Variable Universal Life Insurance (VUL)
With so many people now taking term life insurance policies, the insurance industry has been working to create new insurance products, offering a blend of death benefit and investment accumulation.
The old standby – whole life insurance – is less attractive to a more educated consumer base who are mainly concerned with getting adequate insurance coverage at the lowest possible price. That’s what term life insurance does so well.
But the insurance industry has taken the basic whole life insurance policy and added a bunch of bells and whistles to it, to create insurance/investment hybrids. One is variable universal life insurance, or VUL for short.
It provides a death benefit but also investment returns tied to the financial markets. As is the case with all universal life insurance policies, the premium can change – either higher or lower – depending on how much coverage you want, as well as the performance of the underlying investments.
What is Variable Universal Life Insurance (VUL)?
Similar to a whole life insurance policy, variable universal life insurance is either an investment with a death benefit or a death benefit with an investment provision. The basic setup is the same.
You pay for the policy with premiums, with the majority of the funds going into the investment portion. What’s leftover covers the death benefit.
The main differences between the two are:
- VUL offers fewer guarantees than whole life and
- VUL has more complicated investment provisions – which is the main reason for fewer guarantees.
For example, while whole life policies specify returns on your cash value, and can even make fairly reliable future value projections, VUL policies have no such certainty. That’s because the cash value is invested in the insurance industry equivalent of mutual funds, which are referred to as sub-accounts. I’ll cover those in some detail later in this guide.
A VUL doesn’t offer minimum guaranteed returns or even protection against losses in your investment value. Much like an investment in the financial markets, which is exactly what it is, your portfolio can either rise or fall in value.
The advantage, of course, is that a VUL offers the potential for much higher returns than you’ll get on a whole life cash value, at least if the market performs favorably over the specified investment term.
But if it doesn’t, your account can lose value. It’s even possible the life insurance company will request that you increase your premiums to cover losses in the account. If you fail to make those higher payments, your account could fall to zero, causing your policy to lapse. If it does, your policy will be canceled, and any premiums paid into the policy will be lost.
Adding a “Floor” to Protect Against Investment Losses
A VUL can avoid falling into a negative situation if a “floor” is set for the policy. If the floor is set at 0%, your policy won’t lose money even in a serious market decline. But that floor will be accompanied by a “cap” on investment earnings. If the cap is set at 6%, then 6% is all you’ll get, even if the market rises by 15%. Though you will be protected on the downside, the limit on the upside might mean the returns on a VUL aren’t substantially better than what you would get on a traditional whole life policy.
While it may seem unfair to impose a limit on investment earnings during years when the markets are performing well, it’s really a trade-off. The earnings above the VUL upside limit are used by the insurance company to offset losses below 0% on the downside. You’ll be giving up full participation in a rising market in exchange for protection in a falling one.
Now while the floor may protect you against investment losses, it doesn’t negate the possibility of the need to pay higher premiums. Each year, the insurance company will deduct some of your cash value to cover administrative costs and the death benefit of your policy.
Other Variable Universal Life Insurance Provisions
- The death benefit can be increased or decreased. Unlike a whole life insurance policy – which has a fixed death benefit for life – you can increase or decrease the amount of the death benefit in a VUL as your needs change over the years. For example, once you pay off your mortgage, you may feel comfortable lowering the death benefit. But if you’re starting out in life, and just taking on a new mortgage, you may want to increase it.
- Loan provision. Much like a whole life insurance policy, you can also borrow against the value of your VUL. There will be no monthly payment on your part, and no tax consequences from the receipt of the loan proceeds. Ultimately, the loan will be repaid out of the death benefit. This obviously opens the possibility that an outstanding loan at the time of death will result in a reduced payout to your beneficiaries.
- Investment earnings are tax-deferred. You will be required to pay tax on your investment gains until you begin making withdrawals. The return of your contributions (premiums) are not taxable. But the accumulated investment portion included in a withdrawal will be taxable at the time the distribution is made. The IRS permits you to first withdraw your plan contributions (tax-free), with taxable distributions of accumulated investment earnings happening only after your contributions have been exhausted. This provision has led to VULs being compared to deferred compensation plans.
Variable Universal Life Insurance Sub-Accounts
Sub-accounts are the foundation of the investment provision in a VUL policy. They’re something of the insurance industry equivalent of mutual funds in that they are funds that can be invested in stocks and bonds, but also money markets. Because they are straight-up investments, you’ll have a limited number of transfers in and out of these sub-accounts in any given year. If you exceed the limit, the insurance company may call on you to pay a higher premium to maintain the insurance provision in the policy.
Sub-accounts work very much like mutual funds. But it’s important to understand they are not publicly traded funds. Instead, they’re proprietary funds available only through the insurance company. There may not even be published sources indicating the composition and performance of each fund. You may need to rely entirely on updates provided by the insurance company.
Just as is the case with mutual funds and exchange-traded funds, sub-accounts have internal management fees. These range between 0.05% and 3% per year. It’s not clear if these fees are deducted before or after the investment income caps and floors.
Is Variable Universal Life Insurance A Good Investment?
VULs are good investments, but only if you’re very unlikely to invest otherwise. For some people, paying a bill – like a monthly premium – is much easier to manage than saving money in an investment account or retirement account. And you can generally expect the annual returns will be better than what you can get in completely safe investments, like certificates of deposit.
