I have received a few questions recently regarding indexed universal life (IUL), so I thought I’d write an article about it.
First and foremost, it is a universal life policy. That means that both the premium and the death benefit are flexible, i.e., they can be adjusted (within certain parameters) by the policy owner. The primary difference between universal life and IUL is the manner in which interest is credited to the policy.
With universal life, the interest rate is set by the carrier and can be changed at any time. Premiums are deposited into the policy and after fees, expenses, and mortality charges are deducted, the balance is credited with the current interest rate. Regardless of how often (or whether) premiums are paid, charges and interest are applied monthly.
IUL works the same way, except that the interest rate, instead of being set by the carrier, is determined by an external index, most commonly the S&P 500. The index is measured at the beginning of the period and the end of the period, and the percentage change is applied to the account value, subject to cap rates, participation rates, and floors.
Virtually all IULs have a zero percent floor, meaning that if the index decreases, the account value will earn zero interest, but will not participate in the loss. From a psychological perspective, that is very powerful; having upside potential with downside protection. Unfortunately, it’s not that simple.
As previously stated, charges are deducted monthly. In a period when the index decreases, the account will also decrease unless the premium paid and the interest credited in that period exceed the charges for that period.
Additionally, when the index increases, very rarely is the entire increase credited to the policy. Almost all policies limit the increase by imposing a cap and/or a participation rate. Today, most caps fall between 10 and 13%, although some policies have caps that fall outside that range. Participation rates also have a wide spectrum, but it seems that 70% is a common one.
As an example, let’s assume a policy has a 12% cap, a 70% participation rate and a 0% floor. If the index increased by 20%, the crediting rate would be 12%, because 70% of 20 is 14%, but it is capped at 12%. If the index increased by 15%, the crediting rate would be 10.5% (15 x .70 = 10.5). If the index decreased by 10%, the crediting rate would be 0%, as that is the floor.
While there is nothing intrinsically wrong with IULs, in my opinion, there is a problem with the manner in which they are being illustrated. That problem, again, in my opinion, is that there is a huge probability that the actual policy performance will be less than the illustrated performance.
This is just meant to be an overview, a very simplistic explanation of a very complex product. Should you have any questions, please call or email.