How Variable Life Insurance Works: Pros and Cons of a Variable Policy

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Variable life insurance, also called variable appreciable life insurance, provides lifelong coverage as well as a cash value account. Variable life insurance policies have higher upside potential than other permanent life insurance policies as you can choose how the cash value is invested from a variety of options. However, we urge you to be careful as variable life insurance policies often come with higher fees than other cash value life insurance policies.

What is Variable Life Insurance?

Variable life insurance is a type of permanent life insurance policy, meaning coverage will remain in place for your lifetime so long as premiums are paid. Every variable life insurance policy has three primary components:

  • Death benefit
  • Cash value
  • Premium

Every time you make a premium payment, a portion of it goes towards the cost of insurance and insurer’s fees. This is the money that essentially pays to keep the death benefit in place. The remainder of the premium goes towards the policy’s cash value, which is similar in structure to a brokerage account. The cash value can be invested in certain securities (often called sub-accounts) which resemble mutual funds.

If the cash value performs well, it can be used to increase the death benefit, withdrawn as cash or used as collateral for a loan. The cash value is also the amount of money you would receive if you decided to give up your coverage to the insurer, or surrender it.

Cash Value of Variable Life Insurance

How a variable life insurance policy’s cash value works is what makes it particularly unique from a whole or indexed universal life insurance policy. Each policy comes with a prospectus detailing around 20 to 30 options for investing the cash value. The cash value investment options are similar to mutual funds in that there’s a particular set of securities that the money would be invested in, such as:

  • An index, such as the S&P 500
  • A portfolio of equities, such as an emerging markets fund
  • Bonds
  • A money market fund

In addition to these investment options, variable life insurance policies generally have a fixed interest investment option provided by the insurer. For each investment option, there are management fees, similar to expense ratios for mutual funds. These fees vary according to the securities being invested in and can be quite high if the money is being actively invested (meaning a portfolio manager is picking stocks).

Cash value investment management fees are sometimes listed as “basis points”, and one basis point equals 0.01%. So if an investment option is listed as having a 6% historical rate of return but comes with 125 basis points in management fees, you should keep in mind that returns will be reduced by 1.25%.

Since you’re able to choose from a variety of investment options, variable life insurance policies have higher upside potential than other cash value policies, such as whole life insurance. In addition, the growth of your policy’s cash value is tax-deferred, so you generally won’t pay taxes on gains so long as they remain in the account (which causes the cash value to grow faster).

However, variable life insurance policies may not have a guaranteed rate of return, or it may be quite low. In addition, your cash value investment options typically have a cap on the maximum rate of return. So, your cash value can actually decrease in value during bad years and may not perform as well as it could during good years.

Fees: A Key Downside to Variable Life Insurance

Every permanent life insurance policy comes with fees but the downside to variable life insurance is that it tends to have the highest. Variable life insurance policies will typically have the following costs:

FeeDescription
Mortality and expense risk chargesThese are the costs to provide the actual death benefit.
Sales and administrative feesCosts to cover an agent’s commission, set up and maintain the policy, and the insurer’s ongoing expenses.
Investment management feesThese vary depending on how you choose to invest the policy’s cash value.
Surrender chargesPolicies have a surrender period during which, if you withdraw part of the cash value or decide to give up your coverage, you will pay fees. The cash value of your policy typically isn’t equal to its actual surrender value for the first 10 to 15 years of coverage.
Withdrawal feesEach time you withdraw money from the policy’s cash value you can be charged a fee. This is often relatively small, around $25.
Policy loan interestIf you take out a policy loan using the cash value as collateral, the insurer will charge interest on the loan.
RidersRiders are add-ons that can be used to alter the terms of the policy. Each needs to be evaluated as compared to its cost and your financial situation.

In particular, the administrative fees for a variable life insurance policy will be higher in part because these policies are SEC regulated investments. As the insurer passes these additional charges on to you, it should actually be consideration when you determine how to invest the policy’s cash value.

If you choose relatively conservative investments, you’re likely to have gains that are more similar to a whole life insurance policy’s cash value, but whole life insurance policies will have lower fees. Therefore, with the same cash value rate of return, you would actually perform worse with a variable life insurance policy.

Variable Life Insurance Death Benefit

The death benefit of a variable life insurance policy is typically structured in one of two ways:

  • Level death benefit - Death benefit is equal to the face value of the policy when you purchased it.
  • Face amount plus cash value - This type of policy will cost more but your beneficiaries will receive your cash value in addition to the policy’s face value.

Some variable life insurance policies provide other death benefit structures, such as equaling the policy’s face value plus all premiums paid, but these two are the most common.

No matter your death benefit structure, you’ll always want to check the policy’s actual terms. You should confirm whether the death benefit is guaranteed and, if so, if the guaranteed value is the same as what is projected. The death benefit is essentially a “target” using an assumption of cash value performance, such as a 4% annual rate of return. The insurer projects that, assuming it meets this rate of return, the cash value would equal the policy’s face value when you pass away. However, if your cash value significantly underperforms, it may reduce your actual death benefit, depending on your policy’s terms.

