Exploring Variable Universal Life Insurance (VUL): A Beginner’s Guide

Introduction to VUL

While universal life insurance is a familiar concept, its variant – Variable Universal Life Insurance (VUL) – presents a unique blend of insurance and investment. VUL merges the benefits of a life insurance death benefit with an investment aspect, differentiating it notably from whole life insurance. This article aims to demystify VUL, outlining its functionality and suitability for various individuals.

In this article:

• What it is
• How it works
• Who is it best for?
• Who is it NOT best for?
• Pros & Cons

Understanding Variable Universal Life Insurance

At its core, Variable Universal Life Insurance is an investment-centric life insurance plan. Distinct from typical life insurance products where the insurance aspect is primary, VUL prioritizes its investment feature, closely resembling whole life insurance in being a permanent life insurance form. It remains active unless premiums are defaulted, builds a cash value with tax-deferred income, and allows tax-exempt loans at low interest.

The premium

With whole life, the premium is fixed, and there is an allocation toward the cash value with each payment you make.

But with VUL, the premium is distinctly divided between payment of the insurance portion and allocations toward the investment provision.

Exactly how much goes into the investment provision depends on the cost of the life insurance portion, which increases steadily.

Life insurance coverage

Whole life is stable regarding both the cost and level of life insurance.

However, variable universal life plans include an annual renewal term policy. This will increase in cost each year the policy is in force.

That means a progressively larger portion of your premium payment will go into the insurance provision. And this leaves less for investing.

Investments

Whole life cash values are held in a stable, interest-bearing account within the policy. There’s usually a minimum guaranteed rate of return and no possibility of loss of principal.

Variable universal life policies have no such stability. Cash value is invested in insurance sub-accounts, which are similar to mutual funds. And it’s tied to stocks and bonds.

There are no limits on how much you can earn in those sub-accounts. However, there is the potential for loss.

We just covered the “high-altitude” overview of the features of a variable universal life insurance policy. But this is a complicated insurance plan, so let’s drill down into the details.

Key Features of VUL:

1. Investment Choices: One of the standout features of VUL is the ability to choose how the cash value is invested. Policyholders can select from a variety of investment options, which can range from stocks and bonds to money market accounts.
2. Flexibility: VUL policies offer flexibility regarding premium payments and death benefit amounts. You can adjust these over time.
3. Cash Value Growth: The cash value of a VUL policy has the potential to grow based on the performance of the investments you choose. This growth is tax-deferred, meaning you don’t pay taxes on any gains unless you withdraw them.
4. Risks and Rewards: With potential high returns from investments come higher risks. The value of your policy can fluctuate with market conditions, which means it can require more management than other types of life insurance.

How Does Variable Universal Life Insurance Work?

As you may already suspect, “variable” is the operative word in variable universal life insurance.

It refers to the fact that the specific details and features of a VUL are more like moving parts than fixtures.

Let’s start with the premium. To start, you’ll pay a premium that will cover the insurance cost of your policy.

This also covers an allocation toward the investment provision as well as fees to the insurance company.

But, as noted above, the cost of the life insurance portion will increase steadily throughout the life of the policy. And a larger percentage of the premium will need to be allocated toward the insurance provision.

It’s even possible that the underlying cost of life insurance will exceed the premium you pay.

If that happens, you’ll have one of three choices:

1. Increase your premium payments to cover the rising cost of the life insurance provision.
2. Allow the additional premium cost to be deducted from the investment value of a policy (which is what will happen unless you do otherwise).
3. Surrender the policy and withdraw the investment value that exists at the time.

Now, in some cases, the value of the investment provision rises to a level high enough to sustain the higher premium cost without significantly draining the policy.

But in others, it’s possible the higher premium cost will eventually drain the investment value of the policy down to zero.

If that happens, the policy will lapse unless you make additional contributions.

This is a good point to transition into the tax consequences of VULs.

VUL tax consequences

The investment income earned in a variable universal life insurance policy is tax-deferred. That means you won’t pay tax on it until it’s withdrawn from the policy.

But if the policy lapses, it will mean all the investment income has been drawn out of a policy to cover the increasing premiums of the life insurance provision.

The lapse could trigger an immediate tax liability on the accumulated investment earnings in the policy, which now no longer exists.

If you take a VUL policy, you’ll need to be aware of this possible outcome and prepare accordingly.

One option is to lower the life insurance death benefit progressively.

For example, though you may start out with a $500,000 death benefit when you’re 30, you may be able to reduce that to $300,000 when you’re 50.

The reduced death benefit will lower the premium.

Variable Universal Life Insurance Sub-accounts

Variable universal life insurance is all about investing. And that takes place in the policy’s sub-accounts.

If you’re familiar with mutual funds, you already have a basic idea of what insurance sub-accounts are.

They’re essentially mutual funds managed by the insurance company solely for the benefit of their policyholders.

That means they’re not traded on public exchanges. And not available to the general public.

You can allocate your cash value in sub-accounts that invest in stocks and bonds. This includes either actively managed funds or those that are designed as index funds.

There is usually a money market or interest-bearing cash option as well.

An insurance company may offer anywhere from 10 to as many as 50 sub-account funds for you to choose from.

You can set an allocation when you first get the policy, then make adjustments going forward.

