Four households weighing indexed universal life for retirement

Whether an indexed universal life policy makes sense for retirement depends less on the product than on who is buying it and what else they have already done. A household that has filled every other tax-advantaged account and has a lasting insurance need is in a different position from one that is behind on saving and is being offered a policy as a shortcut. The four households below are invented for this article. Their incomes, premiums and results are round numbers chosen to show how the reasoning goes, not quotes, forecasts or recommendations.

Each case follows the same pattern: the situation, what the policy would and would not do for them, the alternatives they would compare, and where a reasonable person might land. The point is not to say that any of them is right. It is to show which questions move the answer.

First, the shared arithmetic

All four cases rest on one idea, so it helps to see it once. An indexed universal life policy (Indexed universal life (IUL) explained) is life insurance with a savings account attached. Part of every premium pays for the insurance and the insurer's costs; the rest goes into the account, where it can earn interest linked to an index, within a cap and above a floor. The account is called cash value. The insurance cost is the cost of insurance charge, which rises as the insured gets older.

Compare that with simply saving the same money in an ordinary account that has no insurance cost. Say a household sets aside $7,200 a year for 20 years, which is $144,000 in all, and earns 5% a year, with each deposit made at the end of the year. The ordinary account grows to about $238,000 (the sum of the deposits plus their compounding: $7,200 times 33.07, the standard factor for 20 years at 5%).

Now say the same $7,200 goes into a policy where, as an illustration, loads, administrative fees and insurance costs average $2,400 a year over those 20 years. Only $4,800 a year is working in the account. At the same 5% it reaches about $158,700 (that is $4,800 times 33.07). The gap, roughly $79,000, is what the insurance and the policy's costs took. Whether that gap is a bad price or a fair one depends on what the policy provided in return: a death benefit that was there from day one, possible tax treatment of the growth and, if the buyer wanted it, a guarantee. The average charge here is an invented round figure; real charges vary by age, health, product and funding, and the policy's own illustration shows them.

Keep that comparison in mind through the four cases.

Household 1: Dana and Luis, both 38, two incomes

Situation. Dana and Luis have two children, a mortgage and combined household income that is comfortable but not extraordinary. Both contribute to workplace retirement plans and capture the full employer match. They have a 20-year term policy on each of them. A colleague has told them an IUL is "like a Roth with a death benefit," and an agent has proposed $600 a month, which is the $7,200 a year in the arithmetic above.

What the policy would do. It would give them permanent coverage and a growing account, and the death benefit is generally income-tax-free to their beneficiaries. Loans taken against the account in retirement are generally not taxable while the policy remains in force and is not a modified endowment contract (modified endowment contracts and the 7-pay test explains that line). But the policy would be expensive in its first years, with a surrender charge schedule that makes leaving early costly.

What they would compare. Their real alternatives are not "IUL or nothing." They are:

• Putting the $600 a month into increased contributions to the retirement plans they already have. If they have not reached the annual contribution limits, that route has lower costs and no surrender schedule. The comparison guides are IUL vs 401(k): why the comparison misleads and IUL vs Roth IRA for tax-free retirement income.
• A Roth IRA, if their income allows contributions.
• Keeping the term policies and investing the difference in a taxable account.

Where they might land. The threshold question is whether they have used up the lower-cost tax-advantaged space. If not, most of the arguments favor filling it first. A common outcome for a household like this is to keep the term coverage, increase plan contributions, and revisit permanent insurance later if a lasting need appears. A household that has genuinely filled those accounts and still wants more tax-deferred space could take a closer look, but with the proposal questions in Questions to put to an IUL proposal before you sign in hand and a lower-rate illustration on the table.

Household 2: Rosa and Ken, 45 and 47, business owners with high income

Situation. Rosa and Ken own a small company. They have funded their retirement plans to the limit, they hold a taxable brokerage account and they are comfortable with their emergency reserves. They also expect to leave an estate that includes the business, which will not be easy to split among heirs. They can put $30,000 a year toward a permanent policy for 15 years without strain, which is $450,000 in premiums.

What the policy would do. For this couple the death benefit has a purpose beyond retirement: liquidity for the heirs, so the business does not have to be sold to settle taxes or to equalize shares among children. The account would add some tax-deferred growth and a source of loans or withdrawals later. Their budget lets them fund the policy above the minimum, which matters because underfunded policies are the ones that tend to lapse.

The arithmetic. At the same 5% credited assumption and $30,000 a year for 15 years, an ordinary account would reach about $647,000. If the policy's costs averaged, say, $10,000 a year (again an invented round number, one third of the premium), the account would reach about $431,000. The $216,000 difference is the price of the insurance and expenses in that setup. The question for Rosa and Ken is whether the death benefit and the liquidity it brings are worth that price. If the need is real, term insurance, a guaranteed universal life policy or whole life might do the same job at a different cost. If the policy is meant to be held to the end of life, a policy built around a guarantee is the closest comparison; see choosing the guarantee age on guaranteed universal life: 90, 100 or beyond.

