Universal Life vs. Indexed Universal Life: Which One Fits Your Legacy Plan?

Introduction

Universal life insurance can be used to build a strong financial legacy, granting you cash growth over the years. Regular universal and indexed universal life offer different advantages. IULs have cap rates, floors, and participation rates, which can be confusing. Don’t worry, we’re going to break it all down into digestible parts so you can make an informed decision.

Let’s analyze the differences between UL and IUL insurance policies, pros and cons of each, and how to pick one based on your long-term goals.

What Is Universal Life Insurance (UL)?

Universal life insurance (UL) is a type of permanent life insurance that comes with flexible premiums and death benefits. You get lifelong coverage and cash value that grows over time.

UL premiums

Universal life insurance premiums can be adjusted according to your needs. As in, you can opt for a lower premium than usual if you are experiencing financial difficulties and have a lower cash flow.

The premium flexibility is highly useful if in the future, you either struggle to pay the premium or you increase your income and are able to afford better coverage.

UL death benefit

The death benefits of universal life insurance policies can be flexible. Some policies let you adjust the death benefit and thus the premium of an active policy according to your needs.

Your beneficiaries receive the death benefit if you pass away.

UL growth potential

Universal life insurance policies can have good growth potential that is steady and predictable. You agree to a certain interest rate when buying the policy. A higher interest rate means more growth over the years, but also a greater insurance premium.

What Is Indexed Universal Life Insurance (IUL)?

Indexed universal life (IUL) insurance is a special type of universal life insurance. IUL links its cash value growth to a stock market index.

The S&P 500 is typically used for the IUL index.

IUL cap rates

The cap of an IUL is the maximum interest that can be credited. If your policy has a cap rate, this cap prevents your IUL policy from accruing so much cash growth that the life insurance policy starts to struggle. On average, IUl cap rates range from 8% to 12%.

Even with a cap rate, IUL policies should still give you significantly greater potential upsides when compared to fixed-interest life insurance.

IUL floors

The floor is essentially the “guarantee” part of the guaranteed IUL cash value growth. It prevents your IUL policy from plummeting in value and losing you money if the market itself is struggling. Usually the floor is 0%.

(Note that if you are failing to pay the premium or losing active coverage, you could lose money through fees and penalties. So it is a myth that you can’t lose any money from an IUL whatsoever.)

IUL participation rates

The participation rate affects how much of the indexed interest rate you are using for cash value growth.

Example of how does an IUL work?

IUL example:

Let’s say your IUL is tracking the S&P 500.

Your participation rate = 90% You have $10,000 cash value Cap rate = 12% Floor = 0%

If the S&P 500 is at 10%, then you would be earning cash value at 0.9 x 10%, which comes out to 9%.

If the S&P 500 jumps to 15%, the participation rate suggests you would be growing value at 0.9 x 15% = 13.5%. However, you have a cap rate of 12%. That means that you would actually be earning at 12%.

Pros and Cons of UL vs. IUL

One-size-fits-all doesn’t make sense for universal life insurance. It’s important to know the pros and cons of each type of universal life insurance before making an informed decision.

Universal Life Pros

Universal life insurance policies have flexible premiums. You can apply to change your monthly premium if you feel like you require a lower premium for whatever reason.

UL death benefits are also flexible. They can shift as you adjust your premium. If you find your beneficiaries needing a greater death benefit, then UL lets you opt for a higher death benefit–an incredible flexibility when in comparison, regular permanent life insurance is locked in.

UL policies come with guaranteed interest rates. This means predictable growth that you can easily use to plan your future and your loved ones’ financial security.

Plus, universal life insurance is generally easier to understand. You don’t have to worry about all the interest fluctuations and policy performance variations.

Universal Life Cons

UL growth has lower potential than IUL growth. This is because the guaranteed interest rate isn’t that high.

Policy performance can lag behind inflation and other market changes. This means that what you once thought was good growth might actually become worse value over the years.

Indexed Universal Life Pros

IUL products have good potential cash value accumulation. The potential growth upside is typically much better than that of a standard UL policy, allowing you to gain far more cash value over time.

The market-linked growth of indexed life insurance is also protected by the downside protection of IUL floors. Even if there is severe market volatility, you can still rest assured that your IUL investments won’t be dragged down too much.

IUL products give you an opportunity to support your legacy wealth building. It also can provide supplemental retirement income in case the time comes and you realize you want to withdraw more money for your retirement goals.

