What Is Variable Universal Life Insurance? Part 2

Physician's Money Digest, August 2007, Volume 14, Issue 8

The following is Part 2 of a two-part series exploring the ins and outs of variable universal life insurance focusing on its guidelines, structure, and potential advantages and/or disadvantages for physician-investors. To read Part 1 in this series, visit PMDLive.com.

The number and type of choices available to a physician-investor utilizing a variable universal life (VUL) insurance policy is dependent on the insurer, but some policies are available with a wide variety of separate accounts, also known as subaccounts. Some insurers offer more than 50 separate accounts with investment styles including very conservative fixed accounts, bond funds, equity funds, highly aggressive sector funds, international funds, and emerging market funds.

Separate accounts are organized as trusts to be managed for the benefit of the insured, and are named because they are kept separate from the general account, which are the other reserve assets of the insurer. They are very much like mutual funds, but have slightly different regulatory requirements.

Major Tax Advantages

Taxes are the main reason those in higher tax brackets (25%+) use VULs over any other accumulation strategy. For someone in the 35% tax bracket, the investment return on the subaccounts may average 10%, and at age 75 the policy's death benefit would have an internal rate of return of 8.5%. To get an 8.5% rate of return in an ordinary taxable account in the 35% tax bracket, one must earn 13.1%. In a Roth IRA, however, one would get the 10% tax-free. But the limits on the Roth are low, and the Roth is unavailable to those in the 35% tax bracket. The break-even point may be for someone in the 15% tax bracket, where if they maxed out their Roth contribution, then in a taxable account earning 10% after tax they would have 8.5%, equal to the internal rate of return on the VUL. 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. If an individual is unable to max fund the VUL, it may be better to use term insurance until able to convert to VUL.

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.

Risks of VUL

The following are points to consider before choosing a VUL:

  • Cost of insurance. The cost of insurance for VULs is generally more expensive than other types of life insurance policies, mostly due to the permanent nature of the product.
  • 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 subaccounts 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. Proper funding, investing, and planning are usually required for the VUL to work as expected.
  • Fee impact over time. According to the Journal of Risk and Insurance (December; 1987), the management fees, or "loading and expense charges, can make it inferior to an open-market insurance and investment strategy." These account management fees, applied to the total investment account value, reduce the total net return on the portfolio and can be very large compared with the identical investments held outside the VUL, often by several percent per year. These fees must be stated in every policy, although sometimes cryptically. VUL policies must be held until death to obtain the investment growth as part of the tax-free death benefit, so the fee exposure is typically measured in decades. Since an additional 2% annual fee over 36 years cuts the final portfolio value in half, or a 3% extra fee over 48 years yields only one quarter of the final total portfolio value, it can be beneficial to choose to hold the exact same investment outside the VUL policy. Since the sales commission for VUL is often in excess of 70% of the first year, VUL sales agents are often unlikely to discuss these options with you.

The following are some general uses of VUL:

  • Financial protection. VULs can be used to protect a family in the case of a premature death 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 and appropriately funded, the tax advantages may even offset the cost of insurance.
  • Retirement planning. Because of its tax-free policy loan feature, the VUL can be used as a tax-free income source in retirement, assuming retirement is not in the near future. 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.

A Word of Caution

Seek out those individuals whose compensation is fee-driven as opposed to commission-driven. Most of the time when contract owners purchase these policies they fail to notice that the cash accumulation for the first several years of the contract period is, in many cases, far less than the deposits going into the policy. In fact, I have seen illustrations where the cash accumulation is zero in the first few years of the policy because the agent selling you the policy receives their compensation approximating nearly 100% of the "target first-year premium." Please do your homework before making a long-term commitment to funding such a vehicle.

ERRATUM

In the June 2007 issue of Physician's Money Digest there was a misprint in Thomas R. Kosky’s article, "Required Minimum Distribution for Your IRA" found on page 16. In the final paragraph the first sentence should have read: "So, using the charts, Dr. Turner would divide her ending balance of $1,875,530 on December 31, 2006, by 27.4 (years)—the life expectancy factor in the Uniform Lifetime table for age 70." The "%" originally printed after 27.4 was a misprint. A corrected version can be found on www.PMDLive.com. Thomas R. Kosky and his partner, Harris L. Kerker, are principals of the Asset Planning, Group, Inc, in Miami, Florida. The company specializes in investment, retirement, and estate planning. Mr. Kosky also teaches corporate finance in the Saturday Executive and Health Care Executive MBA Programs at the University of Miami in Coral Gables, Florida. Mr. Kosky and Mr. Kerker welcome questions or comments at 800-953-5508, or e-mail Mr. Kosky directly at ProfessorKosky@aol.com.