You may have come across Indexed Universal Life (IUL) insurance and thought of it as a great option: you get life insurance, and your savings grow when the stock market goes up, but you never lose a cent when the market crashes. However, this “guaranteed” protection is offset by high fees, capped returns, and complex rules.
This guide will examine how Indexed Universal Life insurance works, its real benefits and drawbacks, who might genuinely benefit, and what superior alternatives exist for most Canadians.
What Is Indexed Universal Life Insurance?
Indexed universal life (IUL) insurance is a form of permanent life insurance coverage that lasts for the insured’s entire lifetime, provided you continue to pay the required premiums. Like other permanent life insurance policies, it offers a death benefit that pays your beneficiary upon your death and a cash value that accumulates over time.
The defining feature of IUL is how its cash value is credited with interest. Instead of a fixed rate, the interest is linked to the performance of a stock market index, such as the S&P/TSX 60. The insurance company uses financial instruments (typically options) to offer this linkage while managing its risk.
This is controlled by three key factors:
- Floor Rate: The minimum guaranteed interest rate, typically 0%. It protects your cash value from direct market losses. If the index has a negative return, your cash value is credited with 0% interest for that period (though policy costs are still deducted).
- Participation Rate: This determines what percentage of the index’s gain is used in the interest calculation. For example, a participation rate of 80% means you get 80% of the index’s return.
- Cap Rate: This is the maximum interest rate that can be credited to your cash value in a given period, regardless of how high the index climbs. In Canada, caps often range from 8% to 12%.
Example: How Interest is Credited
Let’s assume your policy has an 80% Participation Rate and a 10% Cap Rate.
Scenario 1: Moderate Market Gain
- The S&P/TSX 60 returns +9%.
- Your potential credit is: 9% x 80% = 7.2%.
- Since 7.2% is below the 10% cap, your cash value is credited with 7.2% interest for that period.
Scenario 2: Strong Market Gain
- The S&P/TSX 60 returns +15%.
- Your potential credit is: 15% x 80% = 12%.
- Since 12% is above the 10% cap, the credit is limited. Your cash value is credited with the maximum 10% interest.
Scenario 3: Market Loss
- The S&P/TSX 60 returns -5%.
- Thanks to the 0% floor, your cash value is credited with 0% interest. You do not lose principal due to market performance, but policy fees and the cost of insurance will still be deducted, reducing your cash value.
The Pros and Cons of Indexed Universal Life Insurance
Potential Benefits
- Lifelong Coverage: Guarantees a death benefit for your beneficiaries, provided the policy remains in force.
- Market-Linked Growth Potential: Offers the possibility of higher returns on your cash value compared to traditional fixed-interest universal or whole life policies.
- Downside Protection: The 0% floor protects your accumulated cash value from direct losses during market downturns.
- Tax-Deferred Growth: The cash value grows within the policy on a tax-deferred basis. The death benefit is paid out to beneficiaries tax-free.
- Premium Flexibility: Policyholders may have the flexibility to adjust premium payments within certain limits, depending on the policy’s cash value performance.
- Access to Cash Value: You can typically access the accumulated cash value through policy loans or withdrawals for emergencies or other financial needs.
Drawbacks
- Expensive Premiums & Internal Costs: IUL policies have high internal costs, including the Cost of Insurance, administrative fees, premium loads, and fund management fees. These costs are deducted from your cash value and can significantly reduce your net returns.
- Returns Are Not Guaranteed: Unlike a GIC or whole life policy, the interest credited is not guaranteed and can be 0% for extended periods.
- Caps Limit Upside Potential: In strong bull markets, your returns will be capped, meaning you will not fully participate in the market’s growth.
- Complexity and Management Burden: These policies require active monitoring. If the cash value underperforms, you may be required to pay higher premiums to prevent the policy from lapsing.
- High Surrender Charges: Terminating the policy in the first 10-15 years often results in substantial surrender fees, potentially causing you to lose a large portion of the premiums you’ve paid.
IUL Market Share and Lapse Rates in Canada
Indexed Universal Life represents a small, niche segment of the Canadian life insurance market, significantly smaller than both term life and traditional whole life insurance. It has not gained widespread adoption.
One of the most significant risks associated with IUL is the high probability of the policy lapsing. While precise, official statistics for Canada are not regularly published by regulatory bodies, some industry analyses and consumer advocates have suggested that a very high percentage of universal life policies are terminated before a death benefit is paid. This is often due to policyholders being unable to keep up with rising costs or the cash value failing to perform as projected. This highlights the critical need for caution and a clear understanding of the long-term commitment required.
Who Might Consider Indexed Universal Life Insurance?
