At insurance and estates we don’t try to pretend that there is one best life insurance policy or company. The “best” policy depends on your specific needs, goals and objectives. In some cases the “best” policy will be VUL. Variable life insurance.
In the following article on Variable Universal Life Insurance, we will cover the history of the product, what are the pros and cons associated with Variable Universal Life and when it is a good idea to choose a VUL policy. Is VUL the best life insurance choice for you?
Before we can answer that, let’s start with some basic definitions…
What is Variable Universal Life?
Variable Universal Life (VUL) is defined as a type of permanent insurance policy, in which the cash value can be invested into different accounts consisting, for example, of stocks, bonds and mutual funds.
Variable Universal Life is a form of permanent life insurance that has been around since the early 1980’s. Permanent life insurance is called such because it is in force permanently (as long as you pay your premium payments). This is in contrast to Term life insurance, which is for a set period of years (usually 20 – 30).
Due to the fact that these separate accounts are investments in securities, such as stocks, these policies are regulated under the federal securities laws. And you have to have a securities license in order to sell variable universal life policies. In other words, your normal, run of the mill, insurance agent is not allowed to sell VUL.
History of the VUL policy
During the middle of the 20th century term life insurance provided temporary coverage while Whole Life insurance provided coverage for those that needed it to last a lifetime (or longer than 20 years). For more, see term life vs whole life insurance, where we break down the differences between the two types of policies.
In the 1980’s when interest rates started rising many dividend paying whole life insurance policy owners saw increasing interest rates that did not reflect lower policy dividends. (One reason is life insurance dividends tend to go up at a slower rate than interest rates.)
So many people began to ask if there was a better option. Why not buy term insurance and invest in some sort of money market account that was paying double the dividend rate of the whole life policy?
Americans started to cash in their whole life policies in droves. And the insurance companies were scrambling to figure out a solution. Enter universal life insurance.
This policy didn’t offer the guarantees of the whole life policy, but it did offer flexibility and potential growth comparable with the money market accounts that were so enticing to consumers. For more on how these two compare, see whole life vs universal life.
Just a few years later, in the middle of the 80’s, Whole Life policies were paying over 13%, while their counterpart Universal policies were only paying 7%. Meanwhile the stock market was consistently averaging close to 15%. People wanted to buy term and invest the difference, and who could blame them.
In an effort to suppress the exodus from their products, the life insurance companies decided to add mutual funds to their cash value investment options – and thus the Variable Universal Life policy was born. The VUL was just another form of permanent insurance, but now it could grab the healthy gains of the stock market.
The VUL is still with us today, and the options for policy holders are far greater than when it was introduced. It also has some other benefits that make this product a viable option for some people today. But along with those benefits, there also happens to arise some negatives.
The following is just a quick list of the popular pros and cons of the variable universal life insurance policy. We here at Insurance and Estates hope that this list will help provide just a little insight into this unique insurance and investment product.
Pros of Variable Universal Life
Pro #1 – Death Benefit
The VUL is both an investment product AND a life insurance product. As such, it’s important to note that one of the major benefits over products that are just investments, is that there is an income tax free death benefit payout to the insurance beneficiary.
Money will never be able to replace the loss of a loved one, but avoiding the double-whammy of a family death and massive financial hardship is significant.
All life insurance products have a death benefit, so it may seem odd to discuss this as a pro, but ultimately it is the key aspect that is being purchased, so it shouldn’t be dismissed.
Also, keep in mind that this is permanent life insurance. In other words, this life insurance will not expire as long as you keep paying the premiums. It is different from term insurance which expires after a typical 20 or 30 years.
An additional benefit is you can add certain long-term care riders to your VUL policy to add additional protection if you are disabled and cannot perform 2 of 6 activities of daily living.
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Finally, there is no endowment age with most VUL’s (the age at which the cash value equals the death benefit amount).
Pro #2 – Flexible Premiums
Just about any time you see the word “universal” in the name of an insurance policy, you can assume your premium payments will be flexible. In this case it is true with the VUL. The premiums can go up or down for a couple reasons.
You can choose to raise or lower your death benefit. Keep in mind that in most cases increasing your death benefit will require proof of insurability.
The performance of your cash value account may allow you to lower your premium.
Whole Life policies have relatively fixed premiums which can be supplemented through dividends, whereas Variable Universal Life has more flexibility built into the policy.
