Universal Life Insurance the last policy you will ever need?
Universal- tool or machine, adjustable to or appropriate for all requirements; not restricted to a single purpose or position.*
*definition via Google
What comes to mind when you hear the word universal? Universal Studios? A universal remote? Maybe a Swiss Army knife? We think of things that can be used for a broad number of uses. Things that are all-inclusive, general, generic? Definitely not life insurance? How can life insurance be “universal”?
We will answer that and more.
If you have ever wondered if a universal life policy might be right for you, we can help you work that out.
What is Universal Life Insurance?
Universal life insurance is a type of permanent life insurance policy. It provides death benefit protection, has a potential for cash value growth, and has flexibility built in.
The cash value in a universal life insurance plan earns interest. This interest can be credited in several ways. This is one of the primary ways that a universal life policy is classified.
You can find UL policies that pay a fixed interest, a variable interest, or even one that tracks to an index.
How Does a Universal Life Policy Work?
Universal life is like a hybrid of term life and whole life.
There is a lot of flexibility with universal life. In fact, they are also called “flexible premium adjustable life”. We will see why as we break it down.
This flexibility can be a double-edged sword if you don’t fully understand how universal life works.
There are a couple of key moving parts to take into consideration.
- Premium Paid
- COI or Cost of Insurance
- Premium Charges
- Maturity Age
This is just what it sounds like. The amount of premium that you pay to the insurance company for your policy.
The premium is determined when you purchase your policy and it is calculated using the anticipated cost of insurance schedule, anticipated interest, and the target maturity age.
Flexibility is built into the premium by design. You can pay more or less as you see fit within certain guidelines and conditions. If you want to pay ahead you can, if you have a rough patch and need to skip payments you can to that too! As long as the policy has sufficient cash value to cover the cost of the insurance the policy will remain in force.
This can be good or bad as you will see later on.
Cost of Insurance COI
Universal life has an increasing cost to the insurance component that works just like ART, Annual Renewable Term. Each year as you get older the cost increases slightly. This is called the cost of insurance or COI for short. Eventually, this cost increase becomes more significant each year.
You will get an annual statement every year for a UL policy and this is a very valuable section to review. It will be outlined in the statement what the cost of insurance was for the last year in your policy.
The Cost of Insurance is subtracted from the cash value each month so it is crucial that your cost of insurance does not exceed the premium you are adding.
Depending on the type of universal life you have there are several potential charges. These are also listed on your annual statement and need to be understood and reviewed.
Common expenses you might see on your UL are:
- Premium Charge- deductions prior to applying your payment to the policy. These are to account for taxes and other sales expenses to the company.
- Admin Fees- cover the costs of maintaining the policy. Record keeping and accounting fees.
- Mortality and Expense Charge- These fees are calculated for life expectancy, gender, health status, current age when the policy is issued.
- Cost of Insurance- this is the actual cost of the insurance for the policy.
- Surrender Charges- only applies if you were to terminate the policy during the stated surrender charge period. Similar to an early withdrawal penalty to a CD at the bank. These can be significant and wipe out your entire policy value!
- Fund Management Fees- This would apply for variable policies. A variable policy has internal investment choices that you can select and move funds into and out of at your discretion.
Premium charges are deducted with each premium payment. It is usually a percentage of each payment you make.
These are fees that compensate the company for things like sales expenses, state and local taxes.
The company deducts this amount prior to crediting your cash value so you don’t benefit from this portion of your premium payment.
While universal life is permanent it is also adjustable.
You can essentially adjust what your opinion of a lifetime is. If no one in your family lived past 80 and you don’t think you will need insurance past that you can select an early maturity age. On the contrary, if your great aunt is still kicking @ 106 you may want a policy that can last that long.
The longer your maturity age the more you will want to pay early to help offset those high costs of insurance when you get up in age.
Flexible Premium Adjustable Life
Lets put the puzzle together.
You make a premium payment each month of say $100. The company will subtract the premium charge of 7%? Now $93 is put into your cash value bucket.
Also each month the company charges the cost of insurance. When you are young this will typically be pretty low. Let’s say it is $20. Now your cash value has $73 in it.
You then get credited your interest for the month. This can be a fixed amount outlined in the policy, tied to investment choices you have selected, or based on an index of your choice.
I won’t complicate things with the math on the interest calculation. The interest is paid on the entire cash value not just your current payment.
Early on your interest won’t be much since the CV has not really built up.
Fast forward a year and you would have $876 in cash value after charges and cost of insurance. The cost of insurance doesn’t jump a lot for early ages. You would continue to build cash value and earn interest in a similar fashion until at some stage the COI has increased to a point that the cash value no longer increases.
Flexibility of Premium
As you move through life, things change. Maybe you got a new job with a nice raise? Maybe you were laid off and can’t scrape together the premium for a couple of months?
No problem just don’t pay it? As long as there is enough cash value in the bucket to cover your cost of insurance your still covered.
Be cautious not to abuse this though. Doing this too often will cause the value to dwindle and you might not have enough in the bucket to help offset when that charge is more than you are paying.
