Indexed universal life insurance can be difficult to understand. You can set it up to either leave a nice death benefit to your heirs, or you can set it up so that you can withdraw money from the account to supplement your income in retirement. There are a lot of moving parts, so let’s take a look at what you need to understand about calculating different components in IUL policies such as death benefit, cash value, fees and charges, and retirement income.
When you buy a term life or whole life policy, you usually start with the death benefit amount you like to have, for example $100,000; $300,000; or $500,000 and insurance companies will calculate how much monthly premiums you have to pay for that death benefit amount. It is relatively simple. Since buying IUL policies is more similar to saving money for retirement. The process usually starts with how much money you can set aside a month to invest in an IUL policy. From that, insurance companies will calculate how much death benefit, cash value, and retirement income the policy can provide at different ages.
- How To Calculate Death Benefit Coverage in an IUL Policy
- How to Calculate the Cash Value in IUL Policies
- How to Calculate Fees and Charges in an IUL Policy
- How to Calculate Cash Surrender Value in an IUL Policy
- How to Calculate Retirement Income You can Withdraw from an IUL Policy
How To Calculate Death Benefit Coverage in an IUL Policy
Depending on the main goal of your IUL policy, you can choose either increasing death benefit or level death benefit for your IUL policy. Insurance companies calculate the death benefit in these two scenarios differently.
If your IUL policy is primarily for retirement income and you don’t care about death benefit, ie. you don’t have a need to leave a large amount of money for your loved ones when you pass away or you already have a term life policy for that purpose, you should choose to have increasing death benefit for your IUL policy. This will allow the insurance company to allocate most of the premiums to grow the cash value account in the early years of the policy and leave very little premium to buy a minimum death benefit coverage. This minimum death benefit will increase every year as long as you pay premiums.
If leaving a large amount of money to your loved ones whenever you pass away is as important as having supplemental retirement income from the policy, you should choose to have a level death benefit for your IUL policy. The level death benefit is always much larger than the increasing death benefit in the early years. This will leave less money to grow cash value account in the early years of the policy. As a result, the cash value account and retirement income will be less in this case. However, if you pass away in the early years of the policy, your beneficiaries will receive a much bigger death benefit from the policy, compared to the increasing death benefit scenario.
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How to Calculate the Cash Value in IUL Policies
Each time you pay premiums to an IUL policy, a portion of the premiums will be allocated to buy the death benefit of policy, and the remaining goes into the cash value account. The cash value account of an IUL policy will earn an interest rate each year based on the performance of an index that year. On the other hand, fees and charges for the insurance companies to maintain the policy are deducted from the cash value account of the policy. So, here is the basic formula to calculate the cash value account at the end of each year:
- Year-end Cash Value ($) = Beginning Cash Value * (1+ credited interest rate of that year) – (fees + charges)
If you choose to have the credit interest rate based on an index, the default is the S&P 500 index, but you can also choose from the Nasdaq 100 or the Hang Seng index on some policies. Some policies based the interest on the average of a few indexes. The interest rate you earn depends on the performance of these market indexes. The index is an average—the S&P 500, for example, is the average of the top 500 companies. The risk is therefore mitigated. With IUL policies, it’s important to know that you’re not really investing in the market, you’re just earning interest based on what they market does.
Another thing to be aware of is the cap and the floor rate. The cap is like a ceiling—it’s the maximum amount you can earn. Some companies cap interest earnings at 10%, 11% or 12%. That’s the most you can earn, but you won’t definitely earn that amount. If the market earns 5%, you’ll earn 5%. If the market earns 20%, you’ll earn 10% (or whatever your cap rate is). In 2017, the S&P returned almost 19%. The historical average is a little under 10%.
“Why would I want that?” The opposite of the cap is the floor rate. This is the least amount of money you will earn. It’s often set at 0%, but some companies have a floor of up to 2%. This means that if the market loses money, you will either lose nothing (floor of 0%) or earn a little bit (if the floor is higher than 0%). Many people like this because the market does lose money some years, but this way you will not.
