Introduction
Indexed Universal Life Insurance (IUL) policies are often marketed as a "have your cake and eat it too" financial product, promising both life insurance coverage and tax-advantaged investment growth. However, the reality is far less rosy. In this post, we'll dive deep into why an IUL is generally considered a poor investment choice for most people, explain the hidden risks and costs, and discuss better alternatives for both life insurance and investing.
This article covers the fundamental problems with Indexed Universal Life insurance as an investment vehicle, exploring its high costs, capped returns, and complex structure, while offering more effective alternatives for both life insurance coverage and long-term investing.
If you are new to AdvisorFinder
Welcome! If it's your first time on AdvisorFinder, we want to say hello 👋 Our mission is to help people make more informed financial decisions. Once you're finished with this guide on IULs, you might want to subscribe to our newsletter.
What is an Indexed Universal Life (IUL) policy?
Before we explore why IULs are problematic, let's quickly review what they are:
An IUL is a type of permanent life insurance that combines a death benefit with a cash value component. The cash value is invested in index funds that track market performance, usually with caps on both gains and losses.
Sounds great in theory, right? Unfortunately, the devil is in the details. 😈⬇️
Why IULs are often a bad investment choice
1. High fees and expenses
One of the biggest drawbacks of IULs is their complex fee structure, which can significantly eat into your returns.
Typical fees in an IUL policy include:
- Cost of insurance charges
- Administrative fees
- Premium expense charges
- Surrender charges
- Fund management fees
These fees can add up to 5-7% annually, meaning your investments need to perform exceptionally well just to break even.
2. Cap on returns
While IULs promise to protect you from market downturns, they also limit your upside potential. Most policies cap annual returns at 8-10%, meaning you miss out on the full benefit of strong market years.
For context, the S&P 500 has historically returned about 10% annually on average. By capping your returns, IULs essentially guarantee you'll underperform the market over the long term.
3. Complex and opaque structure
IULs are notoriously complex products, often with 100+ page contracts filled with confusing jargon. This complexity makes it difficult for the average person to fully understand what they're buying and how it will perform under different scenarios.
4. Potential for policy lapse
If the cash value of your IUL policy falls too low (due to poor market performance, high fees, or both), you may need to pay additional premiums to keep the policy in force. If you can't afford these extra payments, your policy could lapse, leaving you without life insurance coverage.
5. Misleading illustrations
Insurance agents sometimes use hypothetical illustrations to show how an IUL might perform. However, these illustrations often use unrealistic assumptions about market returns and policy costs, painting an overly optimistic picture.
6. Lack of flexibility
Once you've committed to an IUL, it can be difficult and expensive to change course. Surrender charges in the early years of the policy can be substantial, sometimes 10% or more of your cash value.
Main Risks of IULs
At the risk of sounding repetitive, we are including a detailed list of what could be considered the main risks associated with IULs.
- Limited gains: IULs typically cap your returns, usually between 8-10% annually. This means you won't fully benefit from strong market years. For example, if the stock market goes up 15%, you might only see an 8% gain in your IUL.
- No guaranteed returns: Unlike some other insurance products, IULs don't promise a specific return. Your cash value can go up or down based on market performance.
- Increasing costs: As you get older, the cost of insurance in an IUL goes up. This can eat into your cash value, especially if market returns are low.
- Risk of policy lapse: If your cash value gets too low to cover the policy costs, you might have to pay more premiums or risk losing your coverage.
- Hard to understand: IULs have many moving parts. It's tough for most people to grasp how these policies work without a financial expert's help.
- Higher fees: IULs often cost more than simpler insurance products like term life. These fees can significantly reduce your overall returns.
- Market risk: While IULs offer some downside protection, you can still end up with minimal growth if the market performs poorly.
- Tax complications: Taking money out of an IUL through loans or withdrawals can lead to unexpected taxes in some cases.
- Limited investment choices: With an IUL, you're restricted to the specific market indices offered by the policy. You can't pick individual stocks or other investments.
- No dividends: Unlike some other types of permanent life insurance, IULs don't pay dividends to policyholders.
- Potential for reduced death benefit: If you take out loans or withdrawals from your IUL, it could lower the death benefit your beneficiaries receive.
- Complexity in retirement planning: The variable nature of IUL returns can make it challenging to accurately predict your retirement income from the policy.
👉 here's our guide on Why Life Insurance is Not for Everyone
Unsuitable for most age groups and financial situations
IULs are often marketed as a one-size-fits-all solution, but they rarely suit the needs of different age groups and financial situations:
Young adults
Those just starting their careers typically benefit more from low-cost term life insurance and aggressive investing in tax-advantaged accounts. The high fees and conservative growth of IULs can significantly hinder long-term wealth accumulation.
Middle-aged individuals
People in their 30s and 40s usually have higher insurance needs due to family obligations. Term life insurance offers more coverage for less money, allowing them to invest the difference in more growth-oriented vehicles.
Near-retirees
Those approaching retirement generally need to focus on preserving wealth and generating income. The complex structure and potential volatility of IULs make them ill-suited for this purpose compared to more stable fixed-income investments.
High-net-worth individuals
While IULs are sometimes pitched as a tax-advantaged investment for the wealthy, there are often more efficient strategies available, such as maximizing contributions to tax-advantaged accounts and employing other estate planning tools.
