From the start, whole life insurance had two compelling problems: It was hard to understand and it was inflexible. Insurance agents had a hard time selling these policies after they explained that the premium would always be the same but the investment returns would be impossible to predict.
To deal with these issues, insurance pundits came up with universal life.
Universal life works much the same way as whole life. The premium more than covers the requisite death benefit, and the amount that isn’t used to pay expenses and mortality fees is invested. That investment builds up a cash value that eventually whittles away at the amount of pure insurance coverage–the death benefit–that you will need.
But this type of insurance offers two things whole life doesn’t: flexibility and transparency.
A universal life policy is broken down–or, in insurance lingo, “unbundled”–to indicate which portion of the premium is paying purely for insurance, which portion is paying for fees and how much is going into the savings element of the policy. In addition, these policies allow individuals to adjust the premium and death benefit. So if your circumstances change markedly–leaving you with less or more insurance needs–you can cut or boost the death benefit of the universal life policy.
Meanwhile, this type of policy gives you the ability to invest more money and let the cash buildup accrue on a tax-deferred basis if you like the investment returns you’re earning. But if you aren’t impressed with the investment returns, or if you simply can’t afford the whole premium during a given year, you can use the cash buildup in your account to pay the mortality fees and expenses.
Because a portion of the policy’s cash value is likely to come from investment returns that grow on a tax-deferred basis, you can, in effect, pay for the term insurance portion of the policy with pretax dollars. But this also reduces the amount of cash value in the policy, and that could eventually cause the policy to lapse if the investment returns don’t keep pace with the mortality expenses and fees.
The cash value of a universal life policy is invested in bonds, mortgages and other fixed-income instruments that both insurance company executives and state insurance regulators have determined are safe enough for a regulated company investing other people’s money.
In the late 1970s and early ’80s, fixed-income investments were posting double-digit returns, so the returns on cash-value policies–whole life and universal life–were impressive. But by the mid-1980s, interest rates had dropped dramatically. Returns on fixed-income instruments became lackluster. The stock market began to take off and, suddenly, investing your money through an insurance policy locked into fixed-income returns seemed less sage.
But insurance executives–not content to let cash-value insurance wither away–began promoting a new variant: variable universal life.
Variable universal life dates to the mid-1970s, when the Equitable Life Assurance Society was able to clear a gantlet of regulations to offer a policy with an element of investment discretion, says Ben G. Baldwin, author of several books on insurance and president of Baldwin Financial Services in Northbrook, Ill. But it wasn’t until 1985 that this first variable investment element was married with the flexibility of the universal life structure.
In effect, variable universal life offers policyholders the structure of a traditional universal life policy–a set death benefit that will be partly funded by insurance and partly by the investment buildup in the policy–and premium flexibility. The investment portion of the policy resembles a 401(k) plan.
Policyholders are generally given investment options that range from safe but often low-yielding fixed-income funds to higher-risk, higher-reward options such as stock and high-yield-bond funds. You can invest all of the cash buildup in your policy in one option or several. And if you want to switch investments, you can do that, too–without triggering a gain from the sale that could be taxed–as long as you choose another investment offered through the policy.
The resulting cash buildup in the policy can’t be predicted–it will vary based on the investment choices made and how well those investments fared.
In effect, you are buying term insurance and investing the rest. But you’re doing it through an insurance vehicle, which gives you tax-favored status, says Don Reiser, president of Veritas Insurance, a division of Ameritas Life Insurance Group of Houston.
“I honestly believe that if you were to sit someone in a room and ask them to create the perfect financial product, this is what they would come up with,” Reiser says.
What’s the downside? Fees. When you buy an insurance product married to an investment product, you get hit with fees that pay the insurance company and insurance agents, and fees that pay the investment companies and investment managers.
A savvy investor may find, then, that the tax benefit of investing through an insurance policy outweighs the additional costs, so variable universal life works better than other investment alternatives.
