Variable Universal Life Insurance: A Comprehensive Guide

Variable universal life (VUL) insurance is a type of permanent life insurance that offers a unique combination of death benefit protection and investment opportunities. It's a contract between you and an insurance company designed to meet insurance needs, investment goals, and tax planning objectives. VUL provides a life insurance benefit in exchange for flexible premiums, allowing policyholders to adjust their payments within certain limits. A portion of these premiums is invested in various sub-accounts, offering the potential for cash value growth.

Understanding Variable Life Insurance

A variable life insurance policy pays a specified amount (the death benefit) to your beneficiaries upon your death. It's crucial to understand how these policies work before investing. Familiarize yourself with key terms and request the policy prospectus from your financial professional, which details the specific policy you're considering.

Is VUL Right for You?

Variable life insurance is suitable for individuals with specific life insurance protection needs. You'll need to pay premiums or maintain sufficient cash value to cover the policy's fees and expenses. Keep in mind that loans or poor investment performance can lower your cash value.

Investment Risks

Variable life insurance involves investment risks similar to those of mutual funds. Each underlying fund has its own unique risks, so review the investment option's prospectus before making any decisions.

Key Features of Variable Universal Life Insurance

VUL policies offer several distinct features that set them apart from other types of life insurance:

Flexible Premiums

One of the hallmarks of VUL insurance is the flexibility it offers in premium payments. Unlike traditional life insurance policies with rigid payment structures, VUL allows policyholders to adjust their premiums within certain limits. After paying the minimum premiums to keep the policy in force, policyholders can pay more to increase the policy’s cash value or pay less if their financial circumstances require it. Excess payments above the cost of insurance and administrative fees are allocated to investment accounts, potentially increasing the policy’s value.

Death Benefit

Upon the death of the policyholder, the policy pays out a death benefit to the designated beneficiaries. This benefit can be largely unaffected by the performance of the policy’s investment accounts, provided that the policy premiums have been managed properly to maintain adequate funding for the death benefit. Policyholders can often choose between a fixed death benefit or a variable one, which includes the account value of the investment component. Hence, the death benefit can potentially grow over time if the investments perform well, which can result in a larger payout for the beneficiaries. However, if investments underperform, there is usually a guaranteed minimum death benefit, ensuring that recipients are safeguarded to a certain extent from investment risk.

Cash Value

The cash value of a VUL insurance policy is a distinctive feature that allows for wealth accumulation within the policy. Portions of the premiums paid above the cost of insurance and administrative fees are allocated to the policy’s cash value account, where they can be invested in a range of sub-account options. As the investments in these sub-accounts potentially grow, so does the cash value of the policy, which can then be used in various ways. The policyholder may borrow against the cash value, use it to pay premiums, or even withdraw it for personal use, subject to potential tax implications.

Customization Options

One of the definitive advantages of VUL insurance lies in the extensive customization options available to policyholders. For starters, the option to select the investment sub-accounts for their cash value allows for a personalization of the investment component of their insurance. Policyholders can choose from a diverse range of sub-account options varying in asset classes and levels of risk, aligning their choices with their risk tolerance and investment strategy. Additionally, the ability to adjust the death benefit provides another layer of flexibility. Fund transfers between sub-accounts are typically permitted, allowing policyholders to react to changing market conditions or life circumstances and adjust their investment strategies accordingly.

Tax Advantages

VUL insurance policies offer several tax advantages that can be beneficial to policyholders. One substantial benefit is the tax-deferred accumulation of cash value. The investment gains in the sub-accounts grow tax-free until withdrawal, allowing for potentially higher returns due to the compound growth effect. Furthermore, if structured properly, policyholders may access the cash value through policy loans which are tax-free. This is because loans are not considered taxable income, given that they are eventually repaid from the death benefit. Additionally, the death benefit itself is typically paid out tax-free to beneficiaries, providing a potentially significant financial advantage to the policyholder’s heirs.

Read also: Understanding Student Loans

How VUL Works

With a VUL policy, you pay premiums into an account. The amount of the premium payments that go into the account may be less than you paid because fees are deducted. You may also be able to allocate part of your premiums to a fixed account, which pays a fixed rate of interest, unlike a mutual fund.

Example

Imagine you purchase a VUL policy with an initial premium payment of $100,000. You allocate 50% of that payment ($50,000) to a bond fund and 50% ($50,000) to a stock fund. Over the following year, the stock fund has a 10% return, and the bond fund has a 5% return.

Important Considerations Before Investing

Before investing in a VUL policy, consider the following:

Affordability

Consider whether you can afford the policy. The fees and expenses associated with the insurance policy may be significant and vary based on personal characteristics like age, gender, health, and family history. Make sure you consider the total actual costs for your specific policy.

Policy Lapse

If you do not maintain sufficient cash value to pay your policy fees and expenses, your policy may lapse. This means it will terminate without value, and your beneficiary will not receive any death benefit. For example, if your policy has a current value of $40,000 and fees and expenses are $10,000 per year (based on a death benefit of $300,000), your policy may lapse within four years. This could occur sooner due to poor investment performance or if you make a withdrawal or take a policy loan.