Many people like the fixed premium of whole life because they know what they have to pay and can budget accordingly.
With variable universal life, your premium can fluctuate up or down depending on various factors, including stock market performance. This can be a plus or minus depending on which side your policy falls on.
In contrast, whole life insurance is a non correlated asset. That means that the performance of the stock market does not have a direct affect on the peformance of your whole life policy. Rather, whole life acts as a safe bucket, that provides peace of mind away from Wall St.
Pro #3 – In the Market – Inflation Hedge – No Rate Cap
This third pro is the reason the Variable Universal Life policy was created. So policy holders could enter the investment market with their cash value .
By entering the market, the VUL provides a permanent life insurance product with NO RATE CAP. If the mutual fund to which the cash value is invested returns a rate that exceeds 20%, the full amount is credited to the policy holder’s account (minus fees of course).
As a product that is fully entered into the stock market, the cash value has the luxury of gaining a hedge against inflation. If the economy is strong and booming, inflation will likely increase, and so will the cash value in this account.
The ability to participate fully in the market and still receive the tax benefits of life insurance is one of the primary reasons variable universal life is used in private placement life insurance.
Variable Universal Life vs Indexed Universal Life
Having no rate cap can be a huge advantage when comparing VUL vs IUL policies. VUL insurance policies have the ability to offer higher returns. Included with higher returns is the ability to lose principal in a down market.
With an Indexed Universal Life policy the max rate cap is around 13%. If the market goes up beyond that you will not participate in the additional gains from the index your policy is correlated with. Some IUL insurance policies offer no cap but have a lower participation rate.
On the other side of the coin is with an IUL policy, there is a floor. The floor of your indexed universal life policy protects your policy from negative market returns. However, with a VUL policy, your loss is potentially unlimited, based on what the stock market does.
Pro #4 – Tax Advantaged
All cash value life insurance has distinct tax advantages. Death benefits are paid out to beneficiaries tax-free. And all gains in cash value are tax-deferred. However, there is a bonus that can make the product virtually tax-free for life – including the gains.
Taxes are typically only charged on withdrawals of the cash value. And even then, your withdrawals occur FIFO (First In – First Out), which means that the premiums you paid in to the cash value would have to be completely depleted before your withdrawals would be taxed.
Just to be a little clearer, your withdrawals will be tax free on the basis (premiums paid in). You will only be taxed on the growth of the account IF you withdraw beyond your basis. But most people don’t choose to withdraw their money because that lowers their cash value – and thus their potential earning. Instead they choose life insurance policy loans – which we’ll discuss next.
Pro #5 – Cash Value / Policy Loans
The variable life insurance policy is a cash value life insurance product. As such, a certain amount of the premium goes toward the cost of insurance while the remainder goes to the cash value.
This cash value is invested in a number of ways across the different permanent life insurance products. The VUL gives the policy holder the option to invest in securities which are not available to any other type of life insurance.
The cash value portion of the policy is the engine that makes the policy work. Without the cash value, the premiums would eventually rise very high and the policy would likely lapse. But if the cash value is invested wisely, and the investments perform well, the cash value may grow faster than any other life insurance product.
You don’t have to withdraw your money to access it!
Life insurance policy loans are a unique way in which many policy holders access their cash value without incurring any tax hit. In addition they don’t reduce their cash value.
It is true that they pay interest on the loan, but they also receive a dividend on the cash value (which is the pool the loan was pulled from). This arbitrage can work in your favor. Or in many cases can just mean that you have a wash loan – it costs you nothing.
Many people with VUL policies take out policy loans at or near 0%, and use the money well into retirement for a variety of wants and needs. When the insured ultimately dies, the death benefit is paid minus the outstanding loans. But again, the death benefit is tax-free to the beneficiaries.
So far this product may sound like it’s perfect, but there are a few negatives.
Variable Universal Life Cons
Con #1 – More Risk / In the Market
When the savings component of the insurance policy is separated from the death benefit, the risk is transferred to the policy holder. The VUL allows the policy holder to invest in various financial markets, and those markets are not guaranteed. Without guarantees the policy holder is required to accept risk.
Risk is acceptable only because there is hopefully a comparable amount of reward.
In other words, the risks are warranted because of the rewards. We talked about the rewards of the VUL above when we mentioned they have no rate cap. The higher possible returns are the carrot that entices the consumer into the VUL.
