Indexed & Variable Universal Life Policies

Indexed Universal Life (IUL) Insurance and Variable Universal Life (VUL) Insurance are both types of permanent life insurance that offer flexibility in premium payments and death benefits, as well as a cash value component. However, they differ significantly in how the cash value grows, and each has its own set of pros and cons.

Here’s a breakdown of the pros and cons of both IULs and VULs:

Indexed Universal Life (IUL) Insurance

What is an IUL?

An Indexed Universal Life insurance policy is a type of permanent life insurance that links its cash value growth to a stock market index (e.g., the S&P 500). The cash value grows based on the performance of the index, but the policyholder is not directly investing in the market.

Pros of IULs:

1. Potential for Market-Linked Growth:
   • The cash value of an IUL is tied to a market index, so it has the potential for higher returns compared to a whole life policy, which offers a guaranteed but modest interest rate.
   • During periods of strong market performance, an IUL can benefit from higher returns, typically capped at a certain percentage (e.g., 12%).
2. Downside Protection (No Negative Returns):
   • IULs typically offer a floor (e.g., 0%) for the cash value, meaning the policyholder will not lose money in a down market. If the index performs poorly, the cash value will not decrease, offering protection from market volatility.
3. Flexible Premiums:
   • Like other types of universal life insurance, IULs offer flexibility in premium payments. The policyholder can adjust premiums and the death benefit within certain limits, making it suitable for changing financial situations.
4. Tax-Deferred Growth:
   • The cash value grows on a tax-deferred basis, which means you won’t pay taxes on the earnings as long as they remain within the policy.
5. Death Benefit Flexibility:
   • The death benefit can be adjusted according to the policyholder’s needs, offering some degree of flexibility to adapt to changing circumstances (e.g., adding a rider or increasing coverage).
6. Loan Options:
   • The cash value of the policy can be borrowed against with favorable terms, and loan proceeds are typically not taxed (as long as the policy is not classified as a modified endowment contract (MEC)).

Cons of IULs:

1. Caps on Returns:
   • While IULs provide the opportunity for growth tied to market performance, returns are capped (e.g., 10%–15%), which means you won’t benefit fully from a market boom.
   • Even in a strong market, the growth of the cash value is limited by the cap.
2. Complexity:
   • IULs can be difficult to understand due to their link to market indexes, participation rates, and caps. It requires careful management and understanding of how the index-based growth works.
3. Costs of Insurance:
   • As with most permanent life policies, the cost of insurance (COI) can increase over time, potentially eroding the cash value, especially in later years.
4. Unpredictability of Growth:
   • While there is downside protection, the growth of the cash value is not guaranteed, and the growth is dependent on how the underlying index performs. This can result in low or moderate growth in poor market years, even with the 0% floor.
5. Surrender Charges:
   • Many IUL policies have surrender charges in the early years (e.g., 5–10 years), meaning if you decide to cancel the policy, you could lose a significant portion of your cash value.

Variable Universal Life (VUL) Insurance

What is a VUL?

A Variable Universal Life insurance policy is another form of permanent life insurance, but unlike an IUL, the cash value is directly invested in separate subaccounts (which can include stocks, bonds, mutual funds, or other investments). The policyholder has more control over how the money is allocated.

Pros of VULs:

1. Investment Flexibility:
   • Policyholders have full control over the investment options within the subaccounts. You can choose a mix of equities, bonds, or other investments, allowing for potentially higher returns compared to both IULs and whole life insurance.
   • There is no cap on how much the cash value can grow, so you can benefit fully from strong market performance.
2. Tax-Deferred Growth:
   • Similar to IULs, the growth in the cash value of a VUL is tax-deferred, so you won’t pay taxes on the gains until you withdraw or borrow against them.
3. Death Benefit Flexibility:
   • The death benefit can be adjusted to meet the policyholder’s needs (subject to underwriting guidelines), providing flexibility.
4. Access to Cash Value:
   • The cash value in a VUL can be accessed via loans or withdrawals. These are typically tax-free if the policy is structured correctly and the cash value does not exceed the amount paid in premiums.
5. No Participation Limits or Caps:
   • Unlike IULs, VULs are not limited by caps on returns. The growth of the cash value depends on the performance of the subaccounts, which can result in potentially unlimited upside if investments perform well.

Cons of VULs:

1. Investment Risk:
   • The primary downside of VULs is that they expose the policyholder to market risk. The cash value can go up or down depending on the performance of the investments chosen.
   • If the investments perform poorly, the cash value could decrease, potentially leading to a reduced death benefit or the need to contribute more to keep the policy in force.
2. Complexity and Active Management:
   • VULs are more complex than IULs and require active management and a solid understanding of investments. The policyholder must monitor the subaccounts and make adjustments as needed based on market performance.
3. Higher Costs:
   • VULs generally have higher costs of insurance (COI) than IULs, as well as administrative fees and investment management fees associated with the subaccounts. These fees can erode the cash value, especially in poor market years.
4. Potential for Lapse:
   • Because the cash value is directly tied to market performance, there is a greater risk of policy lapse if the investments underperform and the policyholder is not able to contribute enough to maintain the policy.
5. Surrender Charges:
   • Like IULs, VULs often come with surrender charges for the first few years if you decide to cancel the policy, which could significantly reduce the amount of cash value returned.

Comparison of IULs and VULs

Conclusion

• IULs might be more appropriate for individuals who want moderate growth potential with downside protection and don’t want to actively manage their investments. They are generally more conservative than VULs and can be simpler to understand, but the growth potential is capped.
• VULs are better for individuals who are comfortable with market risk and want full control over their investment strategy. VULs offer higher growth potential but come with the downside of market volatility and require active management.

Both policies offer flexibility in premium payments and death benefits, but the decision between an IUL and a VUL depends largely on the policyholder’s risk tolerance, investment knowledge, and long-term financial goals. It’s essential to understand both the pros and cons of each and to consult with a financial advisor before committing to either type of policy.