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The Truth About Indexed Universal Life Insurance

Life insurance is something everyone needs. But there’s one kind of coverage getting attention over the past few years that nobody should have. It’s called indexed universal life insurance. It’s a Frankenstein’s monster rip-off product that tries to mix insurance with a gimmicky investment, but winds up falling short in both departments. Sound too bad to be true? It’s very real, and you should avoid it at all costs.

Let’s find out why!

What Is Indexed Universal Life Insurance?

Indexed universal life (IUL) insurance uses your premiums to pay for two features:

  • A life insurance payout for your family or estate
  • A cash value account that’s tied to an index fund (that’s why it’s called indexed)

So much for the definition. But here’s the deal: insurance is not an investment. And any time you see an insurance product that also tries to be a savings or investment account, it’s a huge red flag! That’s what IUL does, and that’s why it’s a terrible way to take care of retirement planning or life insurance. Stay far, far way.

The Truth About Indexed Universal Life Insurance

Don’t get us wrong. We love life insurance—specifically level term life insurance—because it’s the absolute smartest way to guarantee that your loved ones will be well provided for if anything ever happened to you.

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But not all life insurances are created equal, and we would never recommend any form of whole life or universal life insurance. That’s because they try to be both insurance and investment—and that’s a bad deal for you every time.

Indexed universal life insurance puts a new spin on that bad deal. It’s sold as a flexible way to let you set your own premium payments and allow you to pay more into a savings account that is tied to a little something known as an index fund. Wondering what those are? We’ve got you covered.

Even if you’re an investing rookie, you’ve probably heard of the stock market. (We’re big fans of it, and it’s definitely something we recommend people invest in, but only in the right ways.) So you’ve probably also heard of some of the popular indexes like the Dow Jones Industrial Average, the S&P 500 and Nasdaq. Each of those is known as an index that measures how well the market (or a defined portion of the market) is doing.

Index funds invest in the companies that are included in a specific index. So you can invest in an S&P 500 index fund, for example. Some investors like to use them as a safe, passive form of investing that typically leads to average returns on their investment.

The question is, how do index funds tie in with an IUL? We’re glad you asked. We’ve already mentioned an indexed universal life insurance plan has both a life insurance portion with a death benefit and a cash value portion. Well, an IUL invests the cash portion in one of these index funds. And as long as the market does well, the cash value will go up. In theory, it could grow enough to allow you to pay lower premiums as you age, because you’re allowed to cover some (or all) of your premiums through the cash value of your IUL policy! Doesn’t it sound great?

But there is a catch—and there always is with any form of permanent insurance tied with investment. The catch is that in an IUL, your return on investment (ROI) will always be slightly below the performance of the index. Why? Because the insurance company will hit you up hard for fees. Lots of fees (more on those below). Because of the fees, it’s very hard for your cash value to grow fast or large enough to even offset inflation, let alone help you cover premiums.

And about those premiums. Did you know that insuring your life becomes more expensive as you age? Yes, it’s true. So if your cash value is only holding steady over time, or even dipping if the market dips, but your premiums keep rising . . . do you see a problem developing? Yeah. Keeping your policy in force, or active, is going to become very expensive, and it could even wipe out anything you’ve saved in the cash value. This IUL thing is a major rip-off!

As we’ve seen with other kinds of universal life, two good intentions (life insurance and investing) wind up canceling each other out.

Compare this with term life insurance, which is designed to keep coverage simple. Term life companies know the cost of insuring you over time. Based on your age, the company looks ahead 15 or 20 years and calculates the average price to insure you throughout the term. It’s way cheaper than what you’d get with any form of permanent coverage. And the price is locked in throughout the life of the policy. No fluctuating premiums, and no worries about a bad stock performance wiping out your policy! Doesn’t that sound like a much smarter way to be sure your family is covered? (Trust us, it is!)

The terms whole life or universal life should give you another clue about how they work. They’re designed to last your whole life, all the way into your 90s and beyond. Here’s the thing they overlook: If you’re working the Baby Steps plan, you’ll have so much money saved you won’t even need an ongoing life insurance policy. You’ll be self-insured!

The real purpose of life insurance is to guarantee that when you’re young and healthy with people depending on your income, they’ll be okay even if something bad happens to you. A 15- or 20-year term life policy takes care of that at a fair price, and only while you need it—but indexed universal life tries (and fails) to do too many things to be valuable.

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Indexed Universal Life Insurance Pros and Cons

If you’re planning to retire and you love your family—and we’re guessing that describes you well—combining savings and a death benefit in an indexed universal life insurance policy might sound like a win-win. And while a few of the features in an IUL might seem appealing, there are really more catches here than, well, a game of catch.

Let’s start with a look at the benefits, then move on to the drawbacks.

