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Universal life insurance offers lifelong coverage, provides flexibility when it comes to paying premiums and choices for how the policy’s cash value is invested. A standard universal life insurance policy’s cash value grows according to the performance of the insurer’s portfolio and can be used to pay premiums.
Variations such as variable and indexed universal life insurance give you options for how to invest the policy’s cash value. Universal life insurance is often compared to whole life insurance, a policy that also offers lifelong coverage, but is less expensive and offers more policy options.
How Does Universal Life Insurance Work?
Universal life insurance is a form of permanent insurance, meaning coverage can last for your lifetime so long as premiums are paid. This is in contrast to term life insurance which only provides coverage for a set period of time, such as 10 or 20 years. Universal life insurance can be purchased by individuals but is also regularly offered by employers as group universal life insurance.
Cash Value & Premium Payments
Universal life insurance has a cash value component that is separate from the death benefit. Each time you make a premium payment, a portion is put towards the cost of insurance (such as administrative fees and covering the death benefit) and the rest becomes part of the cash value. The cash value is guaranteed to grow according to a minimum annual interest rate, but may grow faster depending on the insurer’s market performance.
A universal life insurance policy’s cash value can be used as:
- Surrender Value - If you decide that you no longer want the policy, you can give it back to the insurer (“surrender” it), and the insurer would give you the cash value in return.
- Loan Collateral - You can borrow money from the insurer and use the cash value as collateral, so that’s the maximum amount you can borrow. These policy loans are subject to interest rates which are set by the insurer.
- Premium Payments - You can use the cash value to pay a portion or the entirety of a premium payment. Just keep in mind that policies will lapse if the cash value drops to zero, so you have to keep close track of the amount.
Since a universal life insurance policy’s premiums are split between the cost of coverage and the cash value, you can choose how much you pay so long as it falls between the minimum and maximum premium amounts. Many people choose to pay the maximum premium possible for the first several years of coverage in order to build a large cash value, then use the cash value to pay premiums later on. This can be a good strategy if you want to maintain permanent coverage even when you have a smaller income during retirement. The downside is that if your cash value runs out, you can get stuck paying the full cost of insurance and there’s no surrender value to the policy. Your policy can also lapse if the cash value reaches zero.
Running out of cash value can be particularly bad if your cost of insurance is increased. The cost of insurance can be level for the life of the policy, but this isn’t typical. Usually, there’s a minimum and maximum cost of insurance so, as you get older, your minimum premium will increase significantly. If this happens when your cash value is depleted and you’re living on a fixed income, you may be stuck and your policy will lapse, meaning you lose your coverage. This is why it’s incredibly important to keep close track of your policy’s cash value if you use it to pay premiums.
When shopping for coverage, make sure to note the difference between the guaranteed performance of a policy and the projected performance. The guaranteed performance indicates the worst-case scenario of minimum returns and maximum fees that can be charged by the insurer.
Universal life insurance policies have a maturity date which occurs when you turn a certain age (often between 85 to 121). When a policy reaches its maturity date, you generally receive a payment and coverage ends. Depending on the policy, the payment might be the death benefit or a specified dollar amount, but it’s usually equal to the policy’s cash value.
This can be a problem if you live past the maturity date and have used most of the cash value to pay premiums, as you can end up with no coverage and little money returned to you. Therefore, you should choose a policy with a maturity date that you’re comfortable with given your intended use of the coverage. For example, if you want to prevent your family from having to pay inheritance taxes when you pass away, no matter when that is, you’ll want a very high age for the maturity date.
Pros and Cons of Universal Life Insurance vs Whole Life Insurance
Whole life and universal life insurance policies are similar as they’re both forms of permanent coverage. The primary differences are that the cash value for whole life insurance policies grows at a guaranteed interest rate and premiums are level for the life of the policy. This can be both an advantage as well as a disadvantage when compared to universal life insurance.
|Key Differences||Universal Life Insurance||Whole Life Insurance|
|Cash Value Interest Rate||Minimum is guaranteed, can perform better depending on market||Guaranteed flat interest rate|
|Premiums||Range of options, minimum can increase over time||Level for life of policy|
Therefore, universal life insurance policies have greater upside potential when the insurer’s portfolio does well, as the cash value can grow at a higher rate. But when the insurer performs poorly, the cash value interest rate for a universal policy would be lower than that of a whole life insurance policy. Similarly, when the insurer performs poorly, usually during periods of low interest rates in the market, or as you get older, the insurer is more likely to increase the cost of coverage. Since whole life insurance premiums are level, you know how much you’ll have to pay at any point to keep coverage in place.
