Most articles about life insurance discuss two basic policy types: term life and whole life. And, for a long time, those were the only options.
Beginning in the 1980s, though, a new form of permanent life insurance came on the scene—universal life (or “UL”). UL often gets left out of the conversation, probably because it’s more difficult to describe than its life insurance brethren.
But under the right circumstances, it can be a great option for people in the market for affordable permanent life insurance coverage with genuine growth potential.
What is Universal Life?
Universal life (“UL”) is a form of cash value life insurance. Every UL policy comes with a death benefit—which is the amount the insurance company pays out in the event of the insured’s death—and also gradually builds up cash value that can be accessed during life.
Similar to whole life insurance, UL policies are usually structured so that coverage remains in place until the insured reaches 100 years old or older. Effectively, that means that most UL policies provide coverage until either the insured dies or the policy is surrendered for its cash value.
One of the words most commonly used to describe universal life is “flexible.” This is in large part because policyholders have the option of paying higher or lower premium payments within a given range.
Higher premiums boost a policy’s cash value, which earns compound interest and can be tapped for a wide variety of purposes. The formula for determining precisely how cash-value growth is measured varies among the different types of UL policies.
In general, universal life is a more complex (and harder-to-summarize) financial product than term or whole life. There are more moving parts, and, in some cases, policyholders can play a much more active role in managing a policy.
The sophistication leads to one of UL’s greatest strengths—its capacity for customization—and one of its most frequent criticisms, its policy fees.
UL’s fees are generally higher than what you get with term or whole life. However, it’s a mistake to evaluate the fees in a vacuum.
Costs charged by an insurer are built into a policy’s premiums, so you’re better off comparing how premiums relate to overall policy performance.
How much do you have to pay? How much coverage are you getting? How much cash value growth will accrue over the life of the policy?
In this context, universal life often compares very favorably with term or whole life. But, of course, a lot depends on an individual policyholder’s situation and goals.
Universal Life Premiums
Like any other life insurance, UL policies require regular premium payments in exchange for the contractual benefits provided by a policy.
Precise premium requirements are determined based upon a variety of factors, including the insured’s age and heath status, the amount of coverage, and any supplemental riders selected by the policyholder.
Instead of defining a fixed premium amount that must be paid each month, quarter, or year (as with most whole life and term policies), UL policies set minimum and maximum premiums.
A policy’s minimum premium is derived from the COI (“cost of insurance”)—which is the underwriting cost for providing the death benefit and any applicable policy fees.
If a policyholder fails to make the required minimum payments, the policy lapses and coverage ceases. Maximum premiums are based on IRS rules defining what products qualify as “life insurance” and are therefore eligible for the tax advantages afforded to life insurance policies.
Each individual UL premium payment is split between COI and cash value. Thus, if a policyholder opts to pay only the minimum premium each month, cash value accrual will be negligible.
But if the policyholder chooses to consistently pay in substantially higher premiums, cash value will build up much faster.
Once a universal life policy has accumulated sufficient cash value, the policyholder has the option of applying cash value toward some or all future premiums.
A popular approach is to pay maximum premiums early to allow for optimum cash value growth. Then, as the insured ages and COI rises, some of the additional cash value can be used to offset the higher minimum premiums.
How Can UL Cash Value be Used?
Cash value is sometimes described as a savings account connected to a life insurance policy or as “equity” built up in a policy’s death benefit.
Whichever way you want to look at it, premium dollars paid above a UL policy’s COI add to cash value.
And funds contributed toward cash value don’t sit idle—the money continuously grows tax-deferred.
“Tax-deferred growth” means that—similar to a retirement account—no income tax is owed on interest earned by a universal life policy until the money is actually withdrawn.
Because interest is compound and there’s no reduction for annual taxes, universal life policies have considerable long-term growth potential, and a policy’s cash value becomes a real financial asset.
Access Cash Value
Although UL cash value isn’t as liquid as cash itself, it can be accessed without much difficulty.
One way is to surrender the policy for cash. Many policyholders purchase universal life thinking that, if anything happens during their working years, the death benefit will be available to provide for their loved ones.
On the other hand, if they reach retirement age without needing the death benefit, the policy’s cash surrender value will be available as an asset to help fund retirement.
Typically, UL policies don’t have surrender fees after the first few years, so the amount paid by the insurance company is more or less equal to its current cash value.
Amounts received from surrender of a UL policy are taxable to the extent the sum exceeds the total premiums paid to date.
However, the IRS will let you roll over cash value into a retirement annuity without any current tax liability through what’s commonly called a 1035 Exchange.
The downside of surrendering a universal life policy outright is that, after the surrender, you don’t have life insurance coverage in place anymore.
Withdrawals or Loans
If you want to retain the coverage, you can access cash value through partial withdrawals (which, of course, reduce the policy’s cash value). Or you can take out a policy loan.
