Indexed universal life (IUL): how it really works

What indexed universal life is

Indexed universal life (IUL) is a type of permanent life insurance. Like other universal life, it has a death benefit, a cash value account and flexible premiums within limits. What makes it "indexed" is how interest is credited to the cash value.

IUL is life insurance first. Its main job is the death benefit. The cash value is a feature of the policy, and how well it performs depends on how the policy is designed, funded and maintained over decades.

Index crediting: caps and floors

Your cash value is not invested directly in the stock market. Instead, the carrier credits interest based on the performance of a market index over a set period, using a formula in the contract.

• A cap limits how much interest can be credited in a period, even when the index does better.
• A floor sets the lowest crediting rate for a period, so a down index year doesn't directly reduce your credited interest below that floor.
• Participation rates and other terms can also limit crediting, and carriers can usually change caps and rates over time within contract limits.

Fees and cost of insurance rise with age

Every month, the policy deducts charges from your cash value: the cost of insurance, administrative fees and other policy charges. The cost of insurance is based on your age and rises as you get older.

In the early years, charges can take up a large share of premiums. Later in life, rising costs can draw down cash value quickly if the policy isn't funded well. That's why the floor protects credited interest, not your account value — fees still come out in a zero-credit year.

Policies can lapse if underfunded

Flexible premiums are a feature, but they're also a risk. If you pay less than the policy needs, or crediting comes in lower than expected, the cash value may not cover the monthly charges. When that happens, you may be asked to pay more to keep the policy in force, or it can lapse and the coverage ends.

Reviewing the policy every year, and asking for an updated in-force illustration, is the best way to catch funding problems early.

Loans and withdrawals reduce the death benefit

You may be able to take policy loans or withdrawals from cash value. Both reduce the death benefit, and loans accrue interest. Large loans combined with rising policy costs can cause a lapse, and a lapse with an outstanding loan can create tax consequences. Ask your tax professional before taking money from any life insurance policy.

Who IUL is best for

IUL tends to fit a narrow group: people who need permanent life insurance, already max out their workplace and individual retirement accounts, and can afford to fund the policy consistently for the long term. Business owners with estate or succession planning needs sometimes look at it too.

If you need affordable coverage to protect your family's income, term life is usually the better starting point. If you want simple, predictable permanent coverage, look at whole life.

Questions to ask an advisor

• What happens to this policy if crediting is at the floor for several years?
• What premium keeps it in force to an advanced age under conservative assumptions?
• Which caps, rates and charges can the carrier change?
• How would a loan affect the death benefit and lapse risk?