What is Universal Life Insurance and How Does It Work?

One broad group of policy types is universal life insurance.

Though it’s more like whole life insurance than term, there are enough differences to make it a policy type all its own.

What is universal life insurance, how does it work, and is it the right life insurance policy for you?

What Is Universal Life Insurance?

Much like whole life insurance, universal life combines life insurance with a savings provision.

In that way, it combines two very important financial services in a single product.

It’s a type of permanent life insurance, but what makes universal life different from whole life is that it offers much more flexibility.

This applies to both the death benefit and the premiums paid.

But you can also choose to allocate varying amounts toward the death benefit and your cash value even after the policy has been put in force.

There’s more flexibility regarding premium payments as well.

While you typically will pay a whole life insurance policy on a yearly basis throughout your life, a universal life policy can be paid either through regular payments or through a single, lump sum.

How Does Universal Life Insurance Work?

The central element in universal life insurance – at least when compared to whole life insurance – is in its flexibility.

Throughout the policy, the policyholder can adjust both their premium and the death benefit.

Premium Allocation

Within your premium, you can adjust the amount allocated toward your life insurance death benefit and your savings allocation.

That is, you can increase one and decrease the other.

Most frequently, that will involve increasing allocation for the cash savings portion.

You can even pay an additional premium to generate faster cash value accumulation.

The cash value will either earn interest or dividends. With most life insurance companies, you’ll be paid interest.

But if the issuing company is a mutual insurance company – where policyholders are also owners of the company – dividends will be paid instead.

Interest Rate

The interest rate will be set in the policy at the time of approval and may have a minimum percentage rate.

However, some universal life policies may also tie the rate of return to a third-party index.

If the index rises, the interest will increase. But if the index falls, the interest rate will be reduced, but no lower than the minimum established in the policy.

This holds the potential for universal life policies to pay higher interest on your cash value than a whole life insurance policy will.

Cash Value

But there’s an important difference between universal life and whole life when it comes to cash value.

With whole life insurance policies, your accumulated cash value will be added to the death benefit and paid to your beneficiaries upon your death.

With a universal life policy, the cash value will be forfeited and retained by the insurance company upon your death.

Your beneficiaries will receive only the death benefit provided for in the policy. (Though some companies allow you to choose to leave either the cash value or the death benefit to your beneficiaries.)

How Much Does Universal Life Insurance Cost?

To get a sampling of premiums for a universal life policy, we turned to the Specimen Flexible Premium Variable Universal Life Policy page provided by the Securities and Exchange Commission.

It doesn’t provide comprehensive premium quotes, but only a generic list of premium rate factors.

Sample Universal Life Insurance Rates

A sampling of premiums from that list shows a $500,000 universal life insurance policy will carry the following premiums based on specific ages:

• 35 years old: $454 per month
• 45 years old: $ 972 per month
• 55 years old: $ 2,230 per month
• 65 years old: $ 6,492 per month

As you can see, universal life – like other types of life insurance – becomes progressively more expensive as you get older.

That by itself is a compelling reason to sign up for a policy as early in life as possible.

You’ll also get the benefit of a larger cash value by taking a policy while you’re young.

Once again, you can either make the premium payments over the life of a policy, or you can fund the policy with an upfront, lump-sum payment.

The advantage of the lump sum payment is that it will provide you with an immediate cash value. But it will also eliminate the need for future premium payments.

Once your policy has been approved and issued, you’ll be able to adjust the allocations in your premium between life insurance and cash value.

However, you should be aware that the cost of life insurance coverage will increase as you age.

This is very similar to a renewable term policy, in which the premiums will increase each time the policy renews.

With a greater percentage of the premium going toward the insurance provision, less will be available for the cash value.

You can overcome this by increasing your premium payments to maintain a constant cash value contribution.

Unique Provisions of Universal Life Insurance Policies

Universal life policies have certain features that you won’t see in other types of life insurance plans. Examples include:

Maturity Date

A maturity date. Depending on the policy you have and the company that issues it, the policy will mature once you reach age 85 or later, as determined in the plan.

Once that age is reached, you’ll either receive the death benefit of the policy, or an amount based on the cash value accumulated in the plan.

Tax Consequences

There may be tax consequences! If the value of cash withdrawals from a universal life policy exceeds the amount you’ve paid in through premium contributions, the difference may be taxable.

This is a real possibility with a universal life insurance policy, given that an increasing percentage of the premium payment goes toward paying for life insurance.

As the cost of life insurance goes up, and the cash value declines, the possibility of withdrawing more than you’ve contributed to the cash value becomes a real possibility.

Policy Lapse

A policy lapse. If you attempt to maintain a fixed premium level, and the cost of the life insurance provision exceeds that premium, the insurance company will draw the difference of your cash value.

