If you are looking for a permanent life insurance policy that lasts your entire life, you want another vehicle to build wealth tax-efficiently, and you are investment savvy, a variable universal life insurance policy is a good option.
Let's go through what variable universal life insurance (VUL) in more detail to help you make the right conclusion on whether it is the best of the many life insurance options available for you.
What Is Variable Universal Life Insurance (VUL)?
Variable universal life (VUL) is a type of permanent life insurance policy with a built-in savings component that allows for the investment of the cash value. Think about a VUL like a mortgage that pays principal and interest. Over time, the VUL policyholder builds up a cash value (equity) that can grow in value.
The premium for VUL is flexible. Although the cash value of a VUL can be invested, there is VUL typically both a maximum cap and minimum floor on the investment return associated with the savings component.
In this regard, investing with a VUL is relatively less volatile on the downside compared to straight up investing in the S&P 500 and experiencing a bear market.
Variable Universal Life Insurance Basics
The term variable in variable universal life insurance comes from the varying results of investment in an unpredictable market. As with all investments that involve risk, there are no guaranteed returns.
If you are focused on guaranteed returns, getting a basic whole life insurance policy where the cash value acts more like a savings account and grows more closely to the rate of inflation is your safer bet.
Variable universal life insurance has variable sub-accounts that allow for the investment of the cash value. The function of the sub-accounts is similar to a mutual fund.
If you are OK with risk and are more investment savvy than the average American, variable universal life insurance is more suitable for your life insurance needs. It offers increased flexibility and growth potential over a traditional cash-value or whole life insurance policies.
How Variable Universal Life Insurance Works
Variable universal life insurance combines a savings component (cash value) with a separate death benefit. When you pay your monthly premium, a portion of the premium goes towards paying for the death benefit another another portion goes towards building up the cash value. The cash value can then be used to invest in various risk assets to hopefully make a positive return over time.
For a variable universal life insurance policy, the savings element consists of separately managed accounts, referred to as sub-accounts. Each year, the life insurer deducts what it needs to cover mortality and administrative costs. The rest remains in the separate accounts to earn further interest.
Given your variable life insurance premium is going to pay for both a death benefit and a cash value, the premium will be much higher than a term life insurance policy. A term life insurance policy is like paying rent or interest only. Subsequently, the payment is lower.
The biggest difference between a whole life policy and a variable universal life policy is that in a whole life policy, the life insurer assumes the investment risk by guaranteeing a minimum cash value growth. Whereas in a variable universal life policy, the policyholder assumes the risk.
You might be thinking why would you assume the risk if the insurance company will instead. The answer is all about risk and reward. In a whole life policy, your guaranteed returns are low. With the 10-year bond yield at under 1% in 2020 and the Fed Funds rate between 0% – 0.125%, the guaranteed returns won't be much higher given all guaranteed returns are relative to a risk-free rate.
With a VUL, the policyholder will take on the risk of losing money for the potential of making a much greater return than the guaranteed return by a whole life policy. Take a look at historical stock market and bond market returns here. The S&P 500 generally averages between 8% – 10% a year while bonds historically average between 4% – 5% returns a year.
You can also check out the historical returns of various stock and bond portfolio compositions since 1929.
Do realize that significant and sustained losses compromise the cash value. As a result, the insured may need to remit higher premium payments to cover the cost of the insurance and rebuild the cash value.
Variable Universal Life Sub-Accounts
The separate sub-account is structured like a family of mutual funds. Each has an array of stock and bond accounts, along with a money market option. Some policies restrict the number of transfers into and out of the funds.
If a policyholder has exceeded the number of transfers in a year and the account in which funds are invested performs poorly, they may need to pay a higher premium to cover the cost of insurance.
In addition to the standard administration and mortality fees paid by the policyholder each year, the sub-accounts deduct management fees that can range from 0.05% to 2%. Because the sub-accounts are securities, the life insurance representative must be a licensed producer and registered with the Financial Industry Regulatory Authority (FINRA).
One Of The Best Benefits Of Variable Life Insurance
Besides being able to use your cash value to invest in the stock and bond market, the growth of the variable universal life policy's cash value is tax-deferred.
When you don't have a tax drag on dividends and capital gains, logically, the value of your investments can compound at higher rates over time. The tax-deferment is very similar to the tax-deferred in a 401(k) or IRA.
VUL policyholders may also access their cash value by taking a withdrawal or by borrowing funds. However, if the cash value falls below a specific level, additional premium payments must be made to prevent the policy from lapsing.
Negatives Of Variable Universal Life Insurance
Of course, no life insurance policy is perfect. Here are the main negatives of a VUL:
- Higher cost: Just like it costs more to buy a house than rent one, it costs more to have a cash value life insurance policy versus a term life insurance policy. Your premiums are higher because you have to also build the cash value. But that's what you want anyway, so the cost really isn't that much of a higher cost as the cash value is yours.
- Cash value can only be used when alive: Should your passing be untimely, your family will only receive death benefits while the cash value you managed to grow stays with the insurance company. Therefore, you must actively use the cash value while living.
- No access to cash value in the beginning: As you are building your cash value, you generally can't access it for the first 5-10 years. This is the waiting period. Like your investments, you need to let them grow, unabated so they can compound over time.
These three negatives are the reasons why a VUL is more appropriate for people with higher incomes and higher wealth trajectories overall. If you are in constant need of liquidity and cannot handle the volatility in the stock market, a VUL is not the most appropriate type of life insurance for you. Instead, getting a term life insurance policy is better.
If you do decide to get a VUL, you MUST make sure to use your cash value while you are still alive. Otherwise, the insurance company will get the remaining balance upon your passing.
You can use your cash value before you die by:
- Borrowing from it
- Use it to pay premiums
- Make a withdrawal
- Boost the death benefit
Variable Life Insurance Key Points
- Variable Universal Life (VUL) is a type of permanent life insurance policy that allows for the cash component to be invested to produce greater returns.
- VUL is built on traditional universal life policies but have a separate sub-account that invests the cash piece in the market.
- The cash value returns are not guaranteed given they are invested in stocks, bonds, and other risk assets that may lose value.
- VUL policies will have some maximum cap as well as a floor (usually 0%) on the returns that the investment part receives
- Wealthier, market savvy individuals who want life insurance for their entire lives are most suitable to get a VUL.
- If you get a VUL, make sure you use up the cash value before death, otherwise, the insurance company gets to keep the cash value balance.
The most efficient way to get competitive life insurance quotes is to check online with PolicyGenius, the #1 life insurance marketplace where qualified lenders compete for your business.
It's much easier to apply on PolicyGenius than go to each carrier one-by-one to get a quote. I've known the founders for years and they have truly built a fantastic resource for individuals.
Remember, life insurance is an act of love and kindness. Hope for the best and plan for the worst. Life is unpredictable and no day is guaranteed.
About the Author: Sam worked in finance for 13 years. He received his undergraduate degree in Economics from The College of William & Mary and got his MBA from UC Berkeley. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $250,000 a year in passive income. He spends time playing tennis, taking care of his family, and writing online to help others achieve financial freedom too.
Sam started Financial Samurai in 2009 and has grown it to be one of the largest independently owned personal finance sites in the world. You can sign up for his free private newsletter here.