Universal and indexed universal life

In short

A friend of mine once bought a life insurance policy because the agent said it worked like a savings account with a free death benefit. If you are holding a quote for universal life or indexed universal life, you may have heard something close to that. Both are permanent life insurance, meaning the cover lasts for life as long as the policy stays funded. Each one has a cash value account, which is a pot of money inside the policy that grows and can be borrowed against. The insurer takes a charge every month for the cost of the cover, plus fees. Ask for a ledger, which is a year by year table showing premiums, charges, and cash value, and read the guaranteed column before the projected one. Check whether you need life insurance at all, since cover and investing are two separate jobs. Take your time here, because these contracts run for decades.

The whole of it

What it is

I once watched a neighbor spend a whole Saturday arguing with a toaster oven that had a warranty longer than his patience. Life insurance contracts can feel like that, so let me keep this plain. Universal life is a form of permanent life insurance. The policyholder pays premiums, and the insurer pays a death benefit to the named beneficiary when the insured person dies. Part of each premium goes to the cost of insurance, which is the monthly charge for the cover itself. The rest goes into a cash value account.

The word universal means the policyholder has some freedom. The policy owner can usually raise or lower premiums within limits, and the policy keeps going as long as the cash value can pay the monthly charges. That freedom is the whole selling point. It is also the whole risk, and we will get to that.

Indexed universal life, often called IUL, is a cousin. The cash value does not earn a declared interest rate. Instead, it is credited based on how a market index, such as the S&P 500, performs over a set period. The money is not actually invested in the index. The insurer uses the index only as a measuring stick. Two settings do the work: a cap, which is the highest credit the policy will give, and a floor, which is the lowest, often zero percent. A zero floor means the account will not lose value from a down market. It does not mean the policy cannot lose value. The monthly charges keep coming either way.

How it works

You have probably paid a bill that went up when you were not looking. That is the heart of universal life. The insurer deducts charges from the cash value every month. These include the cost of insurance, an administrative fee, and sometimes a charge for added riders. The cost of insurance rises as the insured person ages, because the chance of a claim rises.

Think of a leaky bucket under a faucet. The premiums are the water going in. The charges are the holes in the side. When the faucet runs strong and the holes are small, the bucket fills. In later years the holes get bigger. If the water slows down at the same time, the bucket can run dry. When the cash value cannot cover the monthly charge, the policy lapses, which means the cover ends. The policy owner may then owe income tax on gains that were already taken out, even though the cover is gone.

With IUL, the credit works like this. Say the index rises 12 percent over the year and the policy has a cap of 9 percent. The account is credited 9 percent. If the index falls 15 percent, the floor of 0 percent applies, and the account is credited nothing. Some policies also use a participation rate, which is the share of the index gain that counts. At a 60 percent participation rate, an index gain of 10 percent credits 6 percent. Some indexes used in these policies leave out dividends. A policy that uses such an index measures a smaller gain than the total return of the same index would show, so the policy's index rules are worth reading closely.

Policy loans are the other piece. The owner can borrow against the cash value. The loan accrues interest, and unpaid loans plus interest reduce the death benefit. Under federal tax law, a policy that fails certain tests can be treated as a modified endowment contract. That label changes how withdrawals and loans are taxed, and it is tied to how fast money goes in during the first seven years. The IRS explains these rules, and Internal Revenue Code section 7702 sets the definition of a life insurance contract.

The numbers, and where to find yours

Short version, then. Four figures matter. The first is the guaranteed cost of insurance, which is the highest monthly charge the contract allows. The second is the current cost of insurance, which is what the insurer charges today and can change. The third is the cap and the floor on an indexed policy. The fourth is the surrender charge schedule, which is a fee for cashing out early, often lasting ten to fifteen years.

Every one of these lives in two places. The first is the policy illustration, the sales document with projected values. The second is the contract itself, which states the guarantees. The illustration shows hopeful numbers. The contract shows promises. Where they differ, the contract wins.

Ask the agent for a guaranteed column ledger and an in force ledger. Your state insurance department also publishes consumer guides on life insurance, and the National Association of Insurance Commissioners keeps a model rule on illustrations. The tax limits that decide whether a policy keeps its tax treatment are set by law and change by year. For the current premium test limits, see the current figure, which the official source publishes each year. For the federal estate tax exemption, which matters when death benefits are large, see the current figure, which the official source publishes each year.

A worked example

A woman I will call Dorothy is 40 and earns $90,000 a year. She buys an IUL policy with a death benefit of $500,000 and pays $400 a month. That is $400 times 12 months, or $4,800 a year.

The agent shows her a projection that assumes a steady 6 percent credit. At that rate the illustration shows a cash value of about $120,000 at year twenty. Dorothy likes it. Then she asks for the guaranteed column.

In the guaranteed column, the insurer assumes the floor of 0 percent and the highest allowed charges. Her premiums over twenty years add up to $4,800 times 20, which is $96,000. The guaranteed ledger shows the cash value near $20,000 at year twenty. The gap between $120,000 and $20,000 is $100,000. That gap is the difference between hope and promise.

Reality usually lands between the two columns. The index does not pay a steady 6 percent. Some years it pays the cap, some years zero. Say the average credit over twenty years turns out near 4 percent. The cash value then falls well short of the illustration, and Dorothy has to raise her premium or watch the cover shrink. Because the cost of insurance climbs with age, she faces higher charges just when the account is thinnest.

Notice what Dorothy did right. She asked for the second column. That one question changed the whole conversation.

Where it goes wrong

I once knew a fellow who treated a projection like a weather forecast he could bank on. The trouble starts there. An illustration is a sales tool. It assumes the credited rate holds steady every year, which no market does.

Policies lapse. If the owner underfunds the contract, the cash value drains and the cover ends. Charges on the current column can also rise, since the insurer can raise them up to the guaranteed maximum. Surrender charges trap people who want out early. Caps can be lowered by the insurer after the policy is sold, so the cap in the first year may not be the cap in year ten.

Loans can bite as well. A large loan that grows unpaid can push the policy to lapse, and a lapse with a loan outstanding can create a tax bill. Hidden costs sit in the fine print: rider charges, fees per thousand dollars of cover, and administrative fees. The product is also hard to compare, because every insurer builds its own formula for caps and participation.

Finally, a person may simply not need it. Life insurance exists to replace income for people who depend on it. A term policy, which covers a set number of years at a low price, does that job for less. Buying permanent cover to get a savings feature means paying cover prices for a savings tool. Ask who depends on your paycheck, and for how long.

Questions to answer before you leave this page

Who would face real hardship if your income stopped tomorrow, and for how many years would they need help? Could a term policy cover that need for far less money than a permanent one? Have you seen the guaranteed column and the in force ledger, and do you understand the gap between them? What is the cap, the floor, and the participation rate today, and can the insurer change them later? How long does the surrender charge last, and what would cashing out cost in year five? What happens to the policy if you miss a year of premiums? Have you asked whether the policy could become a modified endowment contract, and what that would mean for your taxes? And have you read the contract itself, not only the sales illustration, with a trusted friend or a fee only adviser beside you?