Indexed Universal Life Insurance For Retirement Income

When designed properly, indexed universal life insurance can be a great savings vehicle for investors who have a good ability to save. Indexed universal life or IUL, is a type of permanent life insurance that allows a policy holders to build a cash value. The cash value can be invested in a fixed account that often has a guaranteed minimum interest rate or the owner can derive their returns based on several different equity indexes.
There are several crediting methods that can be used to generate returns on the cash inside the policy. The most common method I see is an annual point to point calculation based on the return of the S&P 500 with a cap rate that protects your principal and limits your upside. When you pay your annual premium, the insurance company deducts some of the premium for state taxes, cost of insurance, and a sales load. After the fees are taken, most of your money goes to the insurance company's general account and a small portion buys derivatives on whatever index you select.
Let's say that the insurance actuary believes that they can earn 5.27% on their pool of investments. They would invest $95 of your $100 in their general account expecting that it one year, the $95 would grow to $100. This is how they can guaranty your principal. The $5 in my example would buy derivatives that could make up to a certain return or they could expire worthless if the index you chose has a negative year. The costs of the derivatives help determine the cap rate or the maximum that you can make per year. Most companies have a 10-15% cap rate on the S&P 500 index currently. If your insurance policy has a 12% cap rate on the S&P 500 and the index does 30%, you will have 12% credited to your account for the year. If the index does 5%, you will make 5%. If the index loses 20%, your return will be zero for the year. You do not receive the dividends of the indexes you invest in.
Principal Protection
Some people are very critical of the fact that IUL limits their upside. There is no free lunch. In order to protect your principal, you have to give up some of the upside. These critics point out that because of the cap rate, IULs would have earned between 5-8% per year over the last few decades during a time when the S&P 500 has averaged 9-11%.
I agree that it is possible to make better returns IF you are willing to stomach the risks of owning an all stock portfolio and my experience has taught me that very few people are able stay invested when the financial world is in a panic. The latest study from Dalbar was recently released and it shows that the average equity investor has averaged 3.79% over the last 30 years while the S&P 500 has averaged 11.06%. Even worse, the average fixed income investor made .72% per year, which is only 1/10 of the return of the Barclays Aggregate Bond Index.

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