Because sub-accounts are investment funds, the insurance representative who sells you the policy must be licensed and registered with the Financial Industry Regulatory Authority (FINRA). And not just a regular life insurance agent.

Once again, you can gain or lose money with sub-account investments. For this reason, you’ll need to possess the risk tolerance required for equity investments.

You’ll also need to be able to manage your own sub-account allocations.

Those sub-accounts also come with fees. Depending on the account, you can expect an annual charge of between 0.5% to as high as 3.0%.

That fee will both reduce the return on the investment in years when the account value rises and increase the losses in down years.

Other fees you can expect in a VUL policy

Sub-account fees aren’t the only cost associated with variable universal life insurance. In fact, these policies tend to be one of the most fee-rich plans in the insurance universe.

You’ll need to pay the commission to the agent who sells you the VUL policy. This is charged within the premium payment and is not an extra fee.

But it can eat up as much as 50% of the first-year premium. This will reduce the amount of cash that goes into your investment account.

The commission may also be paid in reduced amounts for the first several years the policy is in force.

There are also administrative costs charged by the insurance company to manage the policy. These can consume between 5% and 15% of your annual premium.

There are also surrender charges. For instance, you may choose to partially or completely liquidate your policy to recover the cash value.

If so, it’s likely you’ll pay surrender charges within the first few years the policy is in force.

However, surrender fees typically work on a sliding scale. They may range between 1% and 10%, with the highest fees charged in the early years. And the lowest in the later years.

Surrender charges may continue to apply for the first 8-10 years the policy is in force.

So, you’ll need to familiarize yourself with all the fees included in a VUL policy because the fees will both reduce your cash value and lower your investment returns.

Is Variable Universal Life Insurance Right for You?

As you can probably tell from the many details included in a variable universal life insurance policy, these plans are not for everyone.

In fact, they’re not designed for the vast majority of consumers.

Before you consider the suitability of a variable universal life insurance policy, decide if the following apply in your situation:

• You have a need for both life insurance and an investment plan within the same product. You may even find it difficult to save without the requirement of a regular payment.
• You’re interested in increasing your retirement savings contributions. Unlike retirement plans, there are no limits on contributions to a VUL. That means you can contribute as much as you want, over and above contributions made to regular retirement plans.
• You’re late in saving for retirement and looking to make up for lost time with the higher contributions.
• You have a definite familiarity with investing and are prepared to choose the sub-accounts you’ll be investing in.
• You’re aware of the complexities involved in a variable universal life insurance policy, including the fees, the escalating insurance cost, and the terminology in the policy. Otherwise, you have a financial advisor with experience in this policy type available to guide you.
• You have the type of risk tolerance that enables you to invest in assets that may lose money—without losing sleep.

Who is VUL not Right For?

Variable universal life insurance won’t be the right choice for the vast majority of consumers. This is mostly because they don’t fit the requirements above.

That’s not a problem, however. For most consumers, term life insurance is the better choice.

This is because it costs only a fraction of the premium for variable universal life insurance and related cash-value policies. So, you cannot only save money on the premiums, but you can afford to buy more coverage.

And while term life insurance policies don’t have a cash value and investment provision, you could always open a brokerage account and invest in the mutual funds and exchange-traded funds of your choice.

Variable Universal Life Insurance Pros & Cons

Pros:

• Variable universal life insurance offers life insurance and investing in the same product.
• The investment gains in a VUL accumulate on a tax-deferred basis, similar to retirement plans.
• You can contribute as much to a VUL as you like, which will make it an excellent supplemental retirement savings plan. It’s especially good if you are late in saving for retirement. Because you’ll make up for lost time with higher contributions than you can make to traditional retirement plans.
• You can choose the sub-accounts your money is invested in and even make adjustments in the future.
• Once the cash value reaches a certain level, the policy may be “paid up,” eliminating the need for future premium payments.
• A successfully invested VUL can easily outperform a comparable investment in a whole life insurance policy.

Cons:

• VULs are expensive insurance policies. They contain a multitude of fees, including commissions, administrative fees, surrender charges, and sub-account fees.
• Sub-account fees will reduce investment returns but also increase losses in years when the accounts are losing value.
• There is no floor on investment losses. If the market is turned down for an extended period of time, or if you poorly manage your sub-accounts, you can lose money just as you will with any other type of investment plan.
• VULs are complicated and not designed for consumers who are not familiar with how they work.
• Cash withdrawals that exceed the amount of your contributions to the investment portion of the policy can create a tax liability.
• The investment provision in a variable universal life insurance policy is a self-directed plan. You’ll be the one managing your investments within the policy, not the insurance agent.
• The cost of the life insurance provision will rise steadily and may exceed your premiums. That can result in a drawdown of your cash value and even cause your policy to lapse unless you increase your premium payments accordingly.

Bottom Line

Variable universal life insurance policies are designed to work for a very specific consumer. Primarily for those who are looking to combine life insurance with an investment provision.

And it can certainly work well for someone looking to increase their retirement contributions beyond those allowed with regular retirement plans.

However, the primary emphasis of a variable universal life insurance policy is investing.

So, if you’re not comfortable with that, including managing your own investments and accepting the risk of loss, this is not a policy type for you.

For most, a term life insurance policy is the better choice. That’s both the simplest and least expensive type of life insurance there is.

And if you want to invest, you could always do so through a dedicated investment account.