Universal life insurance is a versatile financial product that offers both benefits and drawbacks to policyholders. As a form of permanent life insurance, it provides coverage for the entirety of an individual’s life, with a portion of the premiums going towards a cash value account. This cash value accumulates over time and can be used for various purposes, such as supplementing retirement income or covering unexpected expenses.
Along with its flexibility and potential for cash value growth, universal life insurance also comes with complexities and potential risks. Here in this article, we’ll attempt to delve into both the advantages and disadvantages of universal life insurance to grasp its full impact on one’s financial planning.
By doing so, we hope to help individuals can weigh the benefits against the drawbacks and determine whether universal life insurance aligns with their specific needs, goals, and risk tolerance.
What is Universal Life?
Universal life (“UL”) is a cash-value life insurance form. Every UL policy comes with a death benefit—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.
Like whole life insurance, UL policies are usually structured to maintain coverage until the insured reaches 100 years old or older. Effectively, most UL policies provide coverage until 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 various purposes. The formula for determining precisely how cash-value growth is measured varies among the different types of UL policies.
Generally, universal life is a more complex (and more challenging 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. This sophistication leads to one of UL’s greatest strengths—its capacity for customization—and one of its most frequent criticisms, its policy fees.
You see, UL’s fees are generally higher than 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 on various factors, including the insured’s age and health 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 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 pays only the minimum monthly premium, cash value accrual will be negligible. However, if the policyholder consistently pays substantially higher premiums, the cash value will build up much faster.
Once a universal life policy has accumulated sufficient cash value, the policyholder can apply 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 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 the cash value. And funds contributed toward cash value don’t sit idle—the money continuously grows tax-deferred.
“Tax-deferred growth” means that—like a retirement account—no income tax is owed on interest earned by a universal life policy until the money is 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, it can be easily accessed.
One way is to surrender the policy for cash. Many policyholders purchase universal life, thinking that the death benefit will be available to provide for their loved ones if anything happens during their working years. 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 surrendering a UL policy are taxable to the extent that 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 reduces 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 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. Still, 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 prioritize cash-value growth 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 about the guaranteed death benefit, and cash value is an afterthought.
IUL vs. VUL
The chief difference between UL, VUL, and IUL is the insurance company’s metric 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. Suppose the insurance company’s portfolio performs well. In that case, it might pay a higher rate, but returns will never be below the guaranteed minimum—usually in the neighborhood of 3%.
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 carefully balancing 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 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 work similarly to mutual funds. If the chosen investments earn substantial 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 relatively 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 helpful 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 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 participation rates and growth caps, the additional index appreciation 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 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 a 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.
A policyholder can lower the necessary premiums early on by accepting a shorter period (through age 90 rather than 100, for example). However, premiums are likely to increase significantly if the insured is still living when the guaranty period concludes. Some GUL policies also allow policyholders to voluntarily decrease coverage 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.