IUL Insurance Returns: High or Low?

Indexed Universal Life (IUL) is a unique type of permanent life insurance available on the market. Beyond providing a death benefit, an IUL policy also integrates the potential for rapid and tax-free cash value growth. However, the biggest question remains: Where do IUL insurance returns come from, and are they worth the expectation? This article will analyze how IUL generates returns, its mechanisms, influencing factors, and particularly the key risks associated with this type of insurance.

How IUL generates returns

IUL returns don’t stem from a single fixed source, but rather from a complex interaction between contractual factors and market performance.

Equity Index Linking

The core mechanism that drives potential cash value growth (and thus IUL returns) is the linkage to stock market index performance. Policyholders can allocate their cash value to accounts tied to:

• S&P 500®
• Nasdaq-100®
• Dow Jones Industrial Average® (DJIA)
• Russell 2000®
• International indices (e.g., Hang Seng, EURO STOXX 50®), or custom indices (e.g., blended, volatility-controlled)
  

Importantly, funds are not invested directly. The insurance company uses premiums to invest and purchase options on the chosen indices to cover the credited interest. A crucial point: Most IUL Secrets strategies track only index price changes, excluding dividends, which significantly differentiates them from direct index fund investments (which typically reinvest dividends).

The choice of index impacts potential IUL returns. High-volatility indices (like Nasdaq or Russell 2000) may hit higher caps during strong markets but are also more likely to credit 0%. Volatility-controlled indices may offer higher participation rates or caps (due to lower hedging costs) but often underperform in sustained bull markets.

See also: S&P 500 Index: Growth, Volatility, and Investment Insights

Participation Rates

The participation rate determines what percentage of index gains are credited to the cash value, directly impacting IUL returns.

Example: If the index gains 10% and the participation rate is 75%, the credited rate (before cap/fees) would be 10% × 75% = 7.5%.

This rate can be:

• 100%  –  Common baseline
• Below 100%  –  Typically in uncapped strategies or those with high caps (higher hedging costs)
• Above 100%  –  Sometimes in strategies with low caps or lower-volatility indices

Important: The insurer can adjust participation rates over time based on interest rates, market volatility, and hedging costs. This is a significant risk that may reduce actual IUL returns compared to initial illustrations.

Cap Rates (Interest Rate Ceilings)

The cap rate is the maximum interest rate you can earn during a crediting period, regardless of how much the index increases. It directly limits potential IUL returns.
Example: With a 9% cap and a 15% index gain, the credited interest would still be capped at 9% (before fees).

Typical range in the U.S.: 7% – 12%, though it can fluctuate.
Just like participation rates, cap rates are not fixed and may be adjusted by the insurer based on hedging costs, interest rates, and volatility. The risk of cap reduction is significant and can make actual IUL returns much lower than initially projected, affecting the long-term sustainability of the policy.

Floor Rates

The floor rate is the minimum interest credited, even when the index returns are negative.

• Common in the U.S.: Usually 0%, sometimes 1% or 2%.
• Benefit: Protects cash value from direct market losses.

Common Misunderstanding: A 0% floor doesn’t mean the cash value won’t decrease. Insurance costs (COI) and administrative fees are still deducted. So even if credited interest is 0%, the net cash value may decline. The floor protects against index losses, not internal cost erosion – an essential factor in assessing net IUL returns.

Additional Influencing Factors

• Spread: A fixed percentage subtracted from the index gain before interest is credited. Example: 10% index gain  –  2% spread = 8% credited. Spreads directly reduce IUL returns.

• Crediting Methods: How index changes are measured also affects results. Common methods include: Annual Point-to-Point, Monthly Average, and Monthly Point-to-Point. Different methods yield different results even with the same annual index return.

