What Is Variable Universal Life?
Variable universal life (VUL) is a type of permanent life insurance that offers both a death benefit and an investment component known as cash value. Falling under the broader financial category of Life insurance, VUL policies distinguish themselves by allowing policyholders to allocate their cash value into various investment sub-accounts, which are similar to mutual funds. The "variable" aspect refers to the fact that the cash value and death benefit can fluctuate based on the performance of these underlying investments, while the "universal" aspect denotes the flexibility in premium payments and the death benefit amount. Unlike traditional policies with fixed returns, variable universal life offers the potential for greater cash value growth, alongside inherent market risk.
History and Origin
The concept of variable life insurance, which predates variable universal life, was initially introduced in the Netherlands in the 1950s by DeWaerdye, LTD., before its popularity spread to the United Kingdom. In the United States, variable life insurance was formally introduced in 1976 by Equitable Life Assurance Society, aiming to provide policyholders with greater investment participation.6 The evolution to variable universal life combined the investment flexibility of variable life with the premium flexibility characteristic of universal life insurance. Variable universal life policies first became widely available around 1986, offering considerable tax benefits for investment within the policy's cash value.5 This development stemmed from a desire within the insurance industry to offer products with flexible premiums and the potential for higher returns, building upon the attractive features of universal life.4
Key Takeaways
- Variable universal life (VUL) is a permanent life insurance policy with an investment component.
- Policyholders can direct the cash value into various investment sub-accounts, similar to mutual funds.
- The cash value and death benefit can fluctuate based on investment performance.
- VUL offers flexible premium payments and adjustable death benefits.
- It combines the tax advantages of life insurance (tax-deferred cash value growth, tax-free death benefit) with investment growth potential.
Formula and Calculation
Variable universal life does not have a single, simple formula for its overall value, as it is a complex product with multiple moving parts. Its value is continuously affected by premiums paid, costs of insurance, administrative fees, and the investment performance of the chosen separate account sub-accounts.
The cash value accumulation can be thought of as:
Where:
- (\text{Cash Value}_{\text{New}}) = Cash value at the end of the period
- (\text{Cash Value}_{\text{Old}}) = Cash value at the beginning of the period
- (\text{Net Premiums}) = Premium payments paid minus any premium loads
- (\text{Policy Charges}) = Costs of insurance (mortality charges), administrative fees, and surrender charges
- (\text{Investment Return}) = The return generated by the chosen investment sub-accounts
The death benefit calculation can be more complex, often structured as a level death benefit or an increasing death benefit (cash value plus face amount). The cost of insurance, a key component of policy charges, is determined by factors such as age, health, and the death benefit amount, which are assessed during the underwriting process.
Interpreting the Variable Universal Life
Interpreting a variable universal life policy involves understanding the interplay between its insurance and investment components. Unlike traditional policies where cash value growth is based on a fixed interest rate, VUL's cash value growth is tied directly to the performance of the chosen sub-accounts. A higher investment return in the chosen sub-accounts can lead to a more significant accumulation of cash value, offering potential for increased living benefits or a larger death benefit. Conversely, poor investment performance can lead to a decline in cash value, potentially requiring higher premium payments to maintain the policy or even leading to a lapse if the cash value cannot cover ongoing policy charges. Policyholders must regularly monitor their chosen investments and understand that they bear the market risk associated with these selections.
Hypothetical Example
Consider Sarah, a 40-year-old professional, who purchases a variable universal life policy with a $500,000 death benefit. She initially plans to pay $500 per month in premium payments. A portion of her premium covers the cost of insurance and administrative fees, while the remainder is directed to her chosen investment sub-accounts.
Sarah selects a mix of sub-accounts, including a large-cap equity fund and a bond fund, with the aim of long-term growth.
- Year 1: The net premiums allocated to the cash value, after initial policy charges, are invested. Her chosen sub-accounts perform well, achieving a 10% return. Her initial cash value grows, contributing to the policy's overall value.
- Year 5: Sarah's career takes off, and she decides to increase her premium payments to $700 per month, leveraging the VUL's flexibility to contribute more to her investment sub-accounts. The market continues to perform strongly, and her cash value has grown significantly, exceeding expectations. She also maintains her $500,000 death benefit.
