Variable life insurance was
first sold in 1976, and variable universal life policies (VUL) were rolled out
in the 1980s. However, VUL did not take off in popularity until the 1990s and
sales have been up and down as the stock markets have gone through bull and
bear cycles. According to LIMRA, in 2014 VUL sales were up, but still only
represented about 6% of all life insurance premium sold. What is VUL? VUL a
permanent life insurance policy that builds cash value, has flexible premiums
and allows for loans. VUL also offers the policy owner the potential to earn a
higher rate of return. Unlike whole and universal life policies that invest the
cash value in a fixed account, VUL allows the policy owner to invest in a
selection of mutual fund subaccounts. Mutual fund subaccounts are essentially
clones of retail mutual fund shares offered in life insurance and annuity
products. (See also: Subaccounts as Good Their Clone Funds?) With VUL, the policy
owner manages the allocation and decides how and when to invest the cash value
into the subaccounts or a fixed account.
Most policies do place
restrictions on transfers in and out of the fixed account (unless it part of an
automatic dollar cost averaging program) and limits on frequent transfers
between subaccounts. If the investments don’t provide an adequate return, the
policy owner may have to make additional premium payments and/or reduce the
death benefit to keep the policy from lapsing. If the policy is properly
managed, the cash value can grow, and distributions can be taken from the
policy as low-cost loans and/or tax-free recovery of premiums paid (cost
basis).
Distributions may be limited and subject to with drawl or surrender charges. As long as
the policy stays in force any appreciation or income in the subaccounts is not
taxed. However, if the policy lapses, any distributions, in excess of the cost
basis, would be taxed as ordinary income. Consequently, the policy owner,
rather than the insurer, is taking all the investment risk, since there are no
guarantees. How Does VUL Work? Since VUL offers mutual fund subaccounts, it is
sold with a thick prospectus (some are more than 100 pages). The policies have
a lot of moving parts and can be difficult to fully understand, even for
advisors. When a premium payment is made, a sales or premium charge, which vary
and can be as high as 8-10% is deducted.
The premium charge allows the
insurer to recover sales costs and pay taxes. VUL is subject to a premium tax
that varies by jurisdiction and currently range from 0% to 3.5%. In many
policies, the high initial premium charge is reduced in later years. The
remaining premium is added to the policy cash value and invested in the
selected subaccounts. Each month, the cost of insurance, administrative costs,
asset-based charges (in addition to the subaccount management fees) and other
expenses are deducted from the policy cash value. These costs vary by product
and company. Premium Payments The planned premium is calculated based on a
variety of factors including the insured’s age, sex and health; assumed rate of
return; level or increasing death benefit; additional policy riders, such as a
disability waiver of premium. Many policies also offer a no-lapse premium,
which if paid guarantees that the policy will stay in force for a certain
number of years (in some policies up to 20 years) even if the cash value in the
policy dropped to nothing.
Once the policy has been issued, the policy
owner can pay whatever amount of premium they want as long as it does exceed a
maximum that is governed by federal tax laws and limit premium payments
relative to the amount of insurance in the policy. If they exceed the maximum,
the policy can become a modified endowment contract. The appreciation potential
of the subaccounts and premium flexibility are reasons why VUL is often used in
non-qualified executive benefits plans, such as split-dollar plans. These
individuals have typically maximized contributions to qualified plans, and the
goal is to build cash value while buying as little insurance as possible.(See
also: Can You Fund Nonqualified Deferred Compensation Plans With Life
Insurance?) Managing the Policy Unlike more traditional, whole and universal
life policies, VUL needs to be actively managed. The subaccounts performance
needs to be monitored, and the allocation of the cash value should be
rebalanced periodically. Also, other strategies, such as paying the premium monthly
to dollar cost average into the subaccounts and having the cost of insurance
drawn from the fixed account, rather than the variable accounts, can make sense.