Key determinants of IUL profitability

The actual “return” from an IUL policy depends on a combination of fluctuating factors:

1. Stock Market Performance: This is the foundation for positive IUL returns. A strong market allows the policy to credit higher rates (up to the cap). Flat or declining markets – even with a 0% floor – may lead to minimal interest, while internal costs still erode cash value.
2. Contract-Specific Terms: Every IUL policy is unique. Cap rates, floor rates, participation rates, and spreads dictate the return potential. The insurer’s ability to adjust these terms (especially caps and participation rates) over time poses a hidden risk. Some contracts offer bonuses or multipliers, but these are not always guaranteed.
3. Internal Costs and Fees: This is a critical and often underestimated factor. Key charges include:

• Cost of Insurance (COI): Monthly charge for mortality risk, increases with age and health risk. It’s a major long-term drag on IUL returns.
• Premium Load: A percentage taken from each premium payment.
• Administrative Fees: Monthly or annual fixed charges.
• Surrender Charges: Heavy penalties for early withdrawals or policy lapses in the first 10 – 15 years.
• Rider Charges: For optional benefits (critical illness, waiver of premium, etc.). High internal costs can eat into credited interest or even principal, especially if IUL performance is weak. Fees vary widely among insurers, so careful comparison is essential.

1. Premium Funding Strategy: Flexible premium payments can be a double-edged sword:

• Underfunding Risk: Paying only the minimum may cause cash value to fall short of covering rising costs (especially COI), risking lapse – the worst-case scenario for IUL returns.
• Max Funding Strategy: Treating IUL as a savings vehicle by contributing the maximum allowed under IRS rules (to avoid MEC classification) maximizes tax-deferred growth. This requires a strong financial commitment and disciplined funding. Inadequate premiums are a major cause of policy failure.

1. Loans and Withdrawals: Accessing cash value is a commonly advertised benefit, but it must be managed wisely:

• Impact: Loans accrue interest (if unpaid, they compound and reduce the death benefit). Withdrawals permanently reduce cash value and death benefits. Both affect IUL returns and policy longevity.
• Loan Types: Fixed, variable, or indexed/participating. Participating loans may allow the loaned portion to continue earning index interest, but often involve additional fees or spread differences.
• Risks: Loan interest can accumulate quickly. If loan balances exceed cash value, the policy may lapse. Lapse with outstanding loans can result in significant tax consequences (the unpaid loan is treated as taxable income). Therefore, borrowing must be done cautiously…

Expected vs. Actual returns of IUL

Understanding the mechanics is one thing, but visualizing actual returns and managing expectations is crucial to avoid disappointment.

Reasonable Return Range: There is no exact or guaranteed “average return” number. It varies significantly depending on the policy, the company, and the market. This number depends on choosing low-cost products, funding the policy properly, and long-term market performance.

Importance of Long-Term Vision for Returns: IUL is a long-term product. The potential benefits (overcoming surrender charges, accumulating enough to offset costs, compounding interest) only become effective after decades. It is not suitable for short-term goals. In the early years, growth can be very slow or even negative due to front-loaded charges and high surrender fees. Patience and full premium funding are essential for IUL returns to have a real chance of materializing.

IUL Growth Illustration Table

Assumptions Used in the Illustration:

• Linked Index: S&P 500 (price return only, no dividends, 2015 – 2024)
• Interest Crediting Method: Annual Point-to-Point
• Cap Rate: 9.0% (assumed, subject to change)
• Floor Rate: 0.0% (guaranteed)
• Participation Rate: 100%
• Premium Load: 8% in year 1, 6% in subsequent years
• Administrative Fee: $120 per year
• Cost of Insurance (COI): Estimated as a growing percentage of prior year-end cash value (0.20% in year 1 to 0.65% in year 10), rough estimates only
• Timing: Premiums paid at the beginning of each year, charges deducted before interest is credited, interest applied at year-end

This table shows year-by-year fluctuations in:

• S&P 500 return (price only),
• Credited interest (after applying 9% cap and 0% floor),
• End-of-year cash values based on different premium levels ($2,000, $3,000, and $5,000 annually).

