Universal Life Insurance: Pros vs. Cons to Consider
The two most basic types of life insurance policies are term and whole life.
Term has become more popular in recent years, largely in response to the often-repeated saying, "buy term and invest the difference."
That’s a reference to the fact that the investment returns on the cash value of whole life insurance policies are notoriously low, and that the average person can purchase a low-cost term policy, and invest the money they save more successfully on their own.
The life insurance industry has responded by rolling out more sophisticated cash value life insurance policies --one of which is universal life insurance.
Though it works very much like whole life insurance, it provides a wider range of investment options, and even gives you a choice over which ones to include in your policy.
There are variations of universal life insurance, like variable life insurance, but universal is the basic foundation for them all.
What is Universal Life Insurance?
Much like whole life insurance, universal life insurance is a form of permanent life insurance.
The policy will generally remain in force throughout your life and can only be canceled for nonpayment of premiums.
But once the policy is in force, it will remain so even if your health condition changes after the fact.
But where universal life departs from whole life is with investment options.
With a whole life policy, your cash value will generally accumulate in a single account that will pay you a specified rate of interest.
If it’s a mutual life insurance company, your cash value will earn dividends as they’re declared and paid by the company.
Universal life insurance works similar to a term policy in that a small portion of your premium will be dedicated toward the payment of the life insurance coverage.
Generally speaking, the larger portion of your premium will go into your investment provision.
Be aware that under a universal life insurance policy, your beneficiaries will receive only the death benefit included in your policy. They will not be entitled to the death benefit plus the accumulated investment funds in your plan.
How Universal Life Insurance Works
One of the outstanding features of premiums under universal life is that you can adjust:
- how much of your premium will be allocated toward the life insurance portion, and
- how much will go into the investment provision.
Both premiums and investment options under a universal life insurance policy are more flexible than they are for whole life insurance.
You can choose how much of the premium you want to go toward life insurance, based on the death benefit you select, with the balance going toward your investment account.
But much like a term life insurance policy, the portion of your premium that will be allocated toward your insurance coverage will increase as you age. That will mean less of your premium will be going into cash value accumulation going forward.
The cash value will be assigned a minimum annual interest rate but can earn a higher return if the market returns on the underlying insurance investments is higher than the minimum.
During the application phase, you’ll be presented with two sets of numbers.
- One will show you the performance of the policy based on guaranteed interest rates only.
- The other will be based on projected performance.
For planning purposes, you should pay close attention to the guaranteed interest rate performance, since it’s the worst-case scenario.
It’s possible to pay the maximum premium amount during the first years the policy is in force to build up the cash value more quickly.
This is the exact opposite of whole life, where only a small portion of your premium goes into the cash value during the first few years. With whole life, you’ll have a relatively small cash value even after five years of making premium payments.
The idea of making larger premium payments opens the possibility of accumulating enough cash in the policy to pay the premiums going forward. If you’re able to achieve that goal, you’ll have a paid-up policy for life.
It becomes life insurance with no annual premium payments.
Drawing Your Cash Value Down to Zero & the Consequences
If the life insurance cost of your policy drains the cash value in the plan down to zero, your policy will lapse unless you are able to make premiums from outside financial resources.
The truth is:
This scenario is a real possibility because the portion of your premium payments that’s allocated toward life insurance will increase as you age.
With more of the premiums going toward life insurance, and possibly also reducing your cash value, that cash value can go all the way down to zero.
Borrowing against cash value
Much like a whole life insurance policy, you can take a loan against the cash value in the plan.
If so, you’ll make repayments out of your cash value – including interest payments – which will further reduce your cash value.
You must be aware that if your policy lapses and you’ve drawn more out of your plan, either through loans or withdrawals, you may owe income tax on the excess amounts taken.
This is a provision that may or may not be relevant due to age limits, but universal life policies do have a maturity date.
This usually occurs between the ages of 85 and 121, which is why it may not be relevant to most policyholders.
When the policy matures, you’ll receive either:
- the death benefit, or
- a specific dollar amount roughly equal to the cash value, which it will be will be specified in your policy.
But if your cash value has been drained to a very low level, you’ll receive only a small payment, after which you’ll have no life insurance coverage.
If you select the death benefit, and the cash value is higher, you’ll give up the excess cash.
If you have the option, generally, you should choose the highest maturity date possible to avoid either outcome.
Who is Universal Life Insurance Best For?
Universal life insurance is best for anyone who wants to combine an investment provision with life insurance.
This is usually a strategy when you can’t seem to adopt the savings and investment habit.
But universal life insurance is not recommended if you are relying on the policy to be your primary asset.
The plans contain too many variables, including and especially the possibility that your plan value can go all the way to zero.
If it does, not only will you lose your cash value, but also your life insurance coverage.
Typical Premium Costs for Universal Life Insurance
Premiums paid on a universal life insurance policy can be set up as either payments made over the life of the policy, or even a single, lump sum premium payment.
How the premium is arranged will be up to you.
Much as is the case with all other types of life insurance, how much you will pay for the premium will be based on your age at the time of application, the amount of the death benefit, and any health conditions or other life-threatening risks your profile presents.
But in a unique departure from whole life insurance premiums, the portion of your premium that goes to cover your life insurance benefit will increase as you get older.
A larger percentage of your premium will go toward your death benefit, lowering the amount going into your investment account.
Universal life insurance premiums are extremely difficult to generalize because of the many variables involved.
That includes the amount of life insurance you want, as well as the personal risk factors that will affect the premium. But it will also be determined by how much premium you want to pay the build-up the cash value.
The Securities and Exchange Commission (SEC) website does present a general rate table, but it’s only an example.
Exactly how much your premium will be will depend on all the factors we’ve discussed.
Here are some sample examples based on a policy with a $1 million death benefit:
- 35-year-old, $908 per month
- 40-year-old, $1,217 per month
- 50-year-old, $2,770 per month
As you can see, the premiums on universal life insurance policies are much higher than they are on term life.
But that’s because they do include the cash value provision which builds as you make your premium payments.
- Greater investment options than you can get with a whole life insurance policy.
- Returns on a universal life insurance policy can be higher than on whole life policies.
- You can borrow against your policy without creating tax consequences.
- Like whole life insurance, universal life insurance gives you the dual benefit of an investment provision and a death benefit.
- You can receive the investment portion of your policy if you surrender the policy prior to your death.
- Upon your death, your beneficiaries will receive only the stated death benefit of the policy. Any funds in your investment account will revert to the insurance company.
- Withdrawals of excess cash value from your policy may be taxable under certain circumstances.
- Unpaid loans at the time of death will be taken from the death benefit, lowering the amount of proceeds your beneficiaries will receive.
- The portion of your premium that goes toward your life insurance coverage will increase as you age. Depending on how quickly that happens, it has the potential to fully drain your cash value down to zero.
- Your policy will automatically lapse if the cash value in the plan falls to zero.
Universal life insurance is a complicated policy type.
It may be better to discuss the prospect of taking such a policy with a financial planner, CPA or attorney, rather than relying strictly on the representations of an insurance agent.
The policies are highly specialized and are not recommended for the average consumer.
Unless you have a thorough understanding of how universal life insurance policies work, and what the potential consequences are, they’re best avoided in favor of a much simpler term life insurance policy.