Differences Between IUL and Whole Life Insurance

Those shopping for the right life insurance policy have a wide array of choices, ranging from cheap term life insurance to expensive permanent life insurance policies. When it comes to the latter, two popular options are whole life insurance and index universal life insurance (IUL). Individuals deciding between these options should carefully examine their needs before committing to a life-long decision.

In this article, we’ll take a look at the key differences between these policies and some tips for individuals trying to decide between them. (For background, see "Life Insurance: Putting a Price on Peace of Mind.")

Whole life insurance policies have been around for decades. In general, these policies are considered the safest option for those looking to provide for their families after death.

The Pros

• Guaranteed death benefits
• Fixed premiums that don’t increase with age
• Option to pay up face value in 10 years, 20 years, or at age 65
• Option to borrow against if needed later in life

The Drawbacks

• Interest rate may not be guaranteed
• Potential opportunity cost with low interest rates
• Premiums aren’t flexible and must be paid consistently

Indexed universal life insurance policies are relatively new. As their name implies, their earnings potential is tied to an equity index. In general, these policies are riskier and more complex.

Indexed universal life insurance policies give policyholders the option to allocating all or a portion of their net premiums (after paying for the insurance coverage and expenses) to a cash account. This account credits interest based on the performance of an underlying index with a floor of 0% return and a cap rate and/or participation cap on the return.

The dynamics begin to get a bit murkier when looking at how the index exposure is built. Rather than purchasing equities outright, the insurance company typically enters into options contracts using some portion of the policy premium, which enables them to pass on the upside gains without the downside losses – but at the cost of an additional counterparty risk.

Many insurance companies provide minimum cap rates of between 1% and 4% and participation rates of around 50%, although some provide non-guaranteed cap rates of around 10% to 14% and participation rates in excess of 100% in sales materials, according to a The Bishop Company LLC report. If an underlying index returns 20%, a policyholder may only realize a 10% to 12% return with these caps in place. The use of stock options also eliminates dividends from any index return calculation, which usually account for 2% to 4% of total market return. Without these returns, policyholders may generate a lower return than the benchmark indexes.

The Pros

• Guaranteed benefits
• Flexible premium payments
• Potential for higher interest earnings
• Option to borrow against later in life

The Drawbacks

• Earnings depend on equity performance
• Potential for premiums to rise over time
• Use of complex derivative investments
• Higher expenses

Whole life insurance is designed to be exactly that – life insurance. In contrast, indexed universal life insurance policies are more like retirement-income vehicles. Cash inside of these policies grows on a tax-deferred basis and can be used to pay premiums. Plus, during retirement, policyholders can take tax-free distributions from the accrued cash value to help cover any sort of expenses – useful for those that have already maxed out their Roth IRA and other options. In fact, many policies are sold based on the concept of accumulating cash value rather than guaranteed death benefit.

It’s also important to consider the use of derivatives by indexed universal life insurers. Since a call option is inherently capped at a certain level or expire worthless, IUL policies have limitations to the maximum returns during good years and limit downside to 0% returns during bad years. Insurance providers touting high returns for IUL policies may be trying to take advantage of “recency bias” if equity indexes have been performing well as of late. (For more, see "Life Insurance: How to Get the Most Out of Your Policy.")

Some IULs also come with guaranteed contractual benefits through riders, which can actually provide guaranteed benefits that are comparable to general account products. Still, IUL policyholders should not rely on high equity index returns to fund their life insurance over time. High returns in some years can lead to policyholder neglecting to fund the cash value of the policy, which could lead to a lapse in coverage later in life if returns aren’t quite as good. Taking policy loans from the cash value and paying interest can also be a risky endeavor if the credited interest doesn’t cover the costs of the loan.

Individual shopping for permanent life insurance, which offers a cash component as well as insurance coverage, have a number of different options. Whole life is generally the safest route for those looking for something predictable and reliable, while IUL policies provide an interesting retirement- planning vehicle with greater upside potential and tax advantages. (For more, see "5 Life Insurance Questions You Should Ask.")