That said, VULs don’t match up well with other investment alternatives. For example, a much better strategy will be to purchase a low-cost term life insurance policy for the death benefit, then invest the balance of the premiums you otherwise would pay into a VUL into an index-based exchange-traded fund (ETF).
For example, an index-based ETF tied to the S&P 500 has turned in an average annual return of 10% since 1926. You can reasonably expect that kind of return for 20 or 30 years. And it will almost certainly – and easily – outperform the limited return you’ll get in a VUL plan.
A VUL may qualify as a legitimate investment, but it’s far from the best investment you could make.
Is VUL Good for Retirement?
This question is important because the VUL is often sold as an alternative to a Roth IRA. That in itself is compelling since not everyone qualifies for a Roth IRA contribution. But is it really like a Roth IRA, and is it suitable as a retirement investment at all?
On most accounts, no. In fact, before even considering a VUL, you should first make sure you are already participating in some type of retirement plan. Preferably an employer-sponsored plan, with very generous annual contribution levels. Failing that, you should at least have a traditional or Roth IRA going. Any of those types of plans are likely to be much better as a retirement plan than a VUL.
But where a VUL shines as a retirement plan is when you are already maxing out your contributions to traditional retirement plans and looking to build an even larger retirement portfolio. This may be a desirable strategy if you are either looking to retire early or if you are approaching retirement age and want to build an even larger retirement portfolio.
In this regard, VULs have a built-in advantage in that there is no limit on how much you can contribute to the plan. This is unlike 401(k) and IRA plans that put strict limits on how much you can contribute. If you’re maxing out your retirement plan contributions, and also making premium contributions to a VUL, you can build up a retirement fortune in just a few years.
Pros and Cons of VUL Insurance
- Combining investing and life insurance. If you’re unlikely to invest money otherwise, a VUL can be a good way to build up your investment portfolio while providing a death benefit in the meantime.
- Permanent life insurance. VUL is a form of permanent life insurance – which term insurance certainly is not. However, the possibility does exist of your plan lapsing and being canceled if your cash value disappears.
- You can increase or decrease your death benefit. You can increase the death benefit at times of greater need, such as the birth of a child or the purchase of a home. You can also lower the death benefit when the child reaches the age of emancipation, and the mortgage on the home is satisfied. It’s a level of flexibility that doesn’t exist with a whole life insurance policy.
- Withdrawals and loans can be taken tax-free. You don’t have to wait until you retire to begin taking money out of your plan. You can take loans or withdrawals tax-free at any time before.
- No contribution limits. Even if you max out your annual 401(k) contribution at $19,500, you can still invest another $20,000 in a VUL. And much like the 401(k), the investments in the VUL will accumulate on a tax-deferred basis. That presents an opportunity to supercharge your retirement savings, either for a more prosperous retirement or even an early one.
- They’re not the best investment options. You’ll get better long-term returns if you buy a large, inexpensive term life insurance policy, and invest your money in an index-based exchange-traded fund instead.
- VULs are complicated. They contain a lot of moving parts, which make them incomprehensible to anyone outside the insurance industry.
- You could lose money with a VUL. The agent selling you the policy probably won’t willingly disclose this information, or at least not definitively. That’s strong enough reason to avoid any type of financial product.
- VULs are often sold by insurance agents who present themselves as “financial advisors.” Many do have the required certifications to claim the financial advisor label. But they’re really selling investment-type insurance policies, and little else. Whatever the financial need is, an investment-type insurance policy – quite possibly a VUL – will be the answer. That’s hardly objective financial or investment advice.
- VULs are “commission rich,” which is why they’re so popular with insurance agents. That makes it more likely you’ll be sold a VUL, whether it’s the right financial vehicle for you or not. Commissions have a way of removing agent objectivity. Commissions can consume up to 100% of the premiums paid in the first year, then gradually decline after that. That means the build-up of cash value will happen on an extremely slow basis in the early years.
- The premium may increase. If the investment returns on your policy are negative, you may be asked to increase your premium payments. If you don’t, your policy may lapse, causing you to forfeit all premiums paid for the policy as of the date of cancellation.
- The cancellation of your policy could cause a tax complication. If you’ve taken early withdrawals or loans in excess of your contributions from your plan prior to cancellation, the excess portion will become immediately taxable.
- A VUL transfers investment risk to you. In a whole life insurance policy, the insurance company bears the risk of investment underperformance. This happens because whole life policies provide guaranteed minimum annual returns. With a VUL, you are the policyholder and the investor. So, since a VUL does not provide a guarantee, the risk of underperformance is transferred to you.
Is Variable Universal Life Insurance for You?
The often repeated saying “buy term and invest the difference” is well worth reflecting on if you’re even thinking about buying any type of life insurance policy with an investment provision. You can get more coverage at a lower premium with a term policy, and higher returns on your investment just by making regular contributions into an index-based ETF.
But if you don’t believe you’re likely to take that route, an investment type insurance policy is a good Plan B. It offers an opportunity to make unlimited contributions to the investment side of your policy, raising the possibility of a much larger portfolio at retirement.
At the same time, be aware of the limitations that come with a VUL policy. The investment returns are not guaranteed, and there is at least a remote possibility your policy will be canceled ahead of time, even creating a potential tax liability in the process.