With Variable Universal Life policies your cash value can drop dramatically in a very short period of time. In 2008, there were mutual funds that lost more than 50% of their value in just a few short months. That means there is tremendous risk for those that choose to enter that market.
If you are considering a Variable Universal Life policy, please weigh the risks of market exposure.
Con #2 – Higher Cost
Due to the fact that the VUL cash value is being invested in the financial markets, there are additional oversight, policy charges and management fees. So the VUL typically has a higher cost per year than a comparable Universal Life policy.
Many financial advisors will recommend buying term insurance and investing the rest in low cost ETF’s or money market funds. This strategy provides protection while also enjoying the market gains of financial markets. However, this strategy is not a form of permanent insurance coverage, and therefore isn’t an apples to apples comparison.
Besides, no one actually buys term, figures out the difference in price with whole life, and then invests accordingly. And what this tired mantra fails to take into account is the tremendous leverage associated with the life insurance death benefit, missing from any mutual fund.
Further, as mentioned above, private placement life insurance benefits by using the tax incentives allotted to life insurance by the IRS.
If you want permanent insurance and also want the ability to use the cash value to invest in the financial markets, you’ll likely have to pay more in policy expenses. Not all VUL’s have the same fees, so make sure you do a cost comparison with a trusted life insurance strategist before you sign up.
Con #3 – Complicated / Requires Management
It’s also true that a VUL can be complicated. This is especially true when compared with other forms of insurance. With Variable Life you have the option, and responsibility, to manage multiple investment accounts. You can invest in mutual funds, or money market funds, or even hedge funds.
The policies today often offer 50 or more separate accounts covering an incredible variety of asset classes and management styles. The separate accounts are organized as trusts to be managed for the benefit of the policy holder.
They are called separate because they are not included with the ‘general account’ of the life insurance company. In this way they are similar to mutual funds, but have different regulatory requirements and investment risks.
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Ultimately the variety of options and responsibilities provided to the policy holder requires greater oversight and knowledge. All that to say – the Variable Universal Life policy can be complicated.
Con #4 – Premiums may Rise / Account suffers Loss
The additional complexity and variety of a VUL, along with the added risk, comes the potential for loss. If you you lose your cash value, or you lose a substantial amount of your cash value, the policy will be in jeopardy.
With a VUL the insurance company has passed the risk to the policy holder, in exchange for greater choice and potential gains. But ultimately the death benefit has to be paid.
Therefore the insurance company needs to raise premiums to meet their actuarial targets. The cash value of your VUL policy needs to meet certain targets (seen in your prospectus), or the policy premiums will need to rise. If you don’t pay the increased premiums, the policy will likely lapse, or will need to be modified.
With most permanent life insurance there are guarantees against loss. Some are greater than others, but with the Variable Universal Life policies, the risk of loss is greatest. You are responsible for your investment risk and will need to diversify accordingly.
It is true that many insurers offer guaranteed death benefits up to a certain age, as long as premiums are paid. But this is not much of a guarantee as it really only amounts to a term policy rider.
Con #5 – No True Guarantees
I guess this is pretty obvious by now, but we thought it should be spelled out – no true guarantees. Whole Life has a guarantee. Universal Life has a guarantee. Variable Universal Life does not have a guarantee. At least not a true guarantee in the same sense as the WL and UL policies.
As mentioned above the VUL can provide a death benefit guarantee up through a certain age. But that is really just the bare minimum and is no better than Term. The separate accounts can gain or lose at any rate the market chooses. As such the risk is on your shoulders as a policy holder.
Whole Life offers guaranteed growth and a guaranteed death benefit.
Universal Life offers a guaranteed minimum annually and a guaranteed death benefit.
Variable Universal Life offers a temporary guarantee on the death benefit – that’s it.
For those that believe they have the skills to increase their cash value almost every year – the VUL is a fantastic tax incentivized option. But don’t expect any true guarantees.
As with all forms of life insurance there are advantages and disadvantages to the Variable Universal Life policy. For those people that are savvy investors, and yet want their investments tied to a life insurance product – the VUL is a great option. For others, and I would even say for most, the VUL doesn’t offer enough advantages to outweigh the additional risk.
If you’re considering a permanent life insurance policy and you want to get some solid advice, contact us today. We highly recommend talking with a qualified professional when making financial decisions.