What Is Indexed Whole Life Insurance?

Reviewed by W&S Financial Review Board
 Indexed whole life insurance definition Indexed whole life insurance definition

Key Takeaways

  • Indexed life insurance is a type of permanent coverage with level premiums.
  • The interest rate is tied to a stock or bond index, which offers the potential for higher returns.
  • Indexed policies offer downside protection during periods when the index incurs a loss.

Permanent life insurance provides two important benefits: financial protection for loved ones and the ability to build cash value you can tap during your lifetime. Whole life policies, long a popular option, offer a savings component that can grow cash value predictably.

Thanks to its unique design, indexed whole life insurance offers greater potential growth for your cash value over time. Here's some of what you should know about these policies, so you can decide what works for you and your family.

Indexed Whole Life Insurance Defined

Indexed whole life is a type of permanent life insurance that offers level premiums for life, which helps protect against rising costs. A portion of your premium funds the cost of insurance (the death benefit plus administrative fees). The remainder helps build cash value which can be tapped via withdrawals in later years. That makes it a versatile financial solution, one that helps you protect your family's financial needs as well as address your own.

Traditional whole life products pay a fixed rate of interest from year to year. In contrast, indexed whole life provides a return tied to the performance of an "index" that represents an investment markets segment or strategy. Thus, these policies offer the potential for higher rates of return if Wall Street performs well. But at the same time, there's a chance you could receive a smaller credit — or even a return of zero — in a down year.

Depending on the insurer, you may have the ability to choose which market index it will use when calculating your interest payment. For example, an indexed whole life policy whose investment measure tracks the S&P 500 Index would provide a return based on the performance of the 500 largest U.S. stocks. However, your choices may include bond-based indices or indices that blend stock and bond holdings, seeking to reduce the volatility of your cash value returns.

An important benefit of cash value policies such as indexed whole life is that they grow tax-deferred. That means you aren't taxed on credited interest as it accrues. In addition, withdrawals and policy loans are tax-free as long as they don't exceed your "basis" — the total amount you've paid into the policy. Any gains in excess of your basis are taxed at your ordinary rate.

How Does Indexed Whole Life Work?

As you pay the premiums on an indexed whole life policy, a portion of that amount is credited to your cash value. In addition to the amount you contribute to the cash value through your premium, the insurer pays interest based on the performance of the index component tied to your policy.

To determine the amount of interest paid into your cash value, the insurer compares the index value at the start and end of an "index period." This window may or may not correspond to the calendar year. The insurer will then multiply that return by the policy's "participation rate."

Imagine you have a policy tied to the S&P 500, which has an index period starting on January 1 and ending on December 31. Suppose the index goes up by 8% over that stretch. If your participation rate is 100%, you'll receive an interest credit of 8% on the cash value portion of your policy. However, if the participation rate is 50%, your credit would be 4% (8% x 0.50 participation rate).

Typically, insurers declare a new participation rate before each index period, which reflects the performance of the market and the company's financial liability to its policyholders. The higher the participation rate, the more you can benefit from market gains, if any.

Some insurance carriers offer 100% participation but cap the interest rate you can achieve during a given index period. For example, if the company caps your return at 10% and the index appreciates by 8%, you'll receive the full 8% interest credit. But if the market has a strong year and the index rises by 15%, your policy still is only credited at the 10% rate.

A Degree of Financial Protection During a Market Decline

While indexed whole life policies may not provide the same return as investing directly in the market during "up" years, they also don't expose you to as much risk in "down" years. Policies typically credit at least 0% or 1% guaranteed interest in exchange for a slightly lower participation rate.

Consequently, if the index loses value over the course of the index period, you may receive little if any interest, but your cash value remains stable. Had you put your money directly into an investment that lost 10% of its value during the index period, its value would likely bear the full impact of that decline.

While indexed products are more volatile than traditional whole life policies, they're more stable than owning actual investments. Because of administrative fees, it's still possible for your cash value to decline slightly in a down market, although the impact is generally less than the amount of the investment loss from the index.

What Is the Difference Between an IUL and Indexed Whole Life Insurance?

Indexed whole life insurance has important similarities to another type of permanent coverage: indexed universal life (IUL). Both offer returns pegged in part to variable investments, as opposed to the fixed returns that non-indexed insurance offers. That element offers opportunity for higher returns over the long term.

