If you have unusually high income, it's relatively easy to hit your contribution limit for an IRA or 401(k). When that happens, some investors use life insurance as a way to earn additional tax-sheltered growth. Indexed universal life insurance is designed for that purpose, allowing policyholders to vary their premiums and death benefit to maximize growth. However, as with any investment, it has both pros and cons.
How UL Works
Permanent insurance policies have insurance and investment components. In the case of universal life policies, it's possible to pay substantially more money than necessary into the policy to cover insurance costs. That means more of the premium can go into investments, which can create higher gains. Traditional universal life policies were invested in the insurance company's own pool of funds, which is conservative by nature. Variable UL policies invest in outside products, such as mutual funds, in search of higher gains. Equity-indexed universal life is linked to a specific index, such as Standard and Poor's or the Dow Jones.
Equity-indexed universal life insurance products eliminate the risk of market losses, while still providing a reasonable return. If the death benefit is paid out during a market downturn, the insurer absorbs the loss. On the other hand, when markets are up, the policyholder's gains are calculated from the rise of the underlying index. It's not a direct one-to-one relationship because the insurer retains a percentage to defray its costs and cover its own investment risks. The net result for policyholders is a better investment gain than with more-traditional policies, but without the downside risk of the equity markets.
Advantages of EIUL
Equity-indexed universal life policies, usually abbreviated as EIUL, have some definite advantages. Unlike other tax-sheltered investments, there's no contribution limit on an insurance policy. This makes them an ideal home for a financial windfall, or unusually high short-term earnings. The funds grow without taxation until you withdraw them. If you die prematurely, the investment growth becomes part of the policy's death benefit. It is paid out to your beneficiaries without the expense and time involved in probate. The risk-free investment potential of an EIUL is also alluring to anyone who's lost money on the markets.
Disadvantages of EIUL
On the downside, EIUL policies aren't cheap. They pay out substantial commissions to the broker who writes the policy, and must also account for underwriting and ongoing insurance costs. Because of this, UL policies have higher administrative costs than most other investments such as mutual funds and especially no-load mutual funds. These can sap your returns. If you wish to remove your money from the policy, especially in the early years, the insurer will charge substantial surrender fees to recover its costs. Indexed UL can be a sound investment, but it isn't suited for every purpose.
Fred Decker is a trained chef and certified food-safety trainer. Decker wrote for the Saint John, New Brunswick Telegraph-Journal, and has been published in Canada's Hospitality and Foodservice magazine. He's held positions selling computers, insurance and mutual funds, and was educated at Memorial University of Newfoundland and the Northern Alberta Institute of Technology.