Variable universal life insurance (VUL) is a permanent life policy whose cash value depends in part on the performance of variable sub-accounts within the insurance contract. The variable sub-accounts are usually modeled after mutual funds but may contain their own separate fee structures. A variable universal life insurance contract may be attractive to those clients willing to bear a little extra risk in their life insurance contract for the opportunity to have a higher cash value, over time, with market-rate returns.
Variable life insurance can be thought of as an annually renewable term life insurance policy, with a cash value component that gets invested into stocks and bonds via mutual fund-like investments. The idea is that you can get a higher rate of return on your investment than whole life insurance, while still getting the benefits of permanent life insurance. While this approach may be a positive investment for some people, it comes with a higher risk, higher fees, and doesn’t serve the best interests of most clients. In this article we cover:
- Purpose of a Variable Universal Life Insurance Policy
- Variable Universal Life Insurance Premiums are Flexible
- The Insurance Cost Goes Up Over Time with Age
- How to Make A VUL Policy Work Well
- Why Not to Buy a VUL Policy
Purpose of Variable Universal Life Insurance
A whole life insurance policy or a universal life insurance policy are two relatively fruitful, yet predictable ways to build cash value within a life insurance policy. They are both great savings tools and provide permanent life insurance coverage for the insured person if funded properly. The rate of return of these policies, however, may trail stock or bond market returns significantly during times of high market returns. This can dissuade some people from owning permanent life insurance in favor of either forgoing life insurance altogether and investing in brokerage accounts instead, or owning term life insurance and investing the difference in cost into other investment vehicles.
While both of these strategies may have their merits, there are tax and estate planning advantages of permanent life insurance that can not be replicated in an investment account. In a life insurance contract, for instance, all withdrawals from cash value are taxed on a “First in First Out” basis, meaning that the cost basis is withdrawn before gains, free of tax. Life insurance proceeds are normally distributed to beneficiaries tax-free as well, which is not necessarily true of an investment account. Life insurance cash value also grows completely free of tax, and tax-free loans are permitted from life insurance policies for any reason, and often free of charge from insurance companies (interest will accrue though if not repaid).
Variable Life Insurance Bridges the Gap
Variable universal life insurance is a way to combine the benefits of both savings strategies, all while providing the needed life insurance coverage for beneficiaries and loved ones. Cash value saved in a variable life insurance contract is invested in variable “sub-accounts” within the contract, which are essentially mutual fund offerings. The investment options are limited to the available funds provided by the contract, but there are usually a large number of offerings from across a wide range of asset classes, meaning clients can direct their investment according to their desired strategy.
Variable universal life insurance policies still enjoy the same benefits as other forms of life insurance. Examples of these benefits are the ability to grow tax-free, policies have an increasing death benefit based on contract value (higher returns mean higher death benefit), and withdrawals are still taxed FIFO, so up to the amount you put in the contract is not considered by the IRS to be taxable. A loan can also be taken from a variable universal life insurance policy the same as with whole life insurance or traditional universal life insurance.
Premium Payments Are Flexible
A variable universal life insurance policy does not necessarily require policy owners to always make premium payments. The goal of many VUL policy owners is actually to stop making payments after a certain age and let market growth pay for premiums. As long as the policy has sufficient cash value to cover the monthly cost of insurance, the policy will remain active and is considered “in force”. A variable universal life insurance contract will have a grace period just like any other life insurance policy if insufficient cash value remains to pay for the cost of insurance.
The owner of the policy can choose to make payments or not make payments into the policy, as long as sufficient cash value exists in the account. Payments can also be made at any time, and generally speaking for any amounts. Payments can not exceed TAMRA 7 pay MEC limits or guideline premium limits, however, limits the government places on all insurance contracts regarding total contributions to the policy.
Cost of Insurance Rises With Age
The cost of insurance is not level like with a term life policy or a whole life insurance policy. The insurance costs are essentially the same as a permanent form of term insurance, with premium cost adjustments each year. While insurance costs can drop slightly year to year based on the mortality rate statistical changes or a health rating change, costs will rise over the lifetime of the policy. If a policy is well funded in the beginning years, the cash value growth with market returns theoretically will more than make up for the rising cost of insurance.
When Variable Universal Life Insurance Works Well
A VUL policy works well when the owner funds the policy sufficiently, and the earlier in the policy life the funding takes place the better off the policy will perform in the long run, generally speaking. If premium payments are made well in excess of the cost of insurance early in a variable insurance policy life, the internal returns from the investments should grow the policy value significantly over time. This theoretically will not only cover the rising costs of insurance but also create a nice savings nest egg for the policy owner with cash value. Remember that market returns are not the same every year, and the market can significantly underperform or outperform expectations.
The Argument Against a VUL Policy, Why We Don’t Recommend Them for Most People
In practice, we do not believe that a variable universal life insurance policy suits people well over time. There are a number of reasons for this such as:
- The risk. The investments can perform badly and the cash value can lose money.
- The cost of insurance. The cost of insurance is higher in a VUL policy over time because it renews every year. Late in the insured person’s life, the annual premium becomes very expensive and can easily bankrupt the cash value of a policy that was not really well funded.
- It is not the purpose of life insurance. It is a hybrid product that does not really provide permanent coverage very well due to the risks and insurance costs, and also is not an optimal investment because of the high fees. Life insurance is meant to provide protection to the beneficiary from the death of the insured person, it is not meant as an instrument to access the stock market for the owner.
- The surrender charges are very high. Variable universal life insurance policies have long surrender charge schedules. The fees in the first years can be very high (as high as 10%), and they can last 7-12 years.
- Insurance coverage and investments in the stock market can be handled separately. Most often, it is best to protect the financial interests of the beneficiaries through a stable and reliable method such as term life or whole life insurance. Additional money can be invested in the stock market separately and at much lower costs, which typically results in a better rate of return over time than trying to combine the two into a VUL policy.
When Variable Life Insurance Does not Work Well
A variable life policy does not perform well if the owner does not build cash value early in the insurance policy’s life. If the policy only has a small cash value, even high market returns will not create a lot of total dollar growth in the policy. As the policy ages, the cost of insurance rises, and the owner may not be able, or willing, to cover the cost of insurance late in an insured person’s life. If the policy lapses late in the life of an insured person, a lot of money was paid to the insurance company with no return for the beneficiaries or the owner.
For this reason at Life Ant, we recommend that only clients sophisticated enough to understand a variable universal life insurance policy (and with the means to properly fund it) consider this as a viable option for permanent life insurance. If our clients are not interested in a permanent form of coverage, generally speaking, a level term policy will provide a less expensive option.
Variable universal life insurance contracts contain surrender charge provisions. This means that if a life insurance policy is surrendered before the surrender charge period is over, generally 10-15 years depending on the product, the client will not get the full amount of cash value in the policy. Any client funding a VUL must be aware that these policies are a permanent form of insurance, and if there is any chance that the contract will be surrendered early it is probably not a viable investment.
Variable Life Works for Some People
Variable life insurance can provide an excellent form of permanent life insurance coverage with a higher internal rate of return than whole life or traditional universal life insurance policy. The key to this policy being successful if you ultimately decide to purchase one is to fully understand the benefits and risks, and for the policy to be funded appropriately.
All life insurance companies will provide full illustrations to clients showing the expected future cost of insurance, along with potential cash value growth rates. This can help a client plan an appropriate amount of money to pay as a premium, and help set reasonable expectations for when payments can stop being made into the policy.
Remember that variable insurance is not for those who are risk-averse, and market returns can not be predicted. A VUL insurance policy may outperform or underperform more traditional life insurance.