However, there are important differences between the products. Indexed whole life policies set level premiums that are guaranteed never to increase. IUL policies, meanwhile, within limits allow you to adjust your premium and your death benefit as your needs change. You can even use your accumulated cash value to increase your death benefit or pay your remaining premiums. Because life is unpredictable, such flexibility can be an attractive.

The premiums for indexed universal policies generally rise as you get older. If you're unable to pay the premiums — and you don't have enough cash value to cover the cost — your protection could lapse. In general, whole life products tend to be a better choice for those who desire predictability. Universal life products often hold greater appeal for those who want the ability to adapt their coverage.

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Pros: Benefits of Indexed Whole Life Policies

In general, whole life insurance is a good fit if you're looking for guaranteed coverage for life with fixed premiums. Cash value growth will be tied to conservative interest assumptions. Policies with investment-based crediting may be worth considering if you're looking for potentially larger returns (and willing to accept market volatility) over a longer holding period. With indexed whole life, you benefit from:

  • Level premiums. Once you're approved for your policy, the premium remains the same over the life of the policy. Even as you get older and your medical risk increases, you can be confident that your costs will remain unchanged.
  • Guaranteed coverage. Permanent life insurance policies provide protection for your beneficiaries for as long as you pay the required premiums. With a term policy, however, you generally have to undergo medical underwriting to obtain new protection when the previous coverage ends.
  • Potentially higher returns. Traditional whole life policies pay a fixed rate of return that corresponds to more conservative investments. But indexed whole life insurance offers the potential for greater interest crediting if markets perform well.
  • Downside protection. Most indexed policies have a low or 0% guaranteed return. This enables you to avoid the negative returns that are possible in a given period when you invest in markets directly.

Cons: Drawbacks of Indexed Whole Life Policies

While indexed whole life policies offer certain advantages, they're also more complex than other types of coverage. Before you purchase, it's important to understand the risks associated with these products. Potential drawbacks include:

  • Higher cost. Because whole life policies allow you to build cash value, the premium can be several times greater than term policies with the same coverage amount. Make sure you can afford the cost of this type of coverage over the long term.
  • Larger fees. Because it's more complicated for insurers to manage indexed products versus traditional whole life, annual fees tend to be higher. These costs can be more significant in a down market because you're receiving little or no interest.
  • Potential for surrender charges. If you can't afford your premiums and your policy lapses within the first few years, you may have to pay surrender charges. Generally, these fees are assessed on a sliding scale, gradually reducing the longer you own the policy.
  • Withdrawals will reduce the death benefit. When you make a withdrawal from your cash value — or take out a loan that you don't repay — your death benefit will be reduced by that amount. That means less financial protection for your loved ones when you pass away.

Who Should Consider Indexed Whole Life Insurance?

Although its guaranteed interest payment is lower than that of standard whole life policies, indexed whole life provides the potential for greater interest crediting. Therefore, you may want to consider an index-based policy if you can tolerate receiving little — if any — interest during a market downturn if it could mean more favorable returns over the long run.

Because permanent life insurance is considerably more expensive than term coverage, make sure you can comfortably afford the premiums so you're not in danger of having the policy lapse. If your budget is tight, you may want to buy term insurance and create a budget that allows you to periodically invest a portion of your income for long-term financial needs.

Cash value life insurance, including indexed whole life, can be particularly beneficial for individuals and joint filers in higher tax brackets. Your cash value grows on a tax-deferred basis, allowing you to reduce your current annual tax liability. Plus, you can generally make tax-free withdrawals and loans from your policy, up to the amount you've paid in premiums. Those may be worthwhile considerations if you've maxed out your employer retirement plan or IRA contributions and seeking a tax-advantaged way to pursue wealth growth.

Is Indexed Whole Life Insurance Right for You?

If you're in the market for a life insurance policy, you'll quickly notice that there are many coverage options available. Index whole life insurance may be worth considering if you're looking for lifelong protection for your family as well as the ability to pursue long-term market opportunity.

Index-based life insurance policies are often more complex than other types of insurance, including traditional whole life. A financial professional can help you decide whether this product may help address your financial goals and determine how much coverage you may need.

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