10 per share, you’re making a guaranteed profit of $1 per share if the stock moves to $11 per share. What if Microsoft stock doesn’t jump? What if it falls? Well, your option will expire worthless. You won’t make any money, but you’ll only lose what you paid for the option.
With an index call option, insurance companies buy the value of an entire stock market index (i.e. the S&P 500, the Dow, or the NASDAQ).
When the stock market moves up, the insurer sells the option or exercises it, and credits you with the majority of the gains, up to a specified interest rate cap or participation rate cap. For example, if the insurer sets an interest rate cap of 16 percent on its indexed UL policy, and the market moves up 7 percent, your cash value is credited with 7 percent.
If, however, the market jumps up 20 percent, you’re only credited 16 percent because of the 16 percent cap on interest gains.
Why would you accept this deal? Because, if the market crashes, you don’t lose a dime. That’s right, the insurer guarantees no losses in your cash value account. How can they promise this?
Well, remember, the insurer uses both index call options and bonds to secure investment earnings. Bonds pay a fixed rate of return that’s guaranteed. If the call options expire worthless, the bonds still credit you with interest and protect your cash value from any losses.
There are many advantages to indexed UL policies. First, you’re getting strong life insurance protection that will last your entire life as long as cash values outpace insurance costs. Second, indexed ULs are incredibly flexible. Death benefit amounts, premium payments, and even some core contract provisions can be changed almost at any time.
If you want to use the policy to supplement your retirement income, the insurer can schedule “minimum death benefit/maximum cash value.” This will encourage the policy’s cash value to grow at an accelerated rate.
If you prefer maximum death benefit, the insurer can schedule that as well.
The major disadvantage to indexed UL policies is that there are a lot of assumptions built into the policy. Insurers set interest rate caps, participation rate caps, and insurance charges that can all be changed at any time at the insurer’s discretion.
If the cost to buy the underlying index options rises, for example, insurers can reduce the amount credited to your cash value account – this could significantly impact your long-term cash value growth.
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Index Universal Life insurance may or may not be a good fit for your goals. It is a complicated product that may not give you the best value for your premium dollar. It’s possible that Term Life Insurance or Guaranteed Universal Life may provide to be a better fit depending on your circumstances.
Still, indexed ULs have a lot of potential. If you’d like to learn more about how these products work, and if they can work for you, contact us for a customized quote, or call us at 888-411-1329.
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