Variable Universal Life
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 Internal Revenue 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 age (typically 100) as long as there is sufficient cash value to pay the costs of insurance in the policy, because the death benefit will be paid if the insured dies any time up until the endowment.
Variable universal life insurance receives special tax advantages in the United States Internal Revenue 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.
However, this can be offset by adding and paying for a rider that would pay a death benefit equal to the cash value in addition to the face amount. Or, one that would be equal to all premiums paid in addition to the death benefit.
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.
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. Average returns in these types of policies often exceed 10% per year.
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 code for life insurance. Internal Revenue 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.
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 (similar to mutual funds). 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 free investment earnings while a policy is in force
- FIFO withdrawal status on principal paid into the contract
- Tax free policy loans from non-MEC policies
- The death benefit is paid income tax free if premiums are paid with after tax money
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 34% tax bracket (Federal & State), 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 9%. In order to get a 9% rate of return in an ordinary taxable account, in a 34% tax bracket, one must earn 13.64%. 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 normally unavailable to those in the 34% 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. 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
- Cost of Insurance - The cost of insurance for VULs is generally based on term rates.
- 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.
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.
- Education Planning - The cash value of a VUL can be used to help fund children's education, as long as the policy is started very early. Also, putting money into a VUL can be used to help children qualify for federal financial aid, since the federal government does not consider the cash value when calculating EFC (Expected Family Contribution).
- 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 and the policy is not a modified endowment contract. 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 by setting up ILIT.