Subject: Insurance - Variable Universal Life (VUL)

Last-Revised: 26 Jun 2000
Contributed-By: Ed Zollars (ezollar at mindspring.com), Chris Lott (contact me), Dan Melson (dmelson at home.com)

This article explains variable universal life (VUL) insurance, and discusses some of the situations where it is appropriate.

Variable universal life is a form of life insurance, specifically it's a type of cash-value insurance policy. (The other types of cash value life insurance are whole, universal, and variable life.) Like any life insurance policy, there is a payout in case of death (also called the death benefit). Like whole-life insurance, the insurance policy has a cash value that enjoys tax-deferred growth over time, and allows you to borrow against it. Unlike either term or traditional whole-life insurance, VUL policies allow the insured to choose how the premiums are invested, usually from a universe of 10-25 funds. This means that the policy's cash value as well as the death benefit can fluctuate with the performance of the investments that the policy holder chose.

Where does the name come from? To take the second part first, the "universal" component refers to the fact the premium is not a "set in stone" amount as would be true with traditional whole life, but rather can be varied within a range. As for the first part of the name, the "variable" portion refers to the fact that the policy owner can direct the investments him/herself from a pool of options given in the policy and thus the cash value will vary. So, for instance, you can decide

the cash value should be invested in various types of equities (while it can be invested in nonequities, most interest in VUL policies comes from those that want to use equities). Obviously, you bear the risk of performance in the policy, and remember we have to keep enough available to fund the expenses each year. So bad performance could require increasing premiums to keep the policy in force. Conversely, you gain if you can invest and obtain a better return (at least you get more cash value).

If a VUL policy holder was fortunate enough to choose investments that yield returns anything like what the NASDAQ saw in 1999, the policy's cash value could grow quite large indeed. The cash value component of the policy may be in addition to the death benefit should you die (you get face insurance value *plus* the benefit) *OR* serve to effectively reduce the death benefit (you get the face value, which means the cash value effectively goes to subsidize the death benefit). It all depends on the policy.

A useful way to think about VUL is to think of buying pure term insurance and investing money in a mutual fund at the same time. This is essentially what the insurance company that sells you a VUL is doing for you. However, unlike your usual mutual fund that may pass on capital gains and other income-tax obligations annually, the investments in a VUL grow on a tax-deferred basis. Uncle Sam may get a taste eventually (if the policy is cashed in or ceases to remain in force), but not while the funds are growing and the policy is maintained.

We can talk about the insurance component of a VUL and about the investment component. The insurance component obviously provides the death benefit in the early years of the policy if needed. The investment component serves as "bank" of sorts for the amounts left over after charges are applied against the premium paid, namely charges for mortality (to fund the payouts for those that die with amounts paid beyond the cash values), administrative fees (it costs money to run an insurance company (grin)) and sales compensation (the advisor has to earn a living). How this amount is invested is the principal difference between a VUL and other insurance policies.

If you own a VUL policy, you can borrow against the cash value build-up inside the policy. Because monies borrowed from a VUL policy that is maintained through the insured's life are technically borrowed against the death benefit, they work out tax free. This means a VUL owner can borrow money during retirement against the cash value of the policy and never pay tax on that money. It sounds almost too good to be true, but it's true, with some caveats that are discussed next.

A policy holder who choose to borrow against the death benefit must be extremely careful. A policy collapses when the cash value plus any continuing payments aren't enough to keep the basic insurance in force, and that causes the previously tax-free loans to be viewed as taxable income. Too much borrowing can trigger a collapse. Here's how it can happen. As the insured ages, Cost of Insurance (COI) per thousand dollars of insurance rises. With a term policy, it's no big deal - the owner can just cancel or let it lapse without tax consequences, they just have no more life insurance policy. But with a cash value policy such as VUL there is the problem of distributions that the owner may take. Say on a policy with a cash value of $100,000 I start taking $10,000 per year withdrawals/loans. Say I keep doing this for 30 years, and then the variability of the market bites the investment and the cash value gets exhausted. I may have put say 50,000 into the policy - that's my cost basis, and I took that much out as withdrawals. But the other $250,000 is technically a loan against the death benefit, and I don't have to pay taxes on it - until there's suddenly no death benefit because there's no policy. So here's $250,000 I suddenly have to pay taxes on.

Once the policy is no longer in force, all the money borrowed suddenly counts as taxable income, and the policy holder either has taxable income with no cash to show for it, or a need to start paying premiums again. At the point of collapse, the owner could be (reasonably likely) destitute anyway, so there may be very little in the way of real consequences, but if there are still assets, like a home, other monies, etcetera, you see that there could be problems. Which is why cash value life insurance should be the *last* thing you take distributions from in most cases (The more tax-favored they are, the longer you put off distributions.) What all this means is that the cash surrender value of the VUL really isn't totally available at any point in time, since accessing it all will result in a tax liability. If you want to consider the real cash value, you need realistic projections of what can be safely borrowed from the policy.

This seems like a good time to mention one other aspect of taxes and life insurance, namely FIFO (first-in first-out) treatment. In other words, if a policy holder withdraws money from a cash-value life insurance policy, the withdrawal is assumed to come from contributions first, not earnings. Withdrawals that come from contributions aren't taxable (unless it's qualified money, a rare occurence). After the contributions are exhausted, then withdrawals are assumed to come from earnings.

Computing the future value of a VUL policy borders on the impossible. Any single line projection of the VUL is a) virtually certain to be wrong and b) without question overly simplistic. This is a rather complex beast that brings with it a wide range of potential outcomes. Remember that while we cannot predict the future, we know pretty much for sure that you won't get a nice even rate of return each year (though that's likely what all VUL examples will assume). The date when returns are earned can be far more important than the average return earned. To compare a VUL with other choices, you need to do a lot of "what ifs" including looking at the impacts of uneven returns, and understand all the items in the presentation that may vary (including your date of death (grin)).

While I hate to give "rules of thumb" in these areas, the closest I will come is to say that VUL normally makes the most sense when you can heavily fund the policy and are looking at a very long term for the funds to stay invested. The idea is to limit the "drag" on return from the insurance component, but get the tax shelter.

Another issue is that if you will have a taxable estate and helping to fund estate taxes is one of the needs you see for life insurance, the question of the ownership of the insurance policy will come into play. Note that this will complicate matters even further (and you probably already thought it was bad enough (grin)), because what you need to do to keep it out of your estate may conflict with other uses you had planned for the policy.

Note that there are "survivor VULs", insuring two lives, which are almost always sold for either estate planning or retirement plan purposes (or both). The cost of insurance is typically less than an annuity's M&E charges until the younger person is in their fifties.

A person who is considering purchasing a VUL policy needs to think clearly about his or her goals. Those goals will determine both whether a VUL is right tool and how it should be used. Potential goals include:

  • Providing a pool of money that will only be tapped at my death, but will be used by my spouse.
  • Providing a pool of money that will only be used at my death, but which we want to use to pay estate taxes.
  • Providing a pool of money that I plan to borrow from in old age to live on, and which will, in the interim, provide a death benefit for my spouse.

Once the goals are clear, and you've then determined that a VUL would be something that could fulfill your goals, you then have to find the right VUL.

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