Since the insurer guarantees a lower interest rate and offers a range of premiums, universal life insurance policies are typically less expensive than whole life insurance policies. This makes them a good consideration if you want permanent coverage with lower premiums. However, if you only need coverage for a particular period of time, we would recommend term life insurance as permanent policies will have much higher quotes.
Review of How Indexed Universal Life Insurance Works
Indexed universal life insurance has many of the same characteristics of a standard universal life insurance policy, except that the cash value’s growth is tied to the performance of an index. Each insurer has its own selection of indices available and, depending on the policy, you may be able to choose more than one. Some of the indices most commonly offered are the S&P 500, NASDAQ 100 and Russell 2000. Performance is usually measured excluding dividends.
With indexed universal life insurance, you can often invest the cash value in a fixed interest rate account and an account tied to the performance of an index. You tell the insurer the percentage of the cash value that should go into each investment, and the insurer will keep track of the performance. The fixed interest rate investment is lower risk and carries a higher guaranteed minimum return. The index-tracking investment has higher potential returns but a lower guaranteed interest rate.
When a policy’s cash value growth is tied to the performance of an index, there are a few restrictions you should be aware of:
- Minimum Guaranteed Annual Interest Rate - This might be 0% or higher, depending on the insurer.
- Maximum Annual Interest Rate - The rate of return is tied to the performance of the index, but you’re not actually invested in the index. Therefore, the insurer caps the maximum interest rate they will pay at around 10-12%.
- Participation Rate - This is the percent of money credited with having been invested in the index. So, if you have $10,000 of cash value tracking the S&P 500 and the index had a 10% annual return, you would assume that the cash value increased by $1,000. However, that assumes a 100% participation rate. If the insurer’s participation rate was 50%, your cash value would increase by $500, or just a 5% return ($10,000 x 50% x 10% = $500).
Pros and Cons of Indexed Universal Life Insurance
Indexed universal life insurance offers greater control over the performance of your policy’s cash value growth, since you’re not relying on a figure determined by the insurer and their performance. However, the guaranteed minimum interest rate is typically lower than that of a traditional universal life insurance policy and the insurer can cap your participation rate. In addition, you face the same risks of a standard universal life insurance policy in that your cost of coverage can be increased.
With an indexed universal life insurance policy, you also want to how the insurer calculates your base cash value. Since you’re not actually invested in the index, the insurer determines your return for a given period of time by multiplying your base cash value by the index’s performance. If, for example, you deduct from your cash value each month in order to pay a portion of premiums, you want the base cash value to be measured pre-deduction. This way, a larger amount of money is multiplied by index’s rate of return, and your cash value grows faster.
Say you had a $1,000 cash value and $100 was deducted mid-month for premiums. If the index’s return for that period of time was 10%, you could receive a $100 return based upon a $1,000 base cash value (pre-deduction) or a $90 return based upon a $900 base cash value (post-deduction).
Variable Universal Life Insurance
Variable universal life insurance very similar to an indexed universal life insurance policy. The primary difference is that you invest the cash value in grouped investments that are similar to mutual funds. You’ll receive a list of potential investments, along with their performance history and fees, and can choose how much of the cash value is invested in each.
Pros and Cons of Variable Universal Life Insurance
Each variable universal life insurance investment has management fees which need to be considered, similar to when you’re evaluating a mutual fund. The management fees and administrative fees for variable universal life insurance policies are typically higher than those for other universal life insurance policies. So, even if you choose great investments, the fees can significantly eat into your returns.
Guaranteed Universal Life Insurance
Guaranteed universal life insurance is a universal life insurance policy that won’t lapse if the cash value is zero. Given this, it can essentially behave as a term life insurance policy with the term ending at whatever age the policy matures, whether that’s when you turn 90, 100 or 121.
Since there’s either no cash value component, or the cash value is very little, guaranteed universal life insurance is the best way to get the lowest quotes for permanent coverage. The cost of coverage is significantly lower than that of standard universal life insurance and premiums are usually level for the length of the policy.