What do Caps, Floors, and Participation Rates mean in an IUL
It is important to have a good understanding of the various components that are used in determining the return on an IUL used in a LIRP – and in particular, caps, floors, and participation rates – as these can have a significant impact on your overall return and how the interest is applied to your cash-value account.
What is an IUL Cap?
The cap is the maximum interest rate that may be credited to the policy in a given contract year. For example, if the cap rate is 11%, and the underlying index returns 14% for a contract year, then the cash value account will be credited with 11%.
Keep in mind, though, that if the underlying index has a negative return for a given contract year, the account will not lose value – even if the index suffers a double-digit loss for that time period. See more about floors below.
Caps vary from carrier to carrier and index to index. Caps are not contractually guaranteed and are reviewed annually or quarterly by the carriers.
We know the caps for each carrier’s products and why it’s important to let us guide you to choosing the best index. Some current carrier caps on the S&P can range from 10% to 17%. There are also index choices with no caps. These are powerful indexes as they do not limit upside years and allow you to capture all the upside gains.
What is the IUL Floor?
The floor is the minimum guaranteed return for the interest credited to the policy’s cash value component. Many IUL (index universal life) policies will have a 0% floor, ensuring that the policy won’t lose value, even if the underlying index performs poorly in a given year. This means you never lose money in down years.
Some IUL policies offer a floor of 1% or 2%, which means that the policy is guaranteed to receive at least some amount of positive interest credited to it, no matter how the index performs. In any case, your principal is protected.
How Do IUL Participation Rates Work?
An index universal life insurance policy in a LIRP may also use a participation rate in calculating the return. This rate determines how much of the underlying index’s increase will be used in computing the return in the cash value component.
For instance, if the policy’s participation rate is 80%, then the cash value component will be credited with 80% of the underlying index’s return. In this case, if the index has a 10% return in a given contract year, and the policy’s participation rate is 80%, then there would be an 8% return credited to the cash value.
80% X 10% = 8% credit
Participation rates on some indexes can also be over 100%. For example, if an index has a 130% participation rate, on the same 10% return your annual credit would be 13%.
130% x 10% = 13% credit
Below you can see how a 135% participation rate can add additional interest to the performance of an underlying index. This is a real carrier and historical returns.
Look at the index return in 2017. The index returned a 14.73% rate, but with a 135% par rate, your policy interest credit would have been 19.89% for the year.
It is important to note that IUL policies will have both caps and participation rates. With all of the moving parts that can be found on a LIRP, it is recommended that you first discuss your objectives and your options with an advisor who specializes in these plans before you make a long-term financial commitment.