Given its high costs and complexity, IUL is a niche product suitable for a very small segment of the population, typically:
- High-Net-Worth Individuals: Wealthy Canadians (e.g., earning over $250,000 annually) who have already maxed out their Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs) may use IUL as an additional tool for tax-sheltered wealth accumulation and estate planning.
- Business Owners: IUL can be used in specific corporate strategies. For instance, it can fund a buy-sell agreement or provide key-person insurance. A significant advantage is that upon the death of the insured, a portion of the death benefit can be paid out from the corporation to shareholders tax-free via the Capital Dividend Account (CDA).
For the average Canadian family, IUL is almost never the right choice. It is full of complexity, limitations, and risk for the average Canadian. Here are the key takeaways yyoushould remember befor buying this coverage:
You Must Actively Manage It
IUL policies require diligent tracking and premium adjustments. If you don’t monitor it closely, don’t buy it. Lapsed policies are extremely common.
Max Out Registered Plans First
Do not put money into an IUL policy that could go into the available RRSP or TFSA contribution room first. These registered accounts are the most efficient vehicles for tax-advantaged investing and wealth growth for Canadians. They offer complete control, transparency, and lower costs than insurance-based investment products.
Not A Standalone Investment
View IUL first as permanent life insurance, not an investment. The returns lag a direct equity portfolio in most cases.
Questions to Ask Before Buying an IUL Policy
If you are seriously considering an indexed universal life insurance policy, here are some key questions to ask your advisor and insurance provider:
- What Indexes Are Available?
Ask what market indexes can be linked to the policy’s cash value – common options are the S&P/TSX 60 or S&P 500. Understand how each index has performed historically.
- What Are The Rates For My Policy?
Request the specific participation rate and cap rate that will determine how much of the index gains get credited to your cash value. These are critical factors.
- How Is Interest Credited?
Ask if interest is credited monthly or annually based on index performance. Understand exactly how the gains are calculated.
- What Fees Are Charged?
Inquire about all fees charged on the policy, including administrative fees, fund management fees, mortality costs, etc. Fees can significantly erode net returns.
- How Flexible Can My Premiums Be?
Find out if you have the flexibility to adjust premiums up or down, or if they are locked in. Ask about any limitations or charges for premium changes.
- What Happens If The Policy Lapses?
Learn about the risks and costs if you unintentionally let the policy lapse due to insufficient premiums or cash value. Understand how lapses are handled.
Asking the right questions is crucial to evaluating if IUL insurance truly meets your needs and risk tolerance. Research carefully before making long-term commitments.
The Bottom Line
While Indexed Universal Life insurance offers an intriguing mix of downside protection and market-linked potential, it is an expensive, complex product designed for a very specific, wealthy clientele. The high fees, limited upside, and risk of lapse make it unsuitable for the majority of Canadian families.
The most prudent financial strategy for most people is to first secure affordable term life insurance to protect their dependents and then aggressively fund their RRSPs and TFSAs for long-term growth. These vehicles offer greater transparency, control, and superior net returns over time.
Approach IUL with extreme caution and skepticism. It should only ever be considered after all other registered savings avenues are exhausted and with the guidance of a trusted, fee-based financial planner who can provide an objective analysis of its place in your overall financial plan.
FAQs on Indexed Universal Life Insurance
Is indexed universal life insurance a good retirement investment?
No, IUL is generally not a good retirement investment vehicle compared to RRSPs and TFSAs, given the high costs, fees, and cap on returns. It is first and foremost life insurance.
How does indexed universal life insurance differ from whole life insurance?
Whole life offers guaranteed premiums and minimum cash value interest rates, while IUL offers equity market upside potential but requires closer monitoring and carries more risk.
Can you overfund an indexed universal life insurance policy?
Yes, you can overfund an IUL policy by contributing more than the annual premium limit set by the insurance company, but this can result in tax issues and penalties. It’s important to be aware of IUL contribution limits.
How are premiums calculated for indexed universal life insurance?
IUL premiums are based on factors like the death benefit amount, the insured’s age and health, fees, projected returns, and the minimum required to keep the policy active.
What happens if you stop paying indexed universal life insurance premiums?
The policy may lapse if you stop paying premiums and there is not enough cash value accumulated to keep it active. Premiums may initially be paid from cash value before it depletes and lapses.
Can you borrow from an indexed universal life insurance policy?
Yes, you can take out policy loans against the accumulated cash value in an IUL, but any outstanding loan balance reduces the net death benefit paid to beneficiaries.
Is the death benefit on indexed universal life insurance guaranteed?
The death benefit on IUL is guaranteed as long as you maintain sufficient premiums and cash value to keep the policy active. It can lapse if you stop paying premiums.
Can indexed universal life insurance generate annual dividends?
No, IUL policies do not pay annual dividends. The growth is linked to a market index rather than being eligible for dividends like with some forms of whole life insurance.