Monitor this along the way so you can increase your premium well ahead of this point and continue to grow your cash value. Otherwise, you may be surprised to get a letter from carrier to notify you of a problem.
Just as the premium is flexible the coverage is adjustable.
When you are young and starting out you might only need a modest amount of coverage? But when you get that raise and have a couple of kids your feeling might change?
Maybe you should just get a term life policy for that new need? Maybe, but what if you want to keep it permanent?
With universal life, you can “adjust” your existing policy! You can apply for additional coverage right in your existing policy. Or vice-versa.
Maybe you have had a universal life policy for several years and your kids are all done with college and out of the house? Don’t feel like you have a need any longer for the whole amount? You can adjust the policy down. This will help the policy perform for the future since the cost of insurance will decrease.
Rule of thumb to consider for adjusting a policy. The carrier will allow you to decrease the policy with no requirements. It lets them off the hook for that additional risk.
Increases are not guaranteed when increasing the face amount you will be subject to additional underwriting. The company will not just add the risk without assessing if it is a good move for them? Keep that in mind before adding or dropping coverage.
Types of Universal Life
There are several variations of universal life insurance available. These policies all operate in the same basic way.
The main factor in determining the type of universal life is the method of interest crediting.
Universal Life Types
- Indexed Universal Life IUL
- Variable Universal Life VUL
- Current Assumption Universal Life UL
- Guaranteed Universal Life GUL
Indexed Universal Life- IUL
The newest universal life to hit the market is the indexed universal life or IUL.
Indexed universal life is tied to an index such as the S&P 500.
It is important to note that these policies do not participate in the actual market. They just mirror the performance of the index. The company agrees to pay you interest that is in line with the return of that index. This might seem like a small detail but is where the power in the policies comes from.
With IUL you cannot lose money in the market. You are not invested in the market so you can not lose when the market is down. This can not be emphasized enough. IUL can have market like returns but with none of the risk. The worst case scenario for an indexed universal life is 0% for the year. 0% sounds terrible, I agree, but compared to a big double-digit loss like we see every 10 years or so I will take it!
What is the catch? How can they pay me when things are good and shield me from when things are bad?
One disadvantage of indexed universal life is you won’t participate 100% in the gains. Many plans have a CAP or a Spread or both. For example, if the CAP is 14% and the S&P 500 is up 18% you will max out at 14%. With a spread, you will participate up to the CAP but less the spread amount. So with the same 14% CAP and a spread of 2% in a year that the index returned 9%, you would be credited 7%.
You lock in your gains each cycle as well. So if you have that 14% gain that becomes your new floor. Not bad. Have a gain of 14% and the next period the index is down 10%? You are still locked in! This can be a real policy saver.
Variable Universal Life- VUL
For the ultimate hands-on cash value experience choose Variable Universal Life.
These offer the maximum opportunity to control every single aspect in your universal life plan.
Unlike the IUL a Variable UL does have a separate account for the cash value investment.
If you are a wiz with investing and mutual funds this type of policy might be right up your ally. The investment options inside the policy will vary widely from one carrier to the next. It will depend on what mutual fund providers they have set up on their platform.
It is possible to lose your investment in a variable universal life policy. You are responsible to manage the investments good or bad.
You don’t have a CAP so if your investments are up 20% you get the full 20%. However, there is no downside protection you can just as easily lose 20% if your investments don’t perform.
Not only can you lose money due to poor markets, but you can also lose your policy! To be a valid policy the cash value has to be above $0. Major sustained losses can wipe a policy out. Even if it doesn’t take it out completely it can affect the premium you need to pay to keep it healthy.
To offer VUL agents must be Registered Representatives. This means they have a completed additional licensing for the mutual fund portion of the policy.
We don’t recommend VUL unless you are experienced in actively managing investments, and understand how VUL works.
Current Assumption Universal Life- UL
This is the basic fixed universal life contract. You are paid a fixed interest rate that is consistent with the market when you purchased your policy.
Usually, there is a current interest scale and a guaranteed scale. The current scale usually hovers in the 3-4% range. Many of these plans have a minimum rate they will pay. So even in a down market, they will perform with that rate.
This type of policy will never achieve the upside potential that the more aggressive counterparts do, but they are a slow and steady way to accumulate cash value without having to worry.
Guaranteed Universal Life- GUL
GUL addresses the biggest disadvantage of a universal life insurance policy. In any other universal life policy if the cash value is depleted to $0 the policy will lapse unless you pay the full cost of insurance every month.
This doesn’t seem like that big of a deal, but tell that to all the customers in the late ’70s and ’80s. The original UL had no protection from this flaw.
The guarantee in a guaranteed universal life is referring to the premium rather than the cash value like a whole life. In a GUL there will almost never be any significant cash value accumulation, but that isn’t the purpose of a guaranteed universal life.
With guaranteed universal life you have a minimum premium from the start. The contract has a provision that as long as you make that payment on time your policy will not lapse. This is crucial late in life when the cost of insurance rates can be astronomical. I have worked with clients that the COI was in the $1000+ per month on relatively small policy amounts.
