Understanding Variable Universal Life Insurance
Life insurance is a complex topic to understand. Even after having an uncomfortable conversation about your own mortality, you must decide from what seems to be an endless variety of different policy types, each with its own specific options. An individual first needs to decide whether to buy a term or permanent policy; both have benefits and drawbacks (Click here to see a previous post that goes over some of the differences between these policies). We believe that buying the less expensive term policy and investing the difference is the most prudent approach for the majority of individuals and families. Still, in some instances, permanent insurance does make sense. In this post, we want to discuss a type of permanent policy that we have seen some of our clients benefit from, variable universal life (VUL). Specifically, we will discuss how individuals can access low commission VUL policies available to clients of fee-only financial planning firms like River Capital Advisors.
Basics of VUL Policies
As mentioned before, evaluating these policies can be daunting, especially if you are not familiar with the often-used terminology. While this is by no means an extensive list, we would like to start by defining some terms.
- Cash Value – Each premium payment for permanent insurance consists of two parts, the cost of insurance and cash value. The cash value is held in an account that typically earns interest and grows over time. The type and structure of your policy determine what you can do with these funds.
- Cash Surrender Value – The surrender value describes the amount you will receive if you try to tap into the cash value.
- Surrender Charge – It is in the insurance company’s best interest for you to keep your policy in force and not pull money out of the policy too early. To encourage you to do so, they will often charge a fee for early withdrawal. These fees are usually front-loaded and decrease over time, and eventually, the cost drops off completely. The charge is equal to the difference between the cash value and the surrender value.
- Commissions – This is the payment the insurance agent receives for selling you a policy. Many agents solely get paid on commission and typically receive a percentage of the premium you pay.
- Universal Life Insurance – Universal life insurance policies have a flexible premium usually set to a target to sustain the policy over a certain number of years. These are considered “permanent” policies in that they can be used to provide a death benefit for the insured’s lifetime, but if the target premium is set too low, the policy won’t have enough cash value or account value to sustain the ever-increasing cost of insurance as the insured ages.
- Variable Insurance – The cash value in a traditional permanent insurance policy earns a guaranteed, modest interest rate, while cash value in variable policies can be invested. These policies have what’s called “separate accounts,” which are similar to mutual funds. Like putting your money in the stock market versus a savings account at the bank, these separate accounts can earn a greater return and come with greater risk. These investments are selected by the owner of the contract.
So, putting it together, a VUL policy is a permanent life insurance policy that builds cash value invested in separate accounts and provides policy owners the flexibility to adjust their premium payments and death benefits.
Within the category of variable life insurance, you have two options, option A and option B.
- Option A – This is the more cost-efficient option and provides a level death benefit. The death benefit does not increase until the cash value exceeds the death benefit.
- For example, you own a $100,000 VUL policy and have $50,000 in cash value. If you were to die, your beneficiary would receive $100,000, and the cash value will be returned to the insurance company.
- If you continue to pay your premium and your cash value is now $105,000, your death benefit will increase, and when you die, your beneficiary will receive the increased death benefit.
- Option B – Premiums on these policies are more expensive because the cash value increases the death benefit immediately.
Who Can Benefit?
As was previously mentioned, purchasing permanent insurance is more costly, and if income replacement is your main objective, it is usually better to purchase a cheaper term policy. We find that people who benefit the most are trying to:
- Reduce Estate Taxes – The value of a life insurance policy can be excluded from your gross estate if appropriately structured. This could reduce the amount of estate taxes owed at death or put you under the threshold of having a taxable estate altogether. While this strategy has been less common in recent years since the exemption increased to $11.8 million for single filers and $23.4 million for married couples (based on current law as of November 17, 2021), it can be a helpful strategy if you fall over those thresholds.
- Estate Liquidity – Many individuals and families may leave their heirs an illiquid or hard-to-divide estate. You may not want to force your beneficiaries to sell the family house or business just to cover the taxes owed on your estate or ensure that all beneficiaries receive an equal share. A VUL policy could provide them with the liquidity that is needed for these purposes.
- Leaving a Legacy – Proceeds from a life insurance policy are not taxed to the beneficiary. If your goal is to increase the tax-free money passed down to your heir, putting money into a VUL may make sense, as the underlying cash value can be maximized through investing.
Things to Consider
When shopping for policies, there are several things that you want to consider, especially regarding cost.
- Account Fees – Policies can charge annual account maintenance fees.
- Investment Fees – Like mutual funds, investments may have fees attached, commonly labeled as expense ratios.
- Surrender Fees – Discussed earlier, these are fees for early withdrawal or termination of the policy. They typically have a schedule such as five to ten years, with higher charges in the beginning that reduce over time. These fees can be substantial if you need to surrender the policy.
- Commissions – Mentioned earlier, insurance agents earn a commission on the policies they sell. Their commission is paid out of the premiums you pay and decreases the portion available in cash value. These commission rates can be as much as 70%-100% of the first-year premium!
How River Capital Advisors Can Help
If you are contemplating purchasing life insurance or have an existing life insurance policy that you want to be reviewed, our team of CERTIFIED FINANCIAL PLANNERS™ at River Capital Advisors is well-equipped to help you analyze your need or the existing coverage you have. We do not sell any products, nor do we receive any commissions for our recommendations. As fiduciaries, we are legally obligated to advise you in your best interest.
Additionally, if you need a referral for life insurance, we can refer you to independent insurance agencies that only work with fee-only advisors like River Capital Advisors and focus on our recommendations instead of upselling you. Through these agencies, our clients have access to low load (low commission) and no commission life insurance and annuities when available. These agencies do not solicit individuals, and they offer products to our clients at lower costs than those clients probably could achieve on their own. The lower costs allow the products to build cash value much more quickly and can increase flexibility. If you believe you are in a high-cost insurance product of any kind, we can provide a second opinion and potentially move you to a much lower-cost product. Please contact us if we can help you.