What they would compare. Guaranteed or whole life for the estate purpose; term for a shorter need; a taxable account and business reinvestment for the growth purpose. They should also ask a tax professional and an estate attorney how ownership (personally, or through a trust) affects the estate, because the death benefit is included in an estate when the insured owns the policy.

Where they might land. A reasonable result is a policy sized to the estate need, funded steadily, with a clear understanding that the cap and participation rate are not locked in. Another reasonable result is to separate the two jobs: a simpler policy for the death benefit and the taxable account for growth. Neither is wrong. What would be unwise is to buy the policy mainly for its projected retirement income without testing it at lower assumed rates.

Household 3: the Okafors, both 52, behind on saving

Situation. Ngozi and Emeka have two years left on a child's tuition, a mortgage with 12 years to run and about $90,000 in retirement accounts. They can put aside $20,000 a year, or $300,000 over 15 years. An advisor has shown them an IUL illustration with a retirement income stream starting at 67, and the page looks attractive.

What the policy would do. Cost of insurance rises with age, and at 52 it is much higher than at 38, so a larger share of each premium goes to the insurance. Surrender charges would stand in the way of changing course for years. And the policy's projected income depends on a rate that may or may not be earned.

The arithmetic. Using the same method, $20,000 a year for 15 years at 5% would grow to about $432,000 in an ordinary account. If the policy's costs averaged $8,000 a year, the account would reach about $259,000 (that is $12,000 times the 15-year, 5% factor of 21.58). The gap is large in this case, because the buyers are older.

What they would compare. Their strongest alternatives are plain ones: raising workplace plan contributions (including the catch-up contributions the tax rules allow for people 50 and over, which an accountant can quantify), keeping the mortgage on schedule and buying term insurance sized to the years of need that remain. They may also ask whether delaying retirement by a year or two does more for their income than any product.

Where they might land. For a household that is behind, the question is whether the policy's projection survives a lower rate. Asking for the same illustration at two and four points lower, and with the guaranteed column, is the single most useful step; Stress-testing an IUL illustration with lower assumed rates walks through it. If the plan breaks at the lower rate, a simpler combination of retirement accounts and term coverage is likely to serve them better. If they have a separate need for permanent coverage, such as a dependent who will need support for life, that is a different decision and one for a fee-only planner.

Household 4: Mei, 34, a single parent with a child who has lifelong needs

Situation. Mei has a son with a disability who is likely to need support throughout adulthood. She has a 30-year term policy and is worried about what happens after it ends. She is not mainly shopping for retirement income, but an agent has proposed an IUL that could provide both lasting coverage and a source of retirement cash.

What the policy would do. An IUL can provide permanent coverage, but whether the coverage lasts depends on funding and on the account earning enough to pay rising charges. If the main purpose is a death benefit that will certainly be there, the product designed for that is different: a guaranteed universal life policy, or a whole life policy, built around guarantees (guaranteed universal life: permanent coverage without the cash). Those cost more per dollar of cash value and often provide almost none, but the benefit is not at the mercy of a crediting rate.

What she would compare.

• Keeping the 30-year term and using its conversion privilege to move part of it to permanent coverage later, before the conversion deadline. See converting term life to permanent: how the conversion option works.
• A guaranteed universal life policy for the amount needed for life, with term for the larger but shorter need.
• An IUL funded above the minimum, accepting that its lifetime coverage depends on assumptions.

Where she might land. Because the core goal is certainty of the death benefit rather than growth, many households in her position find that guarantees matter more than upside. She might split the coverage: permanent coverage with a guarantee for the lifelong need, term for the child-raising years, and retirement saving in plans she controls. A special needs trust may also be worth discussing with an attorney. The detail is for a professional, but the pattern holds: match the product to the job it must do.

What the four cases have in common

Lay the households side by side.

Three patterns appear. First, the buyers for whom the policy looks most defensible are those who have already used cheaper options and have a use for a death benefit. Second, the older the buyer, the heavier the insurance cost, and the harder the account has to work to compensate. Third, a household that needs certainty rather than upside is usually better served by guarantees than by index credits.

Questions the households should each ask

Whatever the household, the same short list applies before any signature:

1. What rate does the illustration assume, and how does the policy look two points lower?
2. Which of the policy's numbers (caps, participation rates, cost-of-insurance rates) can the insurer change, and what are the contract limits?
3. What would we do if we could not pay for two years?
4. What does each alternative cost, in dollars, over the same period?
5. What is the surrender charge in the year we might need the money?

For the arguments for and against the product in general, IUL pros and cons: what the sales pitch leaves out sets them side by side.

Key takeaways

• The same IUL can be reasonable for one household and a poor fit for another; the deciding factors are what they have already funded, their age and whether they need a death benefit.
• Compare the policy with the same money in an ordinary account: the gap in the arithmetic is the price of the insurance and costs, and you decide whether the benefits justify it.
• Older buyers pay more for the insurance part, so the account has to work harder to match alternatives.
• If certainty of the death benefit is the goal, a guarantee-based policy may fit better than one that depends on index credits.
• Test any proposal at lower assumed rates before deciding, and ask a fee-only planner or tax professional for the specifics of your case.