Very few people chose to keep pumping that kind of money into a policy. This leads to a lapse with no value. The policy won’t be there when they need it most. Such a shame.
This was the basis for the droves of class action suits against every life insurance company in the late ’80s and ’90s. Universal life still has a bad reputation for this very reason.
It is best to think of a guaranteed universal life policy as a term policy to a set age rather than for a set number of years. GUL is commonly offered to ensure coverage till age 85-121. The longer you select the higher the premiums.
So how much are we talking about? A healthy 40-year old male would expect to pay in the neighborhood of $5700 per year for a GUL. Yikes, that is a lot! It is but keep in mind that same coverage for whole life is a touch over $15,000 per year!
Pros and Cons of Universal Life Insurance
As with most things, it isn’t all rainbows and lollipops, there are pros and cons to universal life policies.
- Lifetime coverage for much less cost than a similar sized whole life policy
- The potential for significant cash value accumulation
- Flexibility to pay according to your circumstances
- Tax-deferred treatment of cash value growth
- Ability to make coverage adjustments when needs change
- If you get in a tight spot financially your policy can continue as long as your cash value can support it
The Disadvantages of Universal Life Insurance Can Be Hard to Ignore
- Universal Life costs significantly more than term life insurance
- Fees and charges add up quickly, each type has charges and expenses associated with it
- Surrender periods can be 10+ years, this can devastate the value if you need to walk away for some reason
- Complex structures lead to the need to monitor your cash values closely
- Fixed rate policies have a conservative return compared to more aggressive products
Universal Life Insurance as an Investment?
Shame on you, what would Dave Ramsey say if he heard you ask that? I can see it now, getting scolded and talked down to just for having the nerve to ask the question.
On a serious note, is universal life a good investment? What do you consider an investment?
From a pure rate of return perspective, of course, no life insurance policy is a good investment. When you factor in all the other benefits, it makes it a little tougher to decide.
If you are an experienced investor you will have many more attractive options on the open market than the limited funds in a variable universal life. You can find indexed funds with lower fees and expenses than an IUL. And the standard universal life insurance offers low rates of return that you can usually find in conservative investments like bonds.
So no from a rate of return point of view NONE of the universal life insurance is a good investment.
But if you have a lifetime need for the death benefit and want flexibility universal life might be one tool in your arsenal. Just like the Swiss Army knife is not the best version of anything it offers. It has a lot of versatility and you can take it anywhere. Universal life is the Swiss Army knife of life insurance.
Universal Life vs. Term Life
It is important to consider what your needs are for life insurance. This is the first thing to look at with any life insurance purchase.
- Flexible Premiums
- Lifetime Protection
- Cash Value
- Investment Options
- Easy to Understand
- Easy to Buy
- Best Bang for Buck Cost
- Flexible Term Lengths
- Level Premium
I am not against Universal Life for every single case, I have experience with each and every one of these policies. There are some very real uses and benefits to each of the universal life options.
But for the vast majority of clients Term Life Insurance is the clear winner. Many people get into a universal life policy and after a few years they forget about all the bells and whistles and are left wondering what the heck they are paying so much money for.
Then they start the internal debate on if the should cancel now and forfeit the cash value (darn surrender charge) or stick with it. Some cancel and lose all the CV, some just let the policy eat itself. Very few double down and build the policy up.
We think it is more important to protect your family with the appropriate amount of coverage than to worry about having a lifetime policy. If you have a lifetime need it is probably not for the full amount. It is pretty common to layer or ladder types of policies to address those concerns.
Universal Life vs. Whole Life
The differences between universal life and whole life are not as obvious as they are with term life.
There is a lot of overlap with what the two can do for you.
Permanent coverage, both types cover you for a lifetime.
Cash Value, both types offer a cash value accumulation that is not available with term.
Inflation Protection, both offer the ability for the policy amount to grow. This can offset inflation.
What is the difference between whole life and Universal Life?
First, what is whole life insurance?
Whole life insurance is a permanent policy with the most guarantees of all the types of life insurance. It has a guaranteed level premium, level face amount, cash value. These things can add up to a powerful plan but comes with a cost to prove it. Many people either can’t or don’t want to spend the premium a whole life policy demands.
That is where universal life insurance can be a great alternative. UL offers a lifetime of coverage for a fraction of the cost of a whole life policy. It is able to do this by removing some of the guarantees.
Advantage Universal Life
- Flexible Premium
- Adjustable Face Amount
- Interest-Based Growth
- Variety of Interest Options
Advantage Whole Life
- Level Premium
- Guaranteed Cash Value Growth
- Ease of Budgeting for Premium
Universal life and whole life are so similar it is difficult to settle in on one being better than the other.
It really comes down to which one is better aligned with your personality type. Are you a hands-on person? Do you like to dig in and get your hands dirty and really understand every detail about things? Universal life is probably for you. If not whole life is a set it and forget it option. Set it up once and just make your payments.
Universal life really is the highest maintenance life insurance on the market. It requires an experienced life insurance broker to sift through all the options. Be prepared to spend hours digging in and learning how to use it effectively.
We have the experience and the patience to walk you through the process. Call us today with your questions.