- Year 15: The market experiences a downturn, and her sub-accounts generate a negative return for the year. Due to the accumulated cash value, the policy charges are still covered, and Sarah does not need to pay additional premiums. While her cash value declines for the year, the policy remains in force, and her death benefit is protected by a minimum guarantee. Had her cash value been minimal, she might have needed to pay more to prevent the policy from lapsing.
This example illustrates how the flexible premiums and investment-linked cash value of a variable universal life policy allow for adaptation to changing financial circumstances and market conditions, while also highlighting the inherent investment risk.
Practical Applications
Variable universal life policies are often utilized in advanced financial planning strategies, particularly for individuals seeking both life insurance coverage and wealth accumulation potential. One common application is in retirement planning, where the policy's tax deferral on cash value growth can be appealing. The accumulated cash value can potentially be accessed through tax-free policy loans or withdrawals, providing a supplemental income stream in retirement.3
Furthermore, VUL policies are employed in estate planning to create a tax-free death benefit for beneficiaries, helping to cover estate taxes or provide liquidity for heirs. The ability to customize investment allocations within the policy also appeals to those with a higher risk tolerance who wish to have more control over their policy's growth potential.2
Limitations and Criticisms
While offering significant flexibility and growth potential, variable universal life policies also come with notable limitations and criticisms. A primary concern is the exposure to market risk; if the chosen investment sub-accounts perform poorly, the cash value can decline, potentially requiring higher premium payments to prevent the policy from lapsing. This contrasts with more conservative policies where cash value growth is guaranteed or linked to stable interest rates.
Another criticism centers on the relatively high fees and expenses associated with variable universal life policies. These can include mortality and expense risk charges, administrative fees, investment management fees for the sub-accounts, and surrender charges if the policy is terminated early. These fees can significantly erode cash value growth, particularly in early policy years or during periods of low investment returns. This complexity and the associated costs can lead to investor complaints.1 Additionally, the variable nature of the returns means there is no guaranteed cash value, only a guaranteed minimum death benefit in many cases.
Variable Universal Life vs. Universal Life Insurance
Variable universal life (VUL) and universal life insurance (UL) are both types of permanent life insurance that offer flexible premiums and a cash value component. However, the key distinction lies in how their cash values grow and the level of investment control the policyholder has.
| Feature | Variable Universal Life (VUL) | Universal Life (UL) |
|---|---|---|
| Cash Value Growth | Tied to performance of policyholder-chosen investment sub-accounts (e.g., stocks, bonds). | Based on a declared interest rate set by the insurer, typically with a minimum guarantee. |
| Investment Control | Policyholder directs allocations among various sub-accounts. | Insurer manages the cash value, usually in its general account. |
| Investment Risk | Policyholder bears the market risk and potential for loss. | Insurer bears the investment risk, offering more stable, though often lower, returns. |
| Complexity | Generally more complex due to investment choices and market fluctuations. | Simpler, with a more predictable cash value growth. |
| Potential Returns | Higher potential for growth but also for losses. | More conservative, with generally lower but more predictable returns. |
While both offer flexible premiums and the ability to adjust the death benefit, variable universal life appeals to those seeking greater investment control and potential for higher returns, while universal life insurance is suited for those preferring more stability and predictability in their cash value accumulation.
FAQs
Q: Is variable universal life considered an investment?
A: Yes, variable universal life is considered a hybrid product, combining a life insurance component with an investment component. The cash value portion is invested in sub-accounts that can fluctuate with market performance.
Q: What are the main advantages of variable universal life?
A: The main advantages include flexible premium payments, potential for higher cash value growth due to market participation, and the ability to adjust the death benefit. It also offers tax-deferred growth on the cash value and a generally tax-free death benefit.
Q: What are the risks of variable universal life?
A: The primary risk is market risk. If the underlying investments perform poorly, the cash value can decrease, potentially leading to a lapse of the policy if there isn't enough cash value to cover policy charges. It also typically has higher fees than other types of permanent life insurance.
Q: Can I change my investment choices in a variable universal life policy?
A: Yes, policyholders typically have the flexibility to reallocate their cash value among the available investment sub-accounts offered by the insurance company. This allows for adjustments based on changing market conditions or personal financial goals.
Q: Is variable universal life suitable for everyone?
A: No, variable universal life is generally more suitable for individuals with a higher risk tolerance who understand investment principles and are comfortable with managing market fluctuations. It is often considered by those who have already maximized other tax-advantaged retirement vehicles.