How Variable Life Insurance Works: Pros and Cons

Variable life insurance, also called variable appreciable life insurance, provides lifelong coverage, as well as a cash value account that you get to decide how to invest.

Variable life insurance policies are permanent life insurance policies that have a higher potential of earning cash compared with traditional policies. That's because with variable life insurance, you get to decide how to invest the cash value. Plus, if you choose variable universal life insurance, you'll also get some flexibility in how much of a premium you'll need to pay. The drawbacks are that variable life insurance policies are complex and require more hands-on attention; they come with risk; and they typically have higher premiums than other cash value life insurance policies.

holding life insurance policy

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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
  • Premium
  • Cash value

A death benefit is what is left to your beneficiaries. Every time you make a premium payment, a portion of it goes toward the cost of insurance and the fees of the insurer who is keeping the death benefit in place. The remainder of the premium goes toward 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 subaccounts), 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If the cash value performs well, it can be used to increase the death benefit, withdrawn as cash or used as collateral for a loan.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 (surrender) your coverage to the insurer.

Cash Value of Variable Life Insurance

The way a variable life insurance policy's cash value policy works is unique from a whole or indexed universal life insurance policy. Each variable life policy comes with a prospectus detailing all of your investing options. 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 fund, such as the S&P 500
  • A portfolio of equities, such as an emerging markets fund
  • Bonds
  • A money market fund

With variable life insurance policies, the insurer may also offer a fixed interest investment option, which has less risk but also less potential reward.

Whatever option you choose, you will be charged 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).

Investments

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.

However, variable life insurance policies typically do not guarantee a rate of return. Because your cash value investment options are influenced by the performance of the market, your investment can decrease in value during bad years and appreciate during good years. Most insurance companies put a cap on the rate of return, so earning potential will be limited compared with a regular investment.

A key downside to variable life insurance

Every permanent life insurance policy comes with fees, but the downside to variable life insurance is that its fees tend to be the highest. Variable life insurance policies typically come with the following costs:

Fee
Description
Mortality and expense risk chargesThese are the costs to provide the actual death benefit if you don't live to the estimated age that was calculated for you
Sales and administrative feesThese cover an agent's commission, policy setup and maintenance costs and the insurer's ongoing expenses.
Investment management feesThese compensate fund managers and vary, depending on how you choose to invest the policy's cash value.
Surrender chargesPolicies have a surrender period, during which you will pay fees if you withdraw part of the cash value or decide to give up your coverage. 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.
Policy loan interestIf you use the cash value of the policy as collateral for a loan, 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, comparing its cost and your financial situation.

Other costs and risks

The administrative fees for a variable life insurance policy will be higher than for other life insurance policies, in part because these policies are investments regulated by the U.S. Securities and Exchange Commission (SEC). When you're determining how to invest the policy's cash value, you should take into consideration that the insurer will pass these charges on to you.

For example, 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. However, if you purchase whole life insurance, you'll pay 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: The 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 the 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 the two above are the most common.

No matter your death benefit structure, always check the policy's actual terms, and confirm whether the death benefit is guaranteed. If it is, make sure 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 the cash value, assuming it meets this rate of return, 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.

Although variable universal life insurance policies typically have minimum and maximum premiums, you're free to pay whatever amount you choose 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 usually only available once your cash value has reached a 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 the investment gains build up quicker. This is often 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 of your required cash value contributions at once. But you also have the option of contributing more to the policy's cash value.

How variable life insurance compares with other products

If you're considering variable life insurance, it's important to consider how the policy stacks up to similar financial products. A variable annuity is just a tax-deferred annuity in which you get to choose how the value of it 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 usually have a wide range of options across equities, bonds and money market instruments. There is a risk that the value of either investment could decrease.
  • It comes with a death benefit. With variable annuities you assign a beneficiary, who would receive a specified amount of money if you pass away. 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. You'll pay income taxes once you withdraw the money, but not sooner.
  • 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 variable life insurance policies, if you withdraw a greater amount of cash value than the total amount you've paid in premiums, you'll 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.

Variable annuity vs. variable life insurance

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

Variable annuities are also restricted in that you may have to pay a fee to make withdrawals before a certain amount of time. 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 offer both lower risk and reward.

Whole life insurance policies have:

  • Level premiums: You'll pay a consistent amount for each premium payment.
  • Level death benefit: The death benefit is guaranteed and won't fluctuate.
  • Guaranteed returns: Your cash value will grow consistently and is typically guaranteed to equal the policy's death benefit when the policy matures (usually when you turn 100).
  • Whole life policies have lower fees and are not regulated as securities.
  • A downside to whole life insurance policies: fixed growth potential.

The cash value of variable life insurance policies can grow at a much faster rate and even be used to pay premiums in certain cases. Whole life insurance policies don't offer the flexible premiums that variable universal life insurance policies do.

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 not likely to go away within 20 to 30 years, then purchasing term life insurance is likely 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'd be paying more to have a death benefit in place for the length of your life. Otherwise, you could simply purchase guaranteed universal life insurance and invest the difference in mutual funds or exchange-traded funds (ETF).

Alternative: Prioritize adding to your retirement fund

There are pros and cons to both options, but we would recommend maxing out contributions to retirement accounts prior to investing in variable life insurance.

With a 401(k) or individual retirement account (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 depends 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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