What Happens to IUL When It’s Light-Funded
Updated April 2024 · by John “Hutch” Hutchinson, ChFC®, CLU®, AEP®, EA
Light-fund an IUL — never getting anywhere near the planned premium — and the policy still works; it just works smaller. Same contract, $60,000-a-year plan: funded on schedule ($300,000 in), it shows $716,000 of cash value; funded at a fraction of plan ($170,000–$185,000 in), it still supports roughly $30,000–$32,000 a year of tax-exempt income for 20 years and leaves six figures of death benefit behind. No agent leads with the underfunded column. It’s the one clients are quietly worried about, so here it is run honestly at three very different premium levels.
Here’s two other videos explaining IUL scenarios:
What Happens to IUL When it’s Late-Funded
Indexed Universal Life’s Full Range of Flexibility
Where are you with your IUL learning journey?
Questions??? Email me at Hutch@BankingTruths.com
Three funding levels, one policy
Squashing the death benefit
What’s left in cash value
Income from a light-funded IUL
Most of these conversations start with the optimal design, and the second one is usually about paying premiums late. This is the harder version of the question: not late premiums, but premiums that never come anywhere close to what was planned. It’s worth understanding, because it’s the scenario clients are quietly worried about when they hesitate to sign.
One aside before the numbers. The case on these illustrations is labeled Ex. Client, which stands for example client — not ex-client, which is what you end up with if nobody ever showed them the range of flexibility inherent in IUL before they signed.
Same Policy, Three Very Different Funding Levels
All three runs are the identical contract: $1.295 million of death benefit and a planned premium of $60,000 a year. All three also start out the same way — $60,000 a year for the first two years, so $120,000 of cumulative funding, which is the maximum allowable non-MEC premium for optimal growth and income later on.
From year three they part ways:
Optimal funding. Five premiums of $60,000 in five years — $300,000 in, on schedule.
The $10,000-a-year scenario. $60,000 for two years, then $10,000 a year for five more, filling the policy up as much as they can over seven years — $170,000 total.
The $5,000-a-year scenario. $60,000 for two years, then $5,000 a year all the way out to year 15 — substantially lighter premiums paid over a much longer stretch, $185,000 total.
So two of these three clients fall far short of the plan. One of them never gets more than a sixth of the planned premium in during any year after year two, and still ends up putting in more total dollars than the other light-funded client — just spread over more than twice as many years.
Squashing the Death Benefit Once the Seven-Pay Test Resets
In both light-funded scenarios we drop the death benefit substantially after the seventh year. Let’s be honest about why: clients don’t start these policies as much for the protection as for the long-term performance. If we want performance on a light-funded policy to look good, we have to drop the death benefit to the lowest amount the IRS will let us.
There’s a seven-pay test in the way of doing that early. But after seven years you get a new seven-pay test, and at that point we can go ahead and squash the death benefit down.
The shape of the death benefit over time tells the story. Through the first seven years the optimally funded policy grows the most, because it uses an Option 2 death benefit — the death benefit increases by the growth of the cash value. When more premium is going in, the death benefit and the cash value grow in tandem.
The two light-funded policies behave almost identically to each other over that stretch. After the initial $60,000 years, their death benefit stays relatively flat, and then after year seven we squash it to the lowest level possible. By that point more money has gone into the $10,000-a-year policy, so its death benefit lands higher than the $5,000-a-year policy’s.
Then the death benefit starts declining again between ages 64 and 65 — that’s where income starts coming out.
What’s Left in Cash Value
Obviously it’s better to get more money into the policy sooner and let it flourish. Pay five premiums of $60,000 a year and you’re looking at $716,000 of cash value — and that’s at the AG-49 crediting rate these illustrations were run at, not an aggressive assumption.
The two light-funded policies come in substantially lower, which they should. One only got $170,000 of premium in and took longer to do it. The other got $185,000 in and took even longer than that. Still not a bad pile of cash for something with the risk profile of CDs, savings accounts, or the like.
Stretch the same policies out to life expectancy and the pattern holds. The optimally funded policy stays higher the whole way — there’s simply more money in there working. But the two light-funded policies hold strong, and they hold strong in tandem with each other.
Income From a Light-Funded Policy
Now turn on income and look at the level amount coming out in the first year. It’s obviously a lot less than the max-funded scenario produces. But remember what went in: substantially less premium, and it took longer to get there.
Put in $170,000 or $185,000 and the two light-funded policies still support somewhere in the range of $30,000 to almost $32,000 a year of tax-exempt income for 20 years — totalling $612,000 and $638,000 of tax-exempt income across those two decades. That’s not too shabby, especially considering that isn’t all that happens here.
Clients Forget This Is Still Life Insurance
Clients often forget that this is a life insurance policy, because they’re using it for income. Go back to the death benefit and, even though it shrank quite a bit, there’s still over six figures of tax-free death benefit left behind for heirs.
Most of our clients aren’t going to leave the undertaker with the bill — some of them are even buying burial policies off infomercials anyway. This essentially acts as their burial policy, and it cleans up any lingering affairs from an illness: hospital bills and whatnot.
Add it up and close to two-thirds of the premium, or somewhere thereabouts, is left behind as a death benefit — on top of two decades of tax-exempt income, with some amount of death benefit in place the whole way.
The Premium Isn’t as Rigid as Clients Think
Here’s the takeaway. Clients look at the bill for their insurance policy as a rigid thing that has to be met. Meeting it may well be optimal for them — but it isn’t as rigid as they think.
Showing them that the escape hatches exist — that there are ways to bow out of what was originally planned and still produce a favorable result, both during their lifetime and at death — is often what helps them wrap their head around why indexed universal life is worth using as an asset class at all. A plan you can under-deliver on and still come out with two decades of tax-exempt income is a plan you can actually commit to.
Where your own escape hatches sit — how low you could go, for how long, and what it would cost you — is a function of your age, health and design, not something any article can answer. Click here to schedule a call with us and we’ll run your version of these three columns.
BankingTruths.com is John “Hutch” Hutchinson’s independent education and brokerage platform, not a captive agency tied to one carrier. Educational only. Indexed Universal Life policies involve fees, caps, participation rates, spreads, policy charges, and loan risk. Index credits are not guaranteed. Policy loans and withdrawals may reduce cash value and death benefit, may cause the policy to lapse, and may create taxable income if not managed properly. This analysis represents the author’s professional opinion based on 19 years of experience and should not be considered tailored financial advice for your personal situation. Consult your tax, legal, and financial professionals before implementing any strategy.