You also need to be aware of the participation rate. Some insurance companies offer 100% participation, which means that if the market earns 10%, you’ll earn 10%. If the participation rate was set at 80%, you would earn 8%.
Different insurance companies have different participation rates, cap rates, and floor rates for their IUL products. Some companies also offer different rates in different IUL products if they have several IUL products or different indexed if they offer several indexes for you to choose from. Be sure to study them carefully before making your final decision. Here are the 6 best IUL companies that we recommend.
How to Calculate Fees and Charges in an IUL Policy
Premium load: this is deducted right off the top of the premium you pay, which goes to taxes and to the insurance company. These are usually front-loaded so that you pay more in the first ten years of the policy.
Monthly charges: This is a fee that the insurance company charges to maintain your account, although some of it goes to costs such as the underwriting they had to do.
Costs are calculated based on the “net amount of risk” which is the difference between the death benefit and the cash value. As your cash value builds up, the amount of risk decreases, and so do your fees.
Withdrawal fees: This is a fee charged to you every time you withdraw money from the cash value. It is usually from $20-40.
How to Calculate Cash Surrender Value in an IUL Policy
If you decide to surrender your policy, the cash surrender value is whatever money is in the cash value account, minus the fees. If you try to surrender the policy before you’ve built enough cash value, you might not get any money.
Ed Slott – a renowned tax expert – on tax benefits of IUL policies
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How to Calculate Retirement Income You can Withdraw from an IUL Policy
The retirement income that you want to withdraw from an IUL policy comes from the cash value account of the policy. How much you can withdraw as annual retirement income depends on how much you have in your cash value account, how many years you want to withdraw, and how the index performs in these years.
For example, when you are 60 years old, there is $320,000 in the cash value account of your IUL policy, and you want to withdraw annual supplemental income from age 61 to 80 (20 years). Of course, you have stopped paying premiums to the policy since it has been considered paid-up. The insurance company calculates an amount that you can withdraw from the cash account of the policy on an annual basis for 20 years assuming an average interest rate the account will earn and other fees and charges the account has to pay to maintain the policy and keep it in force.
The goal of this calculation is to ensure that you can withdraw such an amount consistently for 20 years, it covers fees, charges, and insurance cost needed to maintain the policy until you pass away (at an age based on the estimate of the insurance company), and finally when you pass away, the policy is still in force and able to pay your beneficiaries a death benefit amount (usually a small amount). You probably realize that the calculation is not only complex, but also impossible to calculate exactly because some variables in this calculation are unknown such as the interest rate the cash value account would earn each year in that 20 years period, when you would pass away, etc. So any number the insurance company provides from this calculation are at best an estimate based on their 100+ years of historical data.
You can also have a reverse approach: starting with the amount that you wish to withdraw as annual retirement income from the policy, the number of years of withdrawal, and calculate the premiums you have to pay.
For example, you’ve decided that you need an extra $20,000 a year to supplement your social security and other income during retirement. Based on past market performance (which is just that—past market performance and does not necessarily indicate future results) the insurance company will calculate what you’ll need to pay given how old you are now and when you want to start making withdrawals.
There’s a IUL calculator you can access that will give you estimated amounts on a hypothetical IUL. If you are age 40 and contribute $10,000 annually and expect a 7% rate of return, you’ll have $48,971 to withdraw for retirement every year starting at age 66. Your total benefit is $1.6 million, and you should be set no matter when you pass away. Depending on when that it, your heirs get the rest of the money as the death benefit.
IUL policies have come under fire recently for being difficult to understand and unnecessarily complex. There is a class action lawsuit alleging just that in California. Insurance companies are watching what happens with this lawsuit very carefully, and it could affect the industry as a whole. It’s not that IUL is a bad product, but you do need to understand what you’re getting. There are no guarantees of earning money, there is the potential to earn money. It’s also important to understand this a long-term product—if you cancel before the 10-year mark, you may receive little from the policy. If the product is designed well and you know what you’re getting into, a IUL policy is a great way to supplement your income in retirement.