Blog · Retirement

What’s the Biggest Mistake People Make w/ Indexed Universal Life?

Tom Southard ·

Disclosure: I’m a fan of Indexed Universal Life Insurance (IUL) policies, and of course I sell them as a licensed insurance agent.

The pitfalls mentioned here might likely exist due to the agent’s policy design, not understanding the needs of the client, or not properly educating the client.

IULs can appear to be simple, but they are in fact complex financial instruments that offer the dual benefits of life insurance and market-linked growth opportunities. Sadly, many policyholders, misinformed by agents or not, make critical mistakes that can undermine the financial advantages of their IULs. The most significant of these mistakes is underfunding the policy early on and then expecting to take out rich loans later. Understanding these errors and how to avoid them is crucial for maximizing the benefits of an IUL policy.

1. Underfunding Early

The initial years of an IUL policy are critical. During this period, the cash value of the policy has the potential to grow significantly due to the compounding effect of interest credits linked to a chosen market index. However, many policyholders make the mistake of underfunding their policies during these early years. They contribute the minimum premium necessary to keep the policy active, without considering the long-term impact on the policy’s cash value.

Why It’s a Mistake:

  • Reduced Compounding Potential: Lower initial funding results in less money earning interest, which significantly reduces the potential compound growth over time.

  • Policy Fees and Costs: IUL policies come with various fees, including administrative fees and cost of insurance charges. If these fees outpace cash value growth due to underfunding, it can erode the policy’s value.

How to Avoid It:

  • Efficient Design: At the outset, the policy death benefit should consider your ability to fund it to the maximum IRS allowable amount (the MEC limit). Use Term insurance in the short run (10-20) years for a lower cost to cover your insurance needs, allowing the IUL to grow unburdened by the cost of a higher death benefit.

  • Proper Capitalization: Once issued, you must treat your IUL like a long-term investment by adequately funding it from the start. Consider maximizing your premium payments early on to enhance the policy’s growth potential.

  • Regular Reviews: Work with a financial advisor to review your policy’s performance and make adjustments to your premium payments as needed. Sometimes the policy can be altered to make it more effective, based on available premiums.

2. Expecting Rich Loans Later

A common expectation among IUL policyholders is the ability to take out substantial loans against the policy’s cash value in the future. This expectation is often based on the assumption that the policy will perform optimally without considering the impact of underfunding or market volatility.

Why It’s a Mistake:

  • Overestimation of Cash Value: If the policy is underfunded, the cash value may not be sufficient to support large loans, especially if the policy’s fees have consumed a significant portion of the value.

  • Loan Interest: Loans against the policy accrue interest, which can compound and reduce the overall cash value if not managed properly.

How to Avoid It:

  • Realistic Expectations: Understand the terms and conditions associated with borrowing against your IUL. Be aware of the interest rates and the potential impact on your policy’s cash value. Typically, it will be after the policy’s fifteenth year before one can expect significant excess cash value (due to growth) to augment one’s income.

  • Ongoing Governance: Regularly assess the policy’s performance and adjust your financial strategies accordingly. Ensure that you are not only maintaining the policy but also optimizing its growth to support future loans.

Conclusion

Treating an IUL policy merely as a life insurance product with a savings component can lead to missed opportunities and financial missteps. By recognizing the importance of early and adequate funding and managing expectations regarding policy loans, policyholders can better leverage their IULs as valuable assets in their financial portfolios. Regular consultations with financial professionals can provide guidance tailored to individual financial situations and goals, ensuring that the IUL policy remains a robust part of one’s financial strategy.