How Variable Life Insurance Works – Pros and Cons

     As if life insurance was not hard enough to understand, variable life insurance can get really complex. Most folks understand term life insurance, where you pay so much premium, and get so much death benefit, for the life of the policy. These premium payments go directly to covering the cost of the insurance, just like for auto or homeowners. Term insurance is so named because it only lasts for a certain term, like for ten, twenty, or thirty years. In order to keep premiums reasonable, the term generally expires well before life expectancy, since the cost of providing a death benefit for a given face amount when a person is at or past the expected life span is understandably very high. To use an extreme example, if a 90-year old wanted to buy $100,000 of insurance, the premium could be over $100,000 each year, since the odds of death are very high and the life insurance company would have to cover costs and profit on top of paying out $100,000 pretty darn soon. In this example, the cost of insuring is very high. Permanent life insurance, by contrast, is much more complicated. The permanent means it is designed to be in force for someone’s whole life. The most familiar of these are the old whole life policies, which are designed to stay in force until age 100. Other types, like universal life, adjustable premium life, variable universal life insurance, and more, have different late-life ages. Older ones go to 95, and some newer ones go beyond age 100. These late life ages are often called the endowment age, which means if you make it that far the insurance company essentially will assume you are dead, and pay the death benefit directly to you. With people living longer, this can sound like a nice feature, but the tax consequence can be horrible enough to kill you! With permanent life insurance, you would pay premiums as long as you live, up to the endowment age. These policies generate cash value. While many agents will push the cash value as an attractive investment, which can be extremely misleading, that is not the purpose of the cash value, which is technically called the “terminable reserve.” The cash value is really a part of the death benefit. In order to keep premiums lower on policies designed to last until death, companies need to reduce the actual amount of death benefit at risk. For a vanilla example, if the death benefit is $100,000 and the cash value is $50,000, the amount at risk for the company is only $50,000. As we get older, the risk of death and the cost of insuring go up. Either the premium has to go up, or the amount of insurance has to go down. Agents and companies like to spin this a different way to get people to take policies and keep paying premiums, but in virtually every case this author has examined, the costs of commissions, expenses, and life insurance company profits create such a drag over “real” investments, that the investment performance of permanent insurance seems destined to woefully underperform. Such policies are often marketed as tax deferred or even tax free, but this is often quite misleading. The only way to get any profits out of your cash value is to borrow them – literally – and pay interest by creating policy loans. And if you suck so much cash out that the policy can’t stay in force without massive additional premium payments and interest charges, there is a big chance the policy will lapse, or go kaput. If this happens, the tax consequences may be dire enough to kill you, as in the previous example. Variable life insurance adds a layer of complexity by letting you invest the cash value in securities that look remarkable similar to mutual funds, money market funds, separate accounts, and other investment options. Often there is also a fixed account that pays a stated interest rate. As most readers know, a mutual fund can invest in stocks bonds and other vehicles to seek a rate of return, subject to investment risks. In variable insurance, these mutual fund-like buckets are technically referred to as sub-accounts. Some policies can offer 50 or more. In variable policies, you pay premiums, get a specific face amount of death benefit, and hope the cash value does well over the long term. The mix of investments is purely up to the policyholder. This can be a dual edged-sword, since many policy owners mistakenly believe the agent or insurance company is managing the investments, but the actual responsibility is the policy owner’s. Odds are good if the policy owner’s not watching the investments like a hawk, no one is. Most folks don’t need life insurance that lasts late into life. Typically, if there is enough for two to retire, there is surly enough for one. While there seem to be some limited applications like replacing a pension that stops at the first death, or funding for estate taxes there are often much better ways to tackle these goals. For those that actually need permanent life insurance, variable life insurance offers a way to leverage the cash value in hopes of higher returns, which can be translated into reduced premium liability, or enhanced death benefit. It must be noted that such higher target returns come with higher investment risk, as well as potentially much higher investment and insurance product costs than found in cost conscience investment vehicles. Life insurance is generally confusing for many consumers, and permanent life insurance can be downright mind-boggling. Variable life insurance is one of the very most complicated, and potentially most very expensive. As with all financial products, wise shoppers will study all relevant disclosure information, which, for variable products, will include prospectuses. And remember, most of these policies – and virtually all that might be recommended to you – are sold by agents with very rich – and hard to spot – commission agendas. If you seriously consider such a product, it might be prudent to invest in an objective opinion from a fee-only (not fee-based, which means “fees+commissions”) financial planner who has no dog in the fight.

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