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 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.
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Uses
Variable universal life insurance receives special tax advantages in the United States Internal Revenue Service 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.
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.
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 months cost of insurance. The maximum premium amounts are heavily influenced by the IRS code for life insurance. The IRS code section 7701 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.
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.
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.
Tax Advantages
- Tax free investment earnings while a policy is in force
- FIFO withdrawal status after 10 years
- Tax free policy loans from non-MEC policies
- The death benefit is payed 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%. Compared to a roth, 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. The break even point may be for someone in a 15% tax bracket, where if he maxed out his roth contribution, then in a taxable account earning 10%, after tax he would have 8.5%, equal to the IRR on the VUL. 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.)
Criticisms of Variable Universal Life
Some general Criticisms
- High Costs - VUL's tend to be more expensive than other types of insurance, including Whole Life, Term, and Universal Life (in that order). The total cost of insurance in a VUL policy will be greater over its lifetime than a term policy and therefore more profitable to the insurer (see Buy term and invest the difference). Tax savings however may more than compensate for the costs, assuming the individual has already taken advantage of Roth contributions.
- Limited investment choices, confined to the (sometimes expensive) separate accounts that are run or set up by the insurance company.
- Policy expenses may increase if the company has negative experience with mortality. Usually there is a cap on those expenses. It should not be assumed that the policy will continue to grow and stay robust, particularly if subjected to withdrawals and loans.
Many criticisms of VUL policies are not about the product in and of itself, but rather how it is sold by many insurance agents (This section may be considered biased, as it does not address the product, but rather attacks the individuals marketing the product, known as an ad hominem attack, and a logical fallacy.)
- VUL is more profitable to the insurance company and to the agent which creates a perverse incentive to sell it when term life insurance would be better for the customer.
- Policy purchasers may not be aware of the investment risk involved. This is, however, a clear violation of basic NASD rules, and is a fineable (at the minimum) offense for the agent.
- In order to emphasize the tax free savings aspect of VUL, many agents do not disclose the other tax free savings options open to people, such as Roth IRAs or section 529 plans, which might be better. Also other tax advantaged savings options such as the 401(k) or other pre-tax retirement plans may be more appropriate in a given situation. There are agents promoting themselves primarily as "investment consultants" and who primarily market the policies as "tax free savings" instead of "life insurance with an accumulation benefit", which is illegal. Prudential Insurance was fined heavily for this practice.
- Some insurance companies or agents do not actively encourage the maximum efficient use of the policy by paying the greatest possible premium. Thus cash values do not grow well and costs are maximized.
- While certain Universal Life insurance fees are scrupulously disclosed, there are some who claim that certain additional investment account management fees (MERs) are not fully disclosed in some VUL policy projections. These additional fees can potentially cut the net yield of a VUL policy by a significant margin, compared to the identical investments held outside the VUL.
- It is also important to note that some financial professionals, mostly those who work for wire houses (such as Smith Barney, Merrill Lynch, etc.), try to dissuade clients overall from purchasing permanent life insurance as an investment vehicle over their own mutual funds, stocks or bonds.
External links
google's cache of the full invest-faq article.
A quite mathematically detailed and negative critique of Canadian Universal Life Insurance programs