Flexible Premiums with Variable Universal Life Insurance

Variable universal life insurance policies have the cash value structure of variable life insurance, but you can use the cash value to pay premiums. You can also pay a larger amount in premiums if you choose to do so. Therefore, these policies are sometimes referred to as flexible premium variable life insurance.

While variable universal life insurance policies typically have minimum and maximum premiums, you’re free to pay whatever amount you choose that falls within these limits. This means you can:

  • Pay a portion of premiums - If your premium is $500 per month, you can choose to pay $250 out-of-pocket and use your cash value to pay the rest. This option is typically only available once your cash value has reached a certain minimum size.
  • Not pay premiums - If your cash value is large enough, you can use it to pay the entire premium amount.
  • Pay more than your target premium - You can overfund your policy’s cash value early on so that investment gains build up more quickly. This option is typically favored if you have a sizable income and want the option of not paying premiums later on, such as in retirement.

There are also single premium variable universal life insurance policies which allow you to purchase coverage and fund the policy’s cash value with a single payment. You essentially purchase coverage and make all your required cash value contributions at once. But you also have the option of contributing more to the policy’s cash value if you choose to do so.

How Variable Life Insurance Compares to Other Products

If you’re considering variable life insurance, it’s important to consider how this policy stacks up to similar financial products.

Variable Annuity vs Variable Life Insurance Policy

A variable annuity is just a tax-deferred annuity in which you get to choose how the value of the annuity is invested. It’s somewhat similar to a variable life insurance policy in that:

  • You can choose how the product’s value is invested. Both products typically have a wide range of options across equities, bonds and money market instruments. If you choose poorly, the value of your investment can decrease.
  • It comes with a death benefit. With variable annuities you assign a beneficiary and, if you pass away, your beneficiary would receive a specified amount of money. This is typically the remaining value of the annuity or the sum of your premiums minus any withdrawals. This is a bit different from a variable life insurance policy which has a lifelong death benefit. Investment gains are tax-deferred.
  • Withdrawals above your basis are subject to income tax. For variable annuities, this means you’ll be taxed on the growth of your investments. * For a variable life insurance policies, if you withdraw a greater amount of cash value than the total amount you’ve paid in premiums, you pay taxes on the difference. This also applies if you surrender the policy.
  • You would have to pay surrender charges to make a withdrawal during the first several years.
  • You can choose to pay in a lump sum or in smaller payments over time.

The primary difference between a variable annuity and variable life insurance is that with a variable annuity you receive your investment back in a series of payments from the insurer. With a variable life insurance policy, you can make a series of withdrawals from the policy’s cash value, make a single large withdrawal or simply use the cash value as collateral in a policy loan.

Variable annuities are also restricted in that you may have to pay a fee in order to make withdrawals before a certain age. Withdrawals from variable life insurance policies are only restricted by the amount of cash value available.

Variable Life Insurance vs Whole Life Insurance

Both variable and whole life insurance offer lifelong coverage, but whole life insurance policies are “lower risk, lower potential reward”. Whole life insurance policies have:

  • Level premiums - You pay a consistent amount in each premium payment.
  • Level death benefit - The death benefit is guaranteed and won’t fluctuate.
  • Guaranteed returns - Your cash value grows consistently and is typically guaranteed to equal the policy’s death benefit when the policy matures (usually when you turn 100).

In addition, whole life insurance policies have lower fees are they’re not regulated as securities. The downside is that whole life insurance policies have fixed upside potential. The cash value of variable life insurance policies can grow at a much faster rate and in certain cases can be used to pay premiums. Whole life insurance policies don’t offer the flexible premiums of variable universal life insurance policies.

Variable Life Insurance vs Mutual Funds and Term Life Insurance

“Buy term and invest the difference” is a phrase often used to discourage people from buying cash value life insurance policies, such as variable life insurance. If your financial obligations are likely to go away within 20 to 30 years, then purchasing term life insurance is likely to be a better option as it’s significantly less expensive than variable life insurance.

For example, if you are purchasing life insurance to make sure your family could stay in your home if you pass away and you have a 15 year mortgage, you would do better with term life insurance. Similarly, if you could save enough money over the next couple of decades to handle any future financial obligations, you should do so and just buy term coverage as a backup. With variable life insurance, you’re paying more to have a death benefit in place for the length of your life.

Now, there’s a separate question of whether you would want to buy cheaper permanent life insurance, such as guaranteed universal life insurance, and invest the difference in mutual funds or ETFs. There are pros and cons to both options but we would typically recommend maxing out contributions to retirement accounts prior to investing in variable life insurance. With a 401(k) or IRA, your money will grow tax-deferred and you’ll have a wider variety of investment options with lower fees. The only downside is that it will be harder to access your money for a period of time, but even variable life insurance policies have surrender and withdrawal fees.

Assuming your retirement accounts are fully funded, then whether to put your money in a brokerage account or variable life insurance policy is dependent on how you believe the investment options of the variable policy will perform. Tax-deferred growth can counteract moderate management fees if your cash value performs well enough, but you need to evaluate expected performance for yourself.

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