Indexed Universal Life Insurance
Indexed universal life is complex with shifting components. Anyone considering an IUL policy should find a life insurance agent with a Chartered Life Underwriter (CLU) designation to help navigate the buying and management processes. Agents with this designation have a thorough understanding of the industry and underwriting procedures.
(IUL): How It Works
Indexed universal life insurance policies typically pay interest based on the movement of underlying stock and bond indexes.
If you’re looking for coverage that offers the flexibility of universal life insurance and a cash value account with higher growth potential, you may want to consider indexed universal life insurance. Indexed universal life, or IUL, gives you the opportunity to tie the cash value to the performance of a stock or bond index without directly investing in the market.
IUL policies are highly complex and come with more ups and downs than many other types of life insurance. For a savvy investor looking for a policy with flexibility, IUL could be a good fit. But if you’re simply looking for permanent coverage with guarantees, a whole life policy is a better option.
What is indexed universal life insurance (IUL)?
Indexed universal life insurance is a type of permanent coverage, which means it can last your entire life and build cash value. Unlike other types of universal life, an IUL policy places the cash value in sub-accounts that mirror a stock index, such as the S&P 500. As an alternative to indexed accounts, IUL policies also offer fixed account options that earn interest at a set rate.
Similar to other universal life policies, IUL gives policyholders the flexibility to adjust their premiums and death benefit as needed.
How indexed universal life insurance works
Indexed universal life insurance works similarly to universal life. You pay a premium in exchange for lifelong coverage and have the opportunity to build cash value over time. Part of your premium payment goes toward the cost of insurance — i.e., paying out the death benefit — and other fees. The rest is added to your cash value.
Adjustable premiums and death benefit
As with universal life, IUL premiums are adjustable. If you ever decide to skip a premium payment or underpay, the cost of insurance and policy expenses are deducted from your cash value. You may also be able to adjust the death benefit amount if your needs change. However, you may be asked to complete a life insurance medical exam if you apply to increase your coverage.
Cash value
The cash value in IUL policies can earn interest in two ways:
A fixed interest rate.
The performance of stock and bond indexes.
You can choose to put the cash value in a fixed account, indexed account or a combination of both.
Fixed accounts
Fixed accounts grow at a fixed rate set by the insurer.
Indexed accounts
These accounts are slightly more complex. The cash value is placed in one or more sub-accounts that mirror the performance of a stock or bond index, such as the S&P 500. You can choose which accounts to invest in based on what the insurer has to offer. The insurer then pays interest to policyholders based on the performance of the index. As the index goes up, the account earns interest. If the index drops, the account earns less or nothing.
The amount you can earn is subject to “floors” and “caps” to help minimize large swings in interest payments. The floor is the lowest your account rate can go and is usually guaranteed for the life of the policy but is often set at 0%. This means the account won’t suffer losses if the market crashes.
The cap is the highest interest rate the account can earn, so if the market is up more than the cap, you’ll get credited only for the cap amount. For example, if the cap is 10% and the index rises by 12%, you’ll only earn interest of 10%. Unlike the floor, your insurer can change the cap while the policy is in force.
Participation rate
Caps are not the only way an IUL policy can restrict interest. There’s also the participation rate. This rate dictates whether the cash value that you tied to a market index can fully “participate” in the gains of that index. A participation rate below 100% will further limit the interest you can earn. For example, if the index gain is 12% and the cap is 10% (as outlined in the above example), but your participation rate is 80%, you’ll only earn 8%. The insurer can adjust the participation rate during the life of the policy.
Indexed universal life vs. whole life insurance
Feature | Whole life | Indexed universal life |
|---|---|---|
Policy duration | Permanent. | Permanent. |
Cash value earnings calculation | Fixed rate. | Stock and bond indexes, as well as fixed interest rate options. |
Flexible premiums and death benefit | No. | Yes. |
Cash account value can decline | No. | Yes, if growth is low, fees are high and you pay minimum or no premiums. |
How Much Life Insurance Do I Need?
You need enough life insurance to cover your obligations after you’re gone. Start by looking at your existing financial needs and resources.
It’s hard to pinpoint how much life insurance you should buy down to the penny, but you can make a good estimate by using our life insurance calculator below.
