Variable universal life insurance

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Variable Universal Life Insurance (often shortened to VUL) is a type of life insurance, that builds a cash value. In a VUL, the cash value can be invested in a wide variety of separate accounts, similar to mutual funds, and the choice of which of the available separate accounts to use is entirely up to the contract owner. The 'variable' component in the name refers to this ability to invest in volatile investments similar to mutual funds. The 'universal' component in the name is a bit of a misnomer that is used to refer to the flexibility the owner has in making premium payments. The premiums can vary from nothing in a given month up to maximums defined by the IRS code for life insurance. This flexibility is in contrast to whole life insurance that has fixed premium payments that typically cannot be missed without lapsing the policy.

Variable universal life is also considered to be a type of permanent life insurance, because the death benefit will be paid if the insured dies any time up until the endowment age (typically 100) as long as there is sufficient cash value to pay the costs of insurance in the policy.

Contents

[edit] Uses

Variable universal life insurance receives special tax advantages in the United States IRS code. The cash value in life insurance is able to earn investment returns without incurring current income tax as long as it meets the definition of life insurance and the policy remains in force. The tax free investment returns could be considered to be used to pay for the costs of insurance inside the policy. See the 'Tax Benefits' section for more.

In one theory of life insurance, needs based analysis, life insurance is only needed to the extent that assets left behind by a person will not be enough to meet the income and capital needs of his or her dependents. In one form of variable universal life insurance, the cost of insurance purchased is based only on the difference between the death benefit and the cash value (defined as the net amount at risk from the perspective of the insurer). Therefore, the greater the cash value accumulation, the lesser the net amount at risk, and the less insurance that is purchased.

Another use of Variable Universal Life Insurance is among relatively wealthy persons who give money yearly to their children to put into VUL policies under the gift tax exemption. Very often persons in the United States with a net worth high enough that they will encounter the estate tax give money away to their children to protect that money being taxed. Often this is done within a VUL policy because this allows a tax deferral (for which no alternative would exist besides tuition money saved in an educational IRA or 529 plan), provides for permanent life insurance, and can usually be accessed by borrowing against the policy.

[edit] Contract Features

By allowing the contract owner to choose the investments inside the policy, the insured takes on the investment risk, and receives the greater potential return of the investments in return. If the investment returns are very poor this could lead to a policy lapsing (ceasing to exist as a valid policy). To avoid this, many insurers offer guaranteed death benefits up to a certain age as long as a given minimum premium is paid.

[edit] Premium Flexibility

VUL policies have a great deal of flexibility in choosing how much premiums to pay for a given death benefit. The minimum premium is primarily affected by the contract features offered by the insurer. To maintain a death benefit guarantee, that specified premium level must be paid every month. To keep the policy in force, typically no premium needs to be paid as long as there is enough cash value in the policy to pay that month's cost of insurance. The maximum premium amounts are heavily influenced by the IRS code for life insurance. The IRS code section 7702 sets limits for how much cash value can be allowed and how much premium can be paid (both in a given year, and over certain periods of time) for a given death benefit. The most efficient policy in terms of cash value growth would have the maximum premium paid for the minimum death benefit. Then the costs of insurance would have the minimum negative effect on the growth of the cash value. In the extreme would be a life insurance policy that had no life insurance component, and was entirely cash value. If it received favorable tax treatment as a life insurance policy it would be the perfect tax shelter, pure investment returns and no insurance cost. In fact when variable universal life policies first became available in 1986, contract owners were able to make very high investments into their policies and received extraordinary tax benefits. In order to curb this practice, but still encourage life insurance purchase, the IRS developed guidelines regarding allowed premiums for a given death benefit.

[edit] Maximum Premiums

The standard set was twofold: to define a maximum amount of cash value per death benefit and to define a maximum premium for a given death benefit. If the maximum premium is exceeded the policy no longer qualifies for all of the benefits of a life insurance contract and is instead known as a modified endowment contract or a MEC. A MEC still receives tax free investment returns, and a tax free death benefit, but withdrawals of cash value in a MEC are on a 'LIFO' basis, where earnings are withdrawn first and taxed as ordinary income. If the cash value in a contract exceeds the specified percentage of death benefit, the policy no longer qualifies as life insurance at all and all investment earnings become immediately taxable in the year the specified percentage is exceeded. In order to avoid this, contracts define the death benefit to be the higher of the original death benefit or the amount needed to meet IRS guidelines. The maximum cash value is determined to be a certain percentage of the death benefit. The percentage ranges from 30% or so for young insureds, declining to 0% for those reaching age 100.

The maximum premiums are set by the IRS guidelines such that the premiums paid within a seven year period after a qualifying event (such as purchase or death benefit increase), grown at a 6% rate, and using the maximum guaranteed costs of insurance in the policy contract, would endow the policy at age 100 (ie the cash value would equal the death benefit). More specific rules are adjusted for premiums that are not paid in equal amounts over a seven year period. The entire maximum premium (greater than the 7 year premium) can be paid in one year and no more premiums can be paid unless the death benefit is increased. Because the 7 year level guideline premium was exceeded the policy becomes a MEC.