It may be possible for the cash value to be drained all the way to zero to cover the increasing cost of the life insurance provision.

And once again, this can generate a tax liability.

The cash value directed toward maintaining life insurance coverage will reduce the cash value more rapidly.

If withdrawals and loans you’ve taken against the policy exceed the final cash value, a tax liability may be triggered.

Types of Universal Life Insurance

So far, we’ve been discussing universal life insurance in only the generic sense. But there are several variations that are worth being aware of.

Variable Universal Life Insurance

Variable universal life insurance is universal life insurance with greater investment opportunities.

Instead of earning a certain rate of interest, your return will be based on the performance of insurance company-managed mutual funds.

This will generally provide you with a higher rate of return than you’ll get on a straight universal life policy.

But the amount of investment return you can earn is limited.

For example, if the fund your return is tied to earns 12% for the year, you may be entitled to only 8%. The insurance company will limit your upside potential because they also provide a floor on investment returns.

For example, if the fund declined by 10%, you may simply earn no return on your money for that year.

Indexed Universal Life Insurance

Indexed universal life insurance provides a return that’s tied to popular market indexes, like the S&P 500.

Rather than being tied to the performance of a specific fund, as is the case with variable universal life, you’ll be tied to the broad index.

Similar to variable universal life, you’ll never earn the full return from the index.

It will be reduced to the maximum percentage set in the policy.

But there is the possibility of losing money on your investment within the policy if the index turns negative. That’s because the fees charged on the policy will reduce the return to a negative rate.

Guaranteed Universal Life Insurance

Guaranteed universal life is more of a life insurance policy than a savings vehicle.

Your premium will remain constant throughout the term of the policy, and you’ll earn a specified rate of interest.

But in exchange for those guarantees, the cash accumulation will be minimal.

Universal Life Insurance vs. Whole Life Insurance

On the surface, a universal life policy looks like a variation of whole life insurance. That’s true, but only up to a point.

Both policies offer life insurance with an interest-bearing cash value accumulation feature. And both allow you to take loans against the cash value.

Death Benefit

Whole life insurance policies will pay the death benefit, plus your accumulated cash value to your beneficiaries upon your death.

Universal life insurance policies will pay only the death benefit. The accumulated cash value resorts to the insurance company.

Fees

Both have fees, certainly much more so than term life insurance policies.

But while whole life insurance policies charge the fees within the first few years the policy is in force, resulting in a very slow cash value accumulation, universal life policies charge these throughout the policy term.

This makes universal life policies more expensive than whole life on a fee basis over the long term.

Allocations

Universal life gives you the ability to select allocations between life insurance costs and cash value contributions. Whole life does not offer this feature.

Surrender Charges

But one thing both policy types have in common is surrender charges.

These are fees assessed if you withdraw cash from your policy in the early years.

Those fees can range between 1% and 10% and are applied over time ranging from five to 10 years.

They normally work on a sliding scale, where the penalty will be 10% if you withdraw funds in the first year and 1% in the tenth year.

Universal Life Insurance Pros and Cons

Pros:

• Interest paid on the cash value of a universal life policy is generally higher than that for whole life insurance.
• The policy does offer an option to borrow against the cash value at very favorable interest rates.
• Combines life insurance with a savings provision.
• It’s possible to access the cash value of your policy before your death either through loans or withdrawals.
• Universal life offers a tax-deferred way to save additional funds for retirement, in excess of those offered by dedicated retirement plans, like IRAs and 401(k) plans.

Cons:

• Cash value withdrawn from the policy more than your premium contributions can be taxable.
• Any cash value in the policy will be retained by the insurance company and not paid to your beneficiaries upon your death. They’ll receive only the face amount of the policy death benefit.
• Universal life policies have steadily increasing life insurance costs. They rise throughout your life and can become prohibitive.
• The policy will lapse if the cash value falls to zero.
• Any loans against the policy that are still outstanding at the time of your death will be deducted from the death benefit, reducing the payment to your beneficiaries.

Is Universal Life Insurance Best for You?

Universal life policies are very complicated financial instruments.

True, they’re life insurance combined with a savings provision.

But your ability to access the money has many strings attached to it. In addition, the policies are notorious for their high fees.

The saying “buy term and invest the difference” truly applies to universal life.

With a term policy, you’ll get the benefit of a much lower cost, as well as fixed premiums for the length of the term.

You’ll almost certainly earn more on your savings by investing in a basic index-based exchange-traded fund than you can on the cash value of a universal life policy.

Universal life policies may work for a very narrow range of consumers – primarily those looking to save additional funds for retirement.

But for the vast majority of consumers, they shouldn’t even be considered an option.