Is a Variable Universal Life Insurance Policy for Me?

Q: What is your opinion of variable universal life insurance policies?

A: There are two kinds of universal life insurance policies: basic and variable. With a basic policy, the owner pays premiums and the cash value of the policy builds overtime as the insurance company invests the money -- usually in conservative investments, such as Treasurys. The insurer then pays out dividends on those funds, and when the owner dies the value of the policy is paid as a death benefit.

With a variable policy, policy holders pay the premiums and invest the assets on their own, typically in stock or bond mutual funds. The cash value of the policy builds based on the returns of those investments, and the accumulated value is paid a death benefit. The benefit of a variable policy is if the investments outperform, the potential death benefit could be greater and the amount of premiums paid may be less than initially estimated when the policy was issued. But what happens if those investments lose money?

Both UL policies are considered “permanent” insurance -- as opposed to term-life insurance, which generally expire after a period of 20 or 30 years. But most UL policies do expire, though the age is typically set well past the average life expectancy.

That’s where underperforming investments in a variable policy can come back to bite policy holders. The estimated amount of the death benefit and the length of coverage are calculated based on a number of things, including how well the underlying investments are expected to perform. When performance falls short of those estimates, policy holders may have to pay higher premiums in order to keep the policy from expiring, or agree to accept a much lower death benefit.

Aside from the fact that you’re basically gambling on the potential future outcome of the underlying investments -- particularly in an environment such as the one we’re in now, where market experts are ratcheting down their estimates on stock-market performance over the next decade -- there’s another reason to reconsider UL policies: The fees. Between account maintenance and investment-management fees, mortality and expense charges, and steep-early surrender charges, not to mention the upfront sales commission, your investments already have a high hurdle to clear performance-wise just to breakeven. When investments are losing money, these costs further eat into policy holders’ premiums.

Insurance salespeople will tell you the tax benefits alone outweigh the potential for market fluctuations. Investments earnings in UL policies are tax-free, and you currently pay no income tax on policy loans or the death benefit (though estate taxes may apply). With capital-gains taxes and income taxes on high-income earners expected to rise sharply under the Obama administration, they make a good case. But it takes a thorough understanding of how these complex policies work, and what the actual out-of-pocket costs and net tax benefits are to the policy holders, to ensure that the product is suitable for you.

If your financial advisor is recommending this type of policy, get an objective second opinion. For a fee, the Consumer Federation of America’s “Rate of Return” service will estimate the "true" investment returns on whole life, universal life or variable life policies you’re interested in or one you’ve already purchased. (To learn more, click here.)