Indexed Universal Life Insurance vs. IRAs and 401(k)s: What's the Difference?

Whenever the stock market experiences a growth spurt, it is hard for even the most conservative investors to sit on the sidelines. That phenomenon, no doubt, explains the dramatic rise in something called indexed universal life (IUL) insurance over the past few years.

Unquestionably, indexed universal life policies are one of the hottest offerings in the financial sector. According to the research firm LIMRA, IUL premiums rose by a staggering 23% in 2014 alone.

But they are also one of the most contentious. Now, some financial gurus urge investors to steer clear of whole life policies altogether, repeating the old maxim “buy term and invest the rest.” With IUL, however, the debate is particularly fiery. Even New York’s top insurance regulator has called into question the sales practices surrounding this trendy form of insurance.

Regardless of whether you happen to be a believer in this specialized insurance product, it’s almost always a good idea to maximize your 401(k) and IRA before putting any money into an IUL policy.

Like other permanent life insurance products, IUL features an insurance component as well as a cash benefit that holders can tap when the need arises. But there is a key difference. Instead of crediting a policyholder’s account based on conservative bond funds, insurers tie it to a stock index like the S&P 500. 

One of the main selling points for indexed universal life is that it gives the policyholder exposure to the stock market while protecting against losses. If the underlying stock market index goes up in a given year, owners will see their account increase by a proportional amount.

The word “proportional” here is key. Insurers use a formula for determining how much to credit your cash balance. And while that formula is tied to the performance of an index, the amount of the credit is almost always going to be less. If the market increases 10% over the course of a year, your cash amount may only go up by, say, 7% or 8%.

There is also a cap on the amount of the credit, which limits your account’s growth if stocks have a banner year. According to Moore Market Intelligence, the average upper limit on account credits is 12%. So even if a benchmark like the S&P 500 shoots up 20%, your gain could be a fraction of that amount.

For some consumers, that could be a price they are willing to pay in order to mitigate their downside risk when the market heads in the other direction. Most IUL policies have a 0% guaranteed minimum credit rate, which means – hypothetically, anyway – that your account will not lose value if stocks take a sudden dive. 

However, potential policyholders also have to think about the notoriously high expenses – including administrative fees and surrender charges – associated with permanent life insurance. The commission paid to sales reps is particularly steep, often swallowing up the entire first year of premiums. From there, sales fees frequently continue at around 5% annually before tapering off. As a result, the cash balance of your account may not start to show any substantial growth for years. 

Reps make much less by selling term policies, which offer a death benefit without the cash component. That is one of the reasons that some agents – although certainly not all – are more apt to push universal life policies.

Another factor to consider when it comes to IUL policies is the complexity of the contracts you are signing. What many investors do not realize is that they often contain provisions that let the insurer change the rules of the game at a later date. For example, some policies allow the company to lower the cap on returns in order to strengthen its balance sheet. 

According to some critics, the sales pitch to get clients interested in indexed products can be equally confusing. Reps will sometimes use illustrations that show how much policyholders can potentially earn under certain market conditions. But the industry has come under fire for relying too heavily on rosy projections that will almost certainly never happen.

So is there anyone who would clearly be better off with an indexed universal life policy? there is an argument to be made for having one if you are a high net worth individual and do not want your family to face a giant tax bill after your death. Irrevocable life insurance trusts have long been a popular tax shelter for such individuals. If you fall into this category, you probably want to talk with a fee-only financial advisor to discuss whether buying permanent insurance fits your overall strategy.

For just about everyone else, though, it’s hard to find a compelling reason to choose IUL over term insurance, especially if you have not maxed out on contributions to your retirement accounts.

IRAs and 401(k)s are retirement savings accounts. Money is deposited into the accounts, either pre- or post-tax, and invested to create a retirement nest egg. Earnings in 401(k)s and some types of IRAs accrue tax-free, though taxes are paid when the money is withdrawn.

Retirement savings accounts sometimes come with contribution matches from a participant's employer. In comparison to the high fees of IUL's, 401(k) and IRA accounts with no-load funds, and typical annual expense ratios of around 1.5%, start to look like a much cheaper alternative. Some options may have even lower fees since the fees are negotiated by a large company sponsor representing several participants.

Investment income does not come with a cap, though there is no guaranteed floor, either. Smart investing with properly diversified assets, however, can significantly reduce the risk involved in investing.

For most folks saving for retirement, buying a less expensive term life policy – and investing the remainder in a 401(k) or IRA – is a smart move. In most cases, you will have much lower fees to eat away at your return. Plus, you will not have to worry about the fine print in your IUL contract. 

• IUL contracts protect against losses while offering some equity risk premium.
• IRAs and 401(k)s do not offer the same downside protection, though there is no cap on returns.
• IULs have disconcertingly high fees (which eat away at returns significantly over time) and complicated terms. They may not be a good fit for people other that high-net-worth individuals looking to reduce their tax burden