This blog goes into depth on Indexed Universal Life Insurance. Indexed Universal Life can come across as a complex financial instrument. However, by reading this blog, you will have a much better idea of how Indexed Universal Life works, and you should have a better idea of whether it is right for your situation.
Are you having a hard time deciding on what type of life insurance to purchase? As you can imagine, there is a reason why there are different types of life insurance, as each type of life insurance serves a different purpose. Therefore, it would be foolish to say that everybody should buy term, or that everybody should buy permanent life insurance. This series of articles explain the different options you have when it comes to life insurance.
The Basics of Indexed Universal Life
Indexed Universal Life is a unique type of cash value life insurance policy that offers downside protection from cash value losses and upside growth potential up to a certain cap. However, in recent times, carriers have found solutions that offer uncapped growth potential. More on that later.
Carriers who offer Indexed Universal Life typically have multiple different strategies that you can choose from. The strategies are tied to different stock market indices where you can allocate your premium payments or your already present cash value. The most common index is the S&P 500, but many carriers offer other indices such as the Euro Stoxx 50, Russell 2000, among many others. Each month, you have the choice of where you would like to allocate your funds. Usually, you have the option of allocating into a fixed account (guaranteed ~2-4% returns as of December 2022), or into a variety of different indices. On a set day each month, the insurance carrier will purchase options of the index of your choice at a start point, and allocate the rest of the premium payment or cash value into their own fixed account. Over the next year, the money in the insurance company’s fixed account will accumulate back to your principal cash value, and depending on whether the index of your choice achieved growth, you would capture the growth of the index through the options the carrier purchased. Here is an example of what that might look like.
Example:
On the 15th of every month, Insurance Company A purchases options of the strategy that Tom, an Indexed Universal Life policyholder, requests. Tom has $10,000 allocated in the month of May, and decides to allocate his funds in the standard S&P 500 strategy. On May 15th, Insurance Company A takes around 95% ($9,500) of the total value, and allocates it into their own fixed account that is set to earn interest over the next year to return the principal value back to $10,000. Also on May 15th, the S&P 500 was trading at 4,000, giving Tom that value as his start point which his crediting amount will be based off. The remaining 5% ($500) is used by Insurance Company A to purchase options, giving Tom growth potential should the index grow. For the sake of the example, the current standard S&P 500 strategy offers a 0% floor and a 10% cap.
Fast forward one year and the S&P 500 closed at 4,600. 4,600 means that the index grew by 15%, crediting Tom the full 10% up to his cap. Therefore, his $10,000 initial value grew by $1,000 up to $11,000. Should the S&P 500 have dropped down to 3,700, Tom would receive 0% crediting, and his cash value would be back to $10,000 thanks to the insurance company’s fixed account. A S&P value of 4,200 and Tom would have been credited 5%, earning him $500, leaving his cash value at $10,500.
What Determines Caps?
The caps offered by an insurance company is linked to the current interest rate environment. When interest rates are higher, an insurance company will earn more money from their fixed account. Therefore, instead of allocating 95% of the cash value into the fixed account to grow back to the principal, they may only need 93%. This gives the insurance company more money to buy options. With more options comes more growth potential, hence higher caps.
The inverse is true when interest rates are lower. Lower return on the fixed account results in less available cash to purchase options. This leads to lower caps.
Uncapped Strategies
Uncapped strategies may come in one of two ways. One way is using a spread, and the other is through volatility controlled indices. The way a spread works is that an insurance company announces a spread for a certain index. If the spread is 5% and you picked the S&P 500 spread strategy, then you would receive the return of the S&P 500 minus the spread. Downside protection of 0% still applies. Therefore, if the index grows by 5% or less on the year, there will be no crediting issued. However, anything above 5% and the credit will be whatever the growth of the index is minus the 5% spread. This can be advantageous in bullish times, or when markets drop abruptly. We have had clients use spread strategies where they get credited over 60% on the month.
Volatility controlled indices are the other type of strategy that offer uncapped growth. The key difference between a spread strategy and a volatility controlled strategy is that instead of having a spread, the volatility controlled indices have participation rates. A participation rate of 100% means that if the index you choose grew by 10%, then you get credited 10%. However, with a participation rate of 200%, an index growth of 10% credits you 20%. Participation rates vary by strategy, but can exceed well over 200%. Over the past 10-15 years, some of these strategies have averaged 13-14% in crediting, making them extremely attractive.
Tax Advantages
Indexed Universal Life is taxed much in the same way as a Roth IRA. The growth inside of the policy is not subject to current taxation, and neither are the distributions you take from the policy as long as the policy stays in force. Many people use Indexed Universal Life as another source of retirement income, which is more predictable than a 401(k) where your money is exposed to the market and where you may not have paid taxes yet. Death benefit, like all other life insurance, is also distributed tax free to beneficiaries upon the insured’s death.
Reset Feature
An excellent feature of Indexed Universal Life is the reset feature. Although a sharp economic downturn will result in a 0% credit for a given year, the new start point for the following year’s segment gives the opportunity for tremendous growth, especially if you allocate your funds in an uncapped strategy. During market crashes where the overall market falls 20-50%, unlike people who are exposed to the market, you do not lose money, and you can ride the market back up to its previous levels.
Application
Indexed Universal Life provides a permanent death benefit with downside cash value protection and upside growth potential. Other than death benefit protection, it can be a powerful asset to anybody who is looking for supplemental retirement income, wealth accumulation, estate planning, infinite banking, etc. If you are looking for life insurance, why not take advantage and grow your wealth in a policy that offers you downside protection?
Interested in Indexed Universal Life? Contact us today!
(559) 322-2230
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