To add more confusion the 7 year MEC premium level cannot be paid in a VUL every year for 7 years, and still avoid MEC status. The MEC premium level can only be paid in practice for about 4 years before additional premiums cannot be paid if non MEC status is desired. There is another premium designed to be the maximum premium that can be paid every year a policy is in force. This premium carries different names from different insurers, one calling it the guideline maximum premium. This is the premium that often reaches the most efficient use of the policy.

[edit] Investment Choices

The number and type of choices available is dependent on the insurer, but some policies are available with a wide variety of separate accounts, also known as sub-accounts. Some insurers offer over 50 separate accounts with investment styles from very conservative guaranteed fixed accounts, to bond funds, to equity funds to highly aggressive sector funds.

Separate accounts are organized as trusts to be managed for the benefit of the insureds, and are named because they are kept separate from the general account which is the other reserve assets of the insurer. They are treated, and in all intents and purposes are, very much like mutual funds, but have slightly different regulatory requirements.

[edit] Tax Advantages

  • Tax free investment earnings while a policy is in force
  • FIFO withdrawal status after 15 years
  • Tax free policy loans from non-MEC policies
  • The death benefit is paid income tax free if premiums are paid with after tax dollars

Taxes are the main reason those in higher tax brackets (25%+) would desire to use a VUL over any other accumulation strategy. For someone in a 35% tax bracket, the investment return on the sub-accounts may average 10%, and at say age 75 the policy's death benefit would have an internal rate of return of 8.5%. In order to get an 8.5% rate of return in an ordinary taxable account, in a 35% tax bracket, one must earn 13.1%. However, using long-term gains (e.g. hold stocks for more than a year), you would only need to have a return of 10%, which should be easily accomplishable since this is roughly the long-term return of the stock market. Another alternative is a Roth IRA, because one would get the 10% tax free. But the limits on the Roth are low, and the Roth is unavailable to those in the 35% tax bracket. These numbers assume expenses that may vary from company to company, and it is assumed that the VUL is funded with a minimum face value for the level of premium. If an individual is unable to max fund the VUL, it may easily be more preferred to use term insurance until able to convert to VUL.

The cash values would also be available to fund lifestyle or personally managed investments on a tax free basis in the form of refunds of premiums paid in and policy loans (which would be paid off on death by the death benefit.)

[edit] Risks of Variable Universal Life

  • Cost of Insurance - The cost of insurance for VULs is generally more expensive than other types of life insurance policies, mostly due to the permanent nature of the product.
  • Cash Outlay - The cash needed to effectively use a VUL is generally much higher than other types of insurance policies. If a policy does not have the right amount of funding, it may lapse.
  • Investment Risk - Because the sub accounts in the VUL may be invested in stocks and bonds, the insured now takes on the investment risk rather than the insurance company.
  • Complexity - The VUL is a complex product, and can easily be used (or sold) inappropriately because of this. Proper funding, investing, and planning are usually required in order for the VUL to work as expected.
  • Fee Impact Over Time - The management fees, or "loading and expense charges" (The Journal of Risk and Insurance, Vol. 54, No. 4 (Dec., 1987), pp. 691-711) can "make it inferior to an open-market insurance and investment strategy". These account management fees, applied to the total investment account value (unlike the insurance or policy fees, which are fixed and generally do not apply to the compounding account value) reduce the total net return on the portfolio, and can be very large compared to the identical investments held outside the VUL; often by several percent per year. These fees must be stated in every policy, although sometimes cryptically. VUL policies must be held until death to obtain the investment growth as part of the tax-free death benefit, so the fee exposure is typically measured in decades. Since an additional 2% annual fee over 36 years cuts the final portfolio value in 1/2, or a 3% extra fee over 48 years yields only 1/4 the final total portfolio value (see Rule of 72), it can be beneficial to choose to hold the exact same investment outside the Variable Universal Life policy. Since the sales commission for VUL is often in excess of 70% of first year VUL premiums (vs. 2-5% of annual deposits for the same investment held outside the policy) sales agents are often unlikely to wish to discuss these options with you (or show you how to calculate them yourself). See the External Links section below for actual policy excerpts, calculation of fees compared to identical investments held outside the policy, examples illustrating the impact of this risk, and calculation aids to help you discover and compute this risk from a policy contract.
  • Cannibalization - VUL is essentially annual renewable term with an investment vehicle attached. As such, the cost of insurance within the policy rises yearly until such time as the premiums are insufficient to cover the cost of the insurance portion of the policy, at which time the cash value/investment portion of the policy begins to be redirected toward sustaining the policy. Once the cash value is depleted, the insured receives notice that their policy premiums must be raised in order to keep the policy in force.

[edit] General Uses of Variable Universal Life

  • Financial Protection - VULs can be used to protect a family in the case of a premature death. A VUL can be attractive for this need because it is a permanent policy, and, if funded correctly, will not lapse, unlike term insurance. This may give the insured more insurance flexibility in future years.
  • Tax Advantages - Because of its tax-deferred feature, the VUL may offer an attractive tax advantage, especially to those in higher tax brackets. If highly funded (though still non-MEC), the tax advantages may even offset the cost of insurance.
  • Retirement Planning - Because of its tax-free policy loan feature, the VUL can also be used as tax-advantaged income source in retirement, assuming retirement is not in the near future. Again, the policy must be properly funded for this strategy to work.
  • Estate Planning - Those with a large estate can sometimes use a VUL as part of their estate planning strategy to reduce or avoid estate taxes.

[edit] External links

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