Indexed Universal Life Cons

Any caps rates on your indexed universal life policy will limit the upside potential. Does this cap rate make it still worth it to buy IUL? It depends on your long-term goals and financial plans.

The insurance premiums for indexed universal life insurance tend to be higher due to policy charges and potential when compared to other products.

In addition, IUL policies are naturally more complex than traditional UL policies because of the indexed rates. If you’re feeling overwhelmed juggling different financial products and tools already, then you might prefer to skip the IUL policy and stay with UL or standard life insurance.

Cost Implications

Permanent life duration

UL and IULs are both permanent life insurance policies, so make sure you can afford the premiums comfortably before you commit to any such policy. Keeping the policy “in force” is crucial, since you would lose coverage otherwise. That would be dangerous because your beneficiaries would not get a death benefit if you have lapsed coverage, and regaining coverage could come with a fee.

Some life insurance policies let you lower or pause your payments if you’re struggling financially, such as if you lose your job or become disabled. You may require a rider for these benefits. However, the good part of universal life is that many policies let you lower your premium if you want, giving you more breathing room.

How do cap rates and participation rates affect growth

The cap rate is the maximum portion of the index interest you can use to accumulate cash value.

The participation rate is how much (percentage) of the index rate you actually use to accumulate value.

Difference in cash value growth for UL vs IUL policies

The UL cash growth will always be at the rate you agreed to when signing the life insurance contract. You can easily predict how much growth will have accumulated in 5 years, 10 years, 20 years, or longer. This makes it easier to plan for retirement, legacy needs, and the financial cushion for your loved ones in case you pass away.

Ideal User Profiles

Who should get Universal Life Insurance

Conservative savers and investors who are seeking predictable growth can benefit greatly from choosing a universal life insurance policy instead of a regular or IUL policy. You get the financial protection for your loved ones through UL, but you also get steady cash growth over time so you are gaining more “value” for your life insurance.

Those who want straightforward policies without index tracking can choose UL over IUL products. You get the benefits of cash value accumulation without the stress and uncertainty of market index tracking, cap rates, participation rates, market volatility, and other factors.

Families prioritizing guaranteed death benefits over aggressive growth often find UL products to be more than sufficient.

Who should get Indexed Universal Life Insurance

Individuals with higher risk tolerance and greater investment goals may prefer IUL. IUL products have floors that serve as useful downside protection (usually 0%) so you can’t lose much even if the market is doing poorly.

People who don’t mind the cap rate or participation rate can also feel comfortable with choosing indexed universal life insurance.

Those aiming to build wealth for legacy or retirement generally benefit more from IUL due to the tax-advantaged growth with greater potential. However, IUL does depend on market factors and the unpredictability isn’t for everyone.

Real-Life Scenarios

Let’s take a look at some real world scenarios where IUL and UL have different results and one is preferred.

Scenario 1

A 60 year old man is thinking about legacy planning. He doesn’t really need high growth, especially because he’s going to retire soon. He considers buying an IUL policy. However, he is feeling cautious about new investments. He already has enough investments from stocks and other accounts, he would prefer a more predictable source.

In the end, he decides that a UL policy makes more sense. Although in the next years he sees the market is fairly good for interest rates, he still enjoys the peace of mind of a more predictable investment.

Scenario 2

A 30-year-old professional works as a teacher. She is thinking about financial investments and is looking for tax-advantaged growth. She has two children, so a smooth estate transfer means a lot to her.

Since she is still young, she decides that a IUL could give her the best value over the next decades. It ensures greater growth so that she can give her children more financial protection. She doesn’t mind the greater risk of market volatility because she knows there is a floor.

Key Questions to Ask Before Choosing

It’s an important choice, IUL or UL insurance. Both are permanent life insurance products that can provide a lot of value.

Do I value predictability or potential growth more?

This is the main difference between UL and IUL insurance products. Universal life by default sticks to a fixed rate. This means you have a highly predictable cash value growth for the rest of the lifelong policy. It’s easy to plan around.

What role will this play in my overall estate plan?

Estate plans should take wills, trusts (when applicable), advance healthcare directives, life insurance proceeds, and other plans into account.

Conclusion

UL is more predictable because the interest rate on the cash growth is fixed.

In contrast, IUL tracks a specific indexed interest rate (e.g. S&P 500). This cash growth is protected by a floor, but also limited by a cap rate and participation rate.

The best universal life insurance for you depends entirely on your goals, risk tolerance, and finanical plan. If you’re uncertain or have a complex estate, consult with a financial advisor to get customized advice on the best legacy strategy.