In general, you should add up your long-term financial obligations, such as mortgage payments or college fees, and then subtract your assets. The remainder is the gap that life insurance will have to fill.
How to manually calculate how much life insurance you need
Follow this general philosophy to find your own target coverage amount: financial obligations minus liquid assets.
Step 1: Add up the following items to calculate your financial obligations.
Your annual salary multiplied by the number of years you want to replace that income.
Your mortgage balance.
Any other debts.
Any future needs such as college fees and funeral costs.
The cost to replace services that a stay-at-home parent provides, such as child care, if applicable.
Step 2: From that total, subtract liquid assets, such as savings, as well as existing college funds and current life insurance policies. The number you’re left with is the amount of life insurance you need.
4 more ways to estimate how much life insurance you need
If you want to quickly determine your existing life insurance needs, an estimate can be an easy way to get a value. These methods are better than a random guess but often fail to account for important parts of your financial life.
Use the life insurance calculators above to get a more refined idea of how much coverage you need, and then compare that value to these estimates.
1. Multiply your income by 10
The “10 times income” guideline is often shared online, but it doesn’t take a detailed look at your family’s needs, nor does it take into account your savings or existing life insurance policies. And it doesn’t provide a coverage amount for stay-at-home parents, who should have coverage even if they don’t make an income.
The value of a stay-at-home parent’s work needs to be replaced if he or she dies. At a bare minimum, the remaining parent would have to pay someone to provide the services, such as child care, that the stay-at-home parent provided for free.
2. Buy 10 times your income, plus $100,000 per child for college expenses
This formula adds another layer to the “10 times income” rule by including additional coverage for your child’s education. College and other education expenses are an important component of your life insurance calculation if you have kids. However, this method still doesn’t take a deep look at all of your family’s needs, assets or any life insurance coverage already in place.
3. Use the DIME formula
This formula encourages you to take a more detailed look at your finances than the other two. DIME stands for debt, income, mortgage and education, four areas that you should account for when calculating your life insurance needs.
Debt and final expenses: Add up your debts, other than your mortgage, plus an estimate of your funeral expenses.
Income: Decide for how many years your family would need support, and multiply your annual income by that number.
Mortgage: Calculate the amount you need to pay off your mortgage.
Education: Estimate the cost of sending your kids to school and college.
By adding all of these obligations together, you get a much more well-rounded view of your needs. However, while this formula is more comprehensive, it doesn’t account for the life insurance coverage and savings you already have. It also doesn’t consider the unpaid contributions a stay-at-home parent makes.
4. Replace your income, plus add a cushion
With this method, you’ll buy enough coverage that your beneficiaries can replace your income without spending the payout itself. Instead, they can save or invest the lump sum and use the resulting income to pay expenses.
To calculate the amount, divide your annual income by a conservative rate of return, such as 4% or 5%. As an example, let’s assume your income is $50,000 and you estimate a 5% rate of return. The math works like this: $50,000 divided by 5% equals $1 million. So if you buy a million-dollar life insurance policy and your beneficiaries put the payout into a bank account earning 5% annual interest, they can expect to generate $50,000 a year to replace your income.
When your dependents no longer need the income to meet daily living expenses, the $1 million can go toward other goals such as college tuition, home buying or retirement income.
To use this method for a stay-at-home parent, first add up how much it would cost each year to pay someone else to handle that parent’s tasks. Then plug that number into the formula as if it were the stay-at-home parent’s annual income.
Tips for calculating how much life insurance you need
Keep these tips in mind as you calculate your coverage needs:
Think of life insurance as part of your overall financial plan. That plan should take into account future expenses, such as college costs, and the future growth of your income or assets.
Don’t skimp. Your income likely will rise over the years, and so will your expenses. While you can’t anticipate exactly how much either of these will increase, a cushion helps make sure your spouse and kids can maintain their lifestyle.
Talk the numbers through with your family. How much money does your spouse think the family would need to carry on without you? Do your estimates make sense to them? For example, would your family need to replace your full income or just a portion?
Consider buying multiple, smaller life insurance policies. You can buy more than one life insurance policy to vary your coverage as your needs ebb and flow. For instance, you could buy a 30-year term life insurance policy to cover your spouse until your retirement and a 20-year term policy to cover your children until they graduate from college. Compare life insurance quotes to estimate your costs.