A policy loan is a relatively low-interest loan from the insurance company that is secured by an existing policy’s cash value.
Though it’s called a loan, the policyholder doesn’t technically have to pay it back. Any outstanding loan amounts and interest are deducted from a policy’s death benefit when triggered.
The advantages of policy loans are that the loan funds are not taxed and that a policy loan often doesn’t decrease the growth potential of existing cash value (depending on the specific policy).
So, you have access to funds for emergencies, special occasions, or other investment opportunities, but you don’t necessarily have to miss out on the growth earned by the corresponding cash value.
The downside is that policy loans accrue interest and, as mentioned above, a UL policy’s death benefit is reduced by any unpaid loans.
Cash Value Growth
There are four basic types of universal life insurance: regular Universal Life (“UL”), Variable Universal Life (“VUL”), Indexed Universal Life (“IUL”), and Guaranteed Universal Life (“GUL”).
The first three types are intended for policyholders who view cash-value growth as a priority when choosing coverage.
Individual policies emphasize death benefit or cash value to greater or lesser degrees, but the policies are ultimately designed to provide both.
With GUL, a policy is all about the guaranteed death benefit, and cash value is an afterthought.
IUL vs VUL
The chief difference among UL, VUL, and IUL is the metric the insurance company uses to measure cash-value growth. The differing growth metrics affect the potential upside for growth and the level of risk assumed by the policyholder.
UL policies earn ordinary interest with a guaranteed minimum rate of return. If the insurance company’s portfolio performs well, it might pay out a higher rate, but returns will never be below the guaranteed minimum—usually somewhere in the neighborhood of 3% these days.
Variable universal life is called “variable” because growth is linked directly to the performance of investments chosen by the policyholder.
VUL has much more upside potential than ordinary UL but requires a careful balancing of risk and reward. Growth isn’t guaranteed, and cash value can even go down.
But under the right conditions, a VUL policy can be a great asset for building wealth to fund retirement, while still providing a death benefit just in case.
The way VUL works is that the life insurance company presents policyholders with multiple investment options with varying levels of risk.
The policyholder allocates cash value among the various options, which then work similarly to mutual funds.
If the chosen investments earn strong returns, interest on the policy will be substantially higher than what you can get with UL. But, if investments lose value, cash value can decrease, too.
Indexed universal life is called “indexed” because growth is linked to an equity index, such as the S&P 500.
Though a fairly new product in the realm of life insurance, IUL has become popular by allowing policyholders to enjoy the fruits of high-performing equity markets, but with less downside risk.
With many IUL policies, policyholders can allocate cash value among multiple accounts linked to several different indexes.
If a chosen index increases, the policy grows proportionally. If the index goes down, though, IUL policies are typically guaranteed not to lose money—or are guaranteed to pay a minimum return even if the market drops.
Many indexed universal life insurance companies also offer a “fixed” account that earns interest at a guaranteed rate and is useful for policyholders who want to ensure at least some cash-value growth if markets decline.
Caps & Participation Rates
The price for the mitigated risk of loss IUL policies provide comes in the form of growth caps, participation rates, or both.
A growth cap is the maximum return an IUL policy can earn. For example, if a policy has a 10% growth cap, and the S&P increases by 13% over the relevant period, interest is only credited at 10%.
A participation rate is the percentage of the relevant index’s growth that is actually credited toward a policy’s interest rate. If, for instance, an IUL policy has an 80% participation rate, and the S&P increases by 10%, interest is credited at 8%.
With both participation rates and growth caps, the additional index appreciation that is not credited to the policy effectively acts as the insurer’s fee for shouldering any losses if the market drops.
Guaranteed Universal Life differs from its UL cousins in that cash value is barely a consideration.
GUL is designed to provide affordable coverage for people who need to have life insurance that never expires (or doesn’t expire until the insured reaches 121 years old).
Because cash value growth is negligible, the insurer can provide the death benefit for a much lower premium than whole life or other universal life policies. It’s almost like term, but without a term to eventually come to an end.
Most GUL policies have a guarantee period during which coverage is guaranteed not to lapse as long as minimum premiums are paid.
By accepting a shorter period (through age 90 rather than 100, for example), a policyholder can lower the premiums that are necessary early on.
However, if the insured is still living when the guaranty period concludes, premiums are likely to increase significantly.
Some GUL policies also allow policyholders to voluntarily decrease the coverage amount in the future if they no longer need as much coverage or cannot afford as much premium.
GUL can be very helpful in estate planning—ensuring a reliable source of estate liquidity to pay taxes and administration fees, final expenses, or to protect other assets from creditor claims or the need for sale by the executor.
GUL can also be a good fit for insureds with disabled dependents who need a means of support regardless of how long they live.