Direct risks affecting IUL returns

Besides potential benefits, IUL comes with many risks that can derail return expectations:

Market and Interest Rate Risks:

• Poor Index Performance: Leads to low or zero credited interest.
• Changes in Policy Terms (Cap/Participation): Insurer may lower caps or participation rates, reducing future returns.
• Interest Rate Environment (Indirect): Persistently low interest rates put pressure on insurers’ ability to offer attractive caps/participation rates. Affects variable loan rates as well.

Policy Risks:

• Lapse Risk: The most severe! The policy lapses if the cash value cannot cover policy charges (due to underfunding, poor market performance, high charges, or excessive loans). Results in loss of coverage and potential tax consequences.
• Complexity Risk: Policies are hard to understand, leading to poor decisions and unrealistic expectations.
• Illustration Risk: Over-reliance on optimistic projections that are not guaranteed.
• Policy Persistence Risk: High lapse rates due to poor performance or more attractive alternatives. Early surrender often results in high charges and loss.

High Internal Costs: Again, IUL’s internal costs (rising COI, admin fees, premium loads, surrender charges) are often higher than term insurance or pure investments, significantly reducing potential returns.

Regulatory Oversight Gap (No SEC Supervision): IUL is an insurance product regulated at the state level, not by the SEC like securities (stocks, mutual funds, VULs). Disclosure standards may be lower. Agents only need an insurance license, not a securities license, contributing to complexity and potential mis-selling.

Comparing IUL Returns to Other Solutions in the U.S.

IUL vs. Whole Life Insurance

See also:

• What is Whole Life Insurance? Important notes when purchasing Whole Life Insurance in the US

• What is IUL Secrets Insurance? 9 Benefits of IUL Secrets

IUL vs. Direct Investments (401k, IRA, Brokerage Accounts)

• Growth Potential: Direct investments (like S&P 500 funds) may outperform IUL (no cap, includes dividends).
• Risk: Direct investments carry full market risk (can lose value) vs. IUL offers downside protection with a floor.
• Costs: IUL is expensive (insurance, admin) vs. direct investments (e.g., ETFs) are often low-cost.
• Taxes: IUL offers tax-deferred growth, tax-free death benefit, and tax-free withdrawals/loans if structured properly (not a MEC). Other accounts have separate tax rules (e.g., capital gains tax, deferred taxation, Roth is tax-free on qualified withdrawals).
• Liquidity: IUL allows loans/withdrawals (with risks/costs); retirement accounts have age restrictions (before 59½); brokerage accounts are more liquid.

Conclusion

IUL in the U.S. is a complex product that offers both opportunity and risk. It provides lifelong death benefit protection (if maintained properly), market-linked cash value growth with downside protection (0% floor), flexibility, and tax advantages.

However, expectations of IUL returns exceeding Whole Life come at the cost of complexity, erosion from internal charges, and significant risks (changing terms, market uncertainty, lapse). Most importantly, IUL returns are not guaranteed.

FAQs

1. What is the average annual return of IUL insurance in the U.S.?
   There is no fixed average number. Returns are highly variable, depending on index performance, contract terms (cap, floor, participation rate), costs, and premium funding strategy. Illustrations are not guaranteed. Conservative analysis suggests the long-term net return may range from around 4% to 6%, but this is uncertain and can vary significantly.
2. Can I lose money with IUL insurance in the U.S.?
   Yes. Although a 0% floor protects against index losses, net cash value can still decline if charges (COI, administrative fees) exceed credited interest (especially when the interest rate is 0% or very low). Early surrender can also lead to losses due to surrender charges.
3. Are IUL returns in the U.S. guaranteed?
   No. Returns are generally not guaranteed. The only typical guarantees are the 0% floor and possibly a low fixed interest rate. The key factors affecting returns (cap rates, participation rates, bonuses) are not guaranteed and may be changed by the insurer.
4. Compared to directly investing in the S&P 500, is IUL more or less profitable?
   The long-term return potential of direct S&P 500 investment is typically higher (no cap, includes dividends, lower costs). However, direct investment carries full loss risk. IUL protects against index losses, offers tax advantages, but limits upside potential and involves higher costs. IUL combines insurance with potential investment, serving different goals and risk profiles than pure investments.