In most cases, regardless of age or financial situation, individuals would be better served by separating their insurance and investment needs rather than combining them in an IUL policy.
Real-world examples of IUL underperformance
To illustrate the potential pitfalls of IULs, let's examine some real-world cases:
Case Study 1: The Disappointed Retiree
In 2010, John, a 45-year-old software engineer, purchased an IUL policy with a $500,000 death benefit and $15,000 annual premium. The sales illustration projected a cash value of $350,000 by age 65. However, due to market volatility, capped returns, and high fees, John's actual cash value at 65 was only $180,000 – nearly 50% less than projected. 📉
Case Study 2: The Lapsed Policy
Sarah, a 38-year-old teacher, bought an IUL in 2015 with a $750,000 death benefit and $10,000 annual premium. After five years of lackluster market performance and higher-than-expected policy costs, Sarah's cash value was insufficient to cover the rising cost of insurance. Faced with a choice between significantly increased premiums or losing coverage, Sarah reluctantly let the policy lapse, losing both her life insurance and a substantial portion of her investment. 📉
These examples underscore the importance of thoroughly understanding the risks and limitations of IULs before committing to such a complex financial product.
Industry-wide trends
These sample individual cases reflect broader trends: a detailed report by Milliman, an actuarial consulting firm, revealed that actual IUL returns consistently underperformed illustrated projections by other alternative investment options.
Better alternatives to IULs
So if IULs aren't a great choice, what should you consider instead? Here are some better options for both life insurance and investing:
For life insurance
- Term life insurance: For most people, a simple term life policy provides sufficient coverage at a much lower cost than an IUL.
- Whole life insurance: If you need permanent coverage, a traditional whole life policy is generally simpler and more transparent than an IUL.
For investing
- 401(k) or IRA: These tax-advantaged accounts offer a wide range of investment options without the high fees and complexity of an IUL.
- Index funds: Low-cost index funds provide broad market exposure without caps on returns.
- Roth IRA: This account type offers tax-free growth and withdrawals in retirement, similar to the promised tax benefits of an IUL but without the drawbacks.
Do you need help managing your investing strategy?
How to Choose a Financial Advisor in 2024: 7 Essential Steps
Frequently Asked Questions
What is an Indexed Universal Life (IUL) insurance policy?
An IUL is a type of permanent life insurance that combines a death benefit with a cash value component. The cash value is invested in index funds that track market performance, usually with caps on both gains and losses. IULs are marketed as offering both life insurance coverage and tax-advantaged investment growth.
Why are IULs considered a poor investment choice for most people?
IULs are often considered poor investments due to several factors:
- High fees and expenses that can eat into returns
- Caps on potential gains, limiting upside in strong market years
- Complex and opaque policy structures
- Risk of policy lapse if cash value falls too low
- Misleading sales illustrations that may use unrealistic assumptions
- Lack of flexibility compared to other investment options
How do the returns of an IUL compare to traditional investment accounts?
IULs typically underperform traditional investment accounts like 401(k)s or IRAs invested in low-cost index funds. This is primarily due to the cap on returns (usually 8-10% annually) and high fees associated with IULs. In contrast, the S&P 500 has historically returned about 10% annually on average, without the additional costs and complexities of an IUL.
Are IULs a good option for retirement savings?
For most people, IULs are not an ideal vehicle for retirement savings. They often provide lower returns than traditional retirement accounts, offer less flexibility and liquidity, and their complex nature makes accurate retirement income projections difficult. Additionally, unlike 401(k)s, IULs don't offer employer matching contributions.
What are the tax implications of accessing cash value from an IUL?
While IULs are often marketed as tax-advantaged, accessing the cash value can have significant tax consequences:
- Policy loans accrue interest and can lead to a tax bill if the policy lapses
- Withdrawals beyond your cost basis are taxed as ordinary income
- Aggressive withdrawals and loans can cause policy collapse, triggering a large tax bill
- Overfunding can turn the policy into a Modified Endowment Contract (MEC), subjecting withdrawals and loans to income tax and potential penalties
What are better alternatives to IULs for life insurance and investing?
Better alternatives include:For life insurance:
- Term life insurance for most people
- Whole life insurance for those needing permanent coverageFor investing:
- 401(k) or IRA accounts
- Low-cost index funds
- Roth IRAs for tax-free growth and withdrawals in retirement
Are IULs suitable for any particular age group or financial situation?
IULs are rarely the best choice for any age group or financial situation:
- Young adults benefit more from term life insurance and aggressive investing in tax-advantaged accounts
- Middle-aged individuals usually need more coverage at lower cost, which term life provides
- Near-retirees need to focus on wealth preservation and income generation, which other investment vehicles are better suited for
- High-net-worth individuals often have more efficient tax and estate planning strategies available
What are the risks of policy lapse with an IUL?
Policy lapse is a significant risk with IULs. If the cash value falls too low due to poor market performance, high fees, or both, you may need to pay additional premiums to keep the policy in force. If you can't afford these extra payments, your policy could lapse, leaving you without life insurance coverage and potentially triggering a tax bill if you have outstanding policy loans.
Support
For questions related to this article please ask via the live chatbot.
For questions related to using AdvisorFinder, please contact our support.