Advantages of Indexed Universal Life Insurance

  • It includes a cash value account that can grow through modest returns from investment into an index fund. (But there are many better ways to save and invest.)
  • Any investment growth in your IUL is tax-free. (But the same is true of many kinds of retirement accounts.)
  • The death benefit is in force permanently as long as you keep up with the premiums. (But, like we said before, if you’re staying out of debt and building wealth with the Baby Steps, you’ll eventually become self-insured.)
  • Sometimes an IUL includes a minimum guaranteed rate of return. (But even if it does, it’s unlikely to compare with historic returns in growth stock mutual funds.)

Problems With Indexed Universal Life Insurance

There are so many drawbacks with IUL, and we’ve already touched on several of them above.

  • The investments in an IUL never perform like they should because the cash portion of the premium gets eaten up with fees the insurance company takes for managing the investment.
  • Those aren’t the only fees you’ll face with an IUL: commissions for the sale, administrative expenses, premium expense charges and the surrender charge–yeah, there’s a charge for ending the policy. These fees are common with most kinds of universal life coverage.
  • When you cancel an IUL policy, you give up not only your death benefit, but most or all of the cash value you’ve managed to build. It can make you wonder what exactly you were getting from all those high premiums!
  • Because excessive fees keep returns relatively low, your IUL investment will never beat inflation, one of the main goals of investing. You’re far more likely to stay ahead of inflation by investing in mutual funds through a Roth IRA or 401(k) while enjoying a 10–12% average return. Investing in anything that can’t keep up with inflation is a waste of your money.
  • Market performance will affect your premiums, which might rise or fall depending on how well the index fund underlying your account does. But premiums can definitely rise in a down period. And if they become unaffordable? You’ll risk losing the life insurance coverage that was supposed to be the whole point of buying the policy!

Again, an IUL tries to solve two unrelated financial issues, and is no good at solving either. What’s the real point of combining insurance with investing as a single product? If you said, “Helping insurance companies make money,” give yourself a high five. The bottom line is that having the two services wrapped together winds up making the insurance portion very expensive, especially compared to what you’ll pay for term life coverage.

Can You Build Wealth With Life Insurance?

The answer here is pretty much always going to be no. And even if you do manage to get IUL coverage with a guaranteed minimum rate of return during a decent period for the underlying index fund, its performance will pale in comparison to what you’d see with mutual fund returns in either a Roth 401(k) or IRA.

As we’ve mentioned, an IUL ties your cash value to an underlying index fund. It’s a type of mutual fund that mirrors the stock market (or sometimes a particular area of the stock market). Index funds are not necessarily bad. After all, the stock market can be a smart and reliable way to build wealth!

But the returns on index funds are paid out by taking the average of the returns from a large group of funds. We emphasize average because in the investment game, you want a lot better than average. So while index funds are safe and generally trend up over the long term, they’re also less flexible than investments that allow you to choose from among many good, growth stock mutual funds—our choice for long-term wealth building.

Plus, since this is an investment it’s subject to the same risk all investments share—you could lose money. So with an IUL, your cash value could shrink or disappear completely if the IUL doesn’t have a guaranteed minimum rate of return! See why we say IUL does a terrible job at being both death benefit and investment opportunity?

To sum up the cons of IUL, you’re looking at a sucky form of investment in index funds which don’t give you much buying flexibility or good rates of return, combined with insurance fees which usually devour the already unimpressive cash value growth.

Why Term Life Insurance Is Better

The far better approach is to treat retirement planning as its own animal and do the same thing with your life insurance. The only good solution here is term life coverage.

Buying a term life policy when you’re young is smart and affordable. The term itself should be based on how long you expect to support anyone who depends on your income. If you’re planning to start a family soon, 20-year term life coverage might make sense for you. If you already have a toddler or two on your hands and you’re not expecting any more children, 15-year term coverage might make more sense (and would have a lower premium compared than a 20-year policy).

Whatever your situation, set coverage up to last only as long as your kids are under your roof. Once they’re on their own, you can drop the premiums and put the savings toward your tax-advantaged retirement accounts.

If you’re married, then both you and your spouse need term life policies. Each policy should be worth 10 to 12 times your annual income (stay-at-home parents need coverage too). And if you already have IUL (or some other kind of whole life or universal coverage)? Yes, you’ll want to drop it—but be sure to get term life coverage in place before canceling any existing policies. They’re better than nothing, and you never want even a brief gap in coverage for life insurance.

The Main Point About Life Insurance

Above all, life insurance has one job: to replace your income if you die. IUL might do that, but it might also rob you blind before you ever see the benefits pay out. Life insurance is there to provide for your loved ones, not to make them rich. You can build real wealth—the smart way—by following the Baby Steps and investing wisely.

If you’re in the market for new life insurance or want to talk to an expert, we recommend RamseyTrusted provider Zander Insurance. Don’t let another day go by without being protected. 

Get your term life insurance quotes today.

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners. Learn More.

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