Not a Short-Term Savings Vehicle

VUL policies are not designed for short-term savings. Surrender charges are typically higher in the early years of the policy.

Insurance Company Risk

The financial strength of the insurance company that issues the policy backs all guarantees, including the death benefit.

Fees and Expenses

You will pay several fees and expenses when you invest in a VUL policy. It's essential to understand these costs before investing, as they will reduce the value of your account and may require you to contribute additional premiums to prevent the policy from terminating. Common fees and expenses include:

Sales fees: Imposed on premiums, these fees are a percentage of the amount paid and reduce the amount of your premium payment applied to the policy. They typically compensate the insurance company for sales expenses.
Surrender charge: This fee applies if you surrender the policy or make a withdrawal in the early years of the contract. It compensates the insurance company for sales expenses that it would otherwise not recover in the event of early surrender.
Mortality and expense (M&E) risk fees: These ongoing fees are equal to a certain percentage of your account value and help cover the risks the insurance company assumes with respect to the policy.
Cost of insurance: This ongoing fee varies for each insured based on factors including the insured person’s age, gender, health, and death benefit amount.
Administration fees: These ongoing fees help cover the insurance company’s costs of issuing and administering the policy, and activities such as processing claims, maintaining records, and communicating with you.
Loan interest: Interest charged on any policy loans taken.
Underlying Fund Expenses: You will also indirectly pay the ongoing fees and expenses for the mutual funds that are the underlying investment options for your variable life insurance.
Fees and Expenses for Optional Features: Policies may offer a number of additional features for an additional fee.
Transaction fees: These fees cover services you request.

Certain charges are based on your personal characteristics. The policy may quote fees and expenses on a monthly or yearly basis. Policy fees may go towards your financial professional’s compensation. As you age, the cost to insure you is likely to increase, so a new policy may be more expensive.

Policy Loans and Withdrawals

VUL policies typically permit you to take loans on a portion of the policy’s cash value without incurring surrender charges or paying federal taxes. Policy loans (unlike withdrawals) are not generally considered taxable events. Withdrawals from the cash value of a life insurance policy are tax-free above the amount paid, offering a unique advantage for policyholders seeking access to funds with minimal tax implications.

Optional Insurance Features

VUL policies may offer optional insurance features for an additional fee:

No lapse features: Keeps your policy in effect if you do not have sufficient account value to pay your policy’s charges. These features may only be available in certain years or if a certain level of premiums are paid.
Additional term insurance: Provides the opportunity to purchase additional term life insurance for you or your family as part of your variable life insurance policy.

Carefully consider whether you need these features, as you will pay extra for them.

Who Benefits from VUL?

Clients who may benefit from a VUL policy are those with a long-term perspective who seek the dual benefits of life insurance protection and investment growth potential. These clients are typically financially savvy individuals who have maximized contributions to other tax-advantaged accounts, like 401(k)s and IRAs, and are looking for additional tax-deferred growth opportunities. They should have a stable and sufficient income that allows them to manage the flexibility of VUL premiums and are comfortable with the inherent risks associated with the investment component.

Strategies for Financial Professionals

Financial professionals can effectively present VUL insurance to their clients by:

Educating on flexibility and control: Emphasizing the flexibility in premium payments and coverage adjustments that VUL policies offer.
Highlighting tax advantages: Explaining the tax benefits of VUL, such as tax-deferred growth on the cash value, tax-free loans, and the potential for tax-free distribution of the death benefit.
Showcasing investment potential while managing risk: Presenting the investment aspect of VUL insurance as an attractive feature while also ensuring clients understand the risks. Comparing the VUL’s investment options to mutual funds can help clients grasp how they can participate in the market’s growth potential.

Alternatives to VUL

While VUL offers unique benefits, it's important to understand how it compares to other types of life insurance:

Whole Life Insurance: Offers long-term protection, fixed premiums, and steady cash value growth. It can be a versatile tool to help you meet several needs.
Universal Life Insurance: Offers a combination of long-term coverage and the ability to accumulate cash value with interest.
Indexed Universal Life (IUL) Insurance: Combines a death benefit with investment potential, but cash value growth is tied to a stock market index, offering growth potential with protection against market downturns through a guaranteed minimum interest rate.
Term Life Insurance: Offers coverage for a specific time period, unlike VUL's permanent coverage.

Potential Drawbacks

It's important to acknowledge the potential downsides of VUL policies:

Market Volatility: Since your policy's cash value is invested in the market, it can go up or down in value based on market volatility, which could lead to a lower death benefit in down markets.
Complexity: VUL policies can be complex, requiring careful monitoring and understanding of investment options and fees.

Making an Informed Decision

Before investing in a VUL policy, take these steps:

Know how it works: Research and understand the policy's features, fees, and risks.
Get the details: Ask your financial professional for the policy prospectus, which will describe the policy in detail.
Consider the costs: Evaluate all fees and expenses associated with the policy.
Review illustrations: Request and review personalized illustrations for certain policy features.
Understand tax implications: Consult with a tax advisor to understand the federal and state tax rules that apply to VUL.
Cancellation Period: Be aware that you may cancel your policy within a short period (usually at least 10 days) of receiving it without charge. Upon cancellation, you will typically receive a refund of your premiums.

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