How Variable Life Insurance Works: Pros and Cons of a Variable Policy
Variable life insurance, also known as variable appreciable life insurance, offers both lifelong coverage and a cash value account.
Variable life insurance policies have a higher potential for profit than other types of permanent life insurance policies. You can choose how to invest the cash value of variable life insurance. Variable life insurance policies, on the other hand, frequently have 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, which means that coverage will last as long as premiums are paid.
Every variable life insurance policy consists of three major components:
- Death benefit
- Cash value
- Premium
A death benefit is what is left to your beneficiaries after you die. When you pay your premium, a portion of it goes toward the cost of insurance and the insurer's fees, which keep the death benefit in place. The remainder of the premium is applied to the policy's cash value, which is structured similarly to a brokerage account. The cash value can be invested in securities (often referred to as sub-accounts) that are similar to mutual funds.
If the cash value increases in value, it can be used to increase the death benefit, withdrawn as cash, or used as collateral for a loan.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 surrender or give up your coverage to the insurer.
Cash Value of Variable Life Insurance
The cash policy of a variable life insurance policy differs from that of a whole or indexed universal life insurance policy. Each variable life policy comes with a prospectus that details around 20 to 30 options for investing the cash value, and the cash value investment options are similar to mutual funds in that the money is invested in a specific set of securities, such as:
- An index, such as the S&P 500
- An equity portfolio, such as an emerging markets fund
- Bonds
- A money market mutual fund
Variable life insurance policies typically include a fixed interest investment option offered by the insurer. However, regardless of which option you select, you will be charged management fees, which are similar to expense ratios for mutual funds. These fees vary depending on the securities being invested in and can be quite high if the funds are actively invested (meaning a portfolio manager is picking stocks).
Investments
Cash value investment management fees are sometimes expressed in terms of "basis points," with one basis point equaling 0.01 percent.
This means that if an investment option is listed as having a 6% historical rate of return but also has 125 basis points in management fees, returns will be reduced by 1.25 percent.
Variable life insurance policies have a higher upside potential than other cash value policies, such as whole life insurance, because you can choose from a variety of investment options.
Variable life insurance policies, on the other hand, may not have a guaranteed rate of return or may have a very low rate of return. Furthermore, the maximum rate of return on your cash value investment options is usually limited. During bad years, your cash value may actually decrease in value and may not perform as well as it could during good years.
A key downside to variable life insurance
Every permanent life insurance policy has fees, but the disadvantage of variable life insurance is that it has the highest. The following expenses are common with variable life insurance policies:
Fee | Description |
Mortality and expense risk charges | These are the costs to provide the actual death benefit. |
Sales and administrative fees | Costs to cover an agent’s commission, set up and maintain the policy, and the insurer’s ongoing expenses. |
Investment management fees | These vary depending on how you choose to invest the policy’s cash value. |
Surrender charges | Policies 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 fees | Each 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 interest | If you take out a policy loan using the cash value as collateral, the insurer will charge interest on the loan. |
Riders | Riders 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. |
Other costs and risks
Administrative fees for variable life insurance policies will be higher than for other types of life insurance policies, owing to the fact that these policies are SEC-regulated investments. When deciding how to invest the policy's cash value, keep in mind that the insurer will pass these charges on to you.
For example, if you choose relatively conservative investments, you are more likely to achieve gains comparable to the cash value of a whole life insurance policy. However, if you buy whole life insurance, you will pay lower fees. As a result, with the same cash value rate of return, a variable life insurance policy would actually perform worse.
Variable life insurance death benefit
A variable life insurance policy's death benefit is typically structured in one of two ways:
- Level death benefit - The death benefit is equal to the face value of the policy at the time it was purchased.
- Face amount plus cash value - This type of policy is more expensive, but your beneficiaries will receive your cash value in addition to the face value of the policy.
Other death benefit structures, such as equaling the policy's face value plus all premiums paid, are available in some variable life insurance policies, but these two are the most common.
Regardless of the structure of your death benefit, you should always review the policy's actual terms. Furthermore, you should confirm whether the death benefit is guaranteed and, if so, whether the guaranteed value is the same as the projected value.
The death benefit is essentially a "target" based on a cash value performance assumption, such as a 4% annual rate of return. If the insurer achieves this rate of return, the cash value will equal the face value of the policy when you die. However, depending on the terms of your policy, if your cash value significantly underperforms, it may reduce your actual death benefit.
Flexible premiums with variable universal life insurance
Variable universal life insurance policies have the same cash value structure as variable life insurance policies, but the cash value can be used to pay premiums. You can also pay a higher premium if you prefer. As a result, these policies are also known as flexible premium variable life insurance.
While variable universal life insurance policies usually have minimum and maximum premiums, you are free to pay whatever amount you want as long as it falls within these limits. This means that you can:
- Pay a portion of your premiums - If your monthly premium is $500, you can choose to pay $250 out of pocket and the rest with your cash value. This option is usually only available once your cash value reaches a certain minimum.
- Pay no premiums - If your cash value is sufficient, you can use it to cover the entire premium amount.
- Pay more than your target premium - You can overfund your policy's cash value early on to accelerate the accumulation of investment gains. This option is typically preferred if you have a substantial income and want to avoid paying premiums later in life, such as in retirement.
There are also single premium variable universal life insurance policies that allow you to buy coverage and fund the cash value of the policy with a single payment. You essentially buy insurance and make all of your required cash value contributions all at once. However, you have the option of contributing more to the policy's cash value if you so desire.
How variable life insurance compares to other products
If you're thinking about getting variable life insurance, you should think about how it compares to other financial products. A variable annuity is simply a tax-deferred annuity in which you have control over how the annuity's value is invested. It is similar to a variable life insurance policy in the following ways:
- You have control over how the product's value is invested. Both products typically offer a diverse selection of equities, bonds, and money market instruments. If you make a poor decision, the value of your investment may suffer.
- It includes a death benefit. Variable annuities allow you to name a beneficiary, and if you die, your beneficiary will receive a set amount of money. This is typically the annuity's remaining value or the sum of your premiums minus any withdrawals. This is not the same as a variable life insurance policy with a lifelong death benefit.
- Gains on investments are tax-deferred.
- Withdrawals in excess of your basis are taxed. This means that you will be taxed on the growth of your investments if you have variable annuities.
- If you withdraw more cash value from a variable life insurance policy than you paid in premiums, you must pay taxes on the difference. This also holds true if you surrender the policy.
- To withdraw during the first few years, you would have to pay surrender charges.
- You have the option of paying in a lump sum or in smaller instalments over time.
Variable annuity vs. variable life insurance
The main distinction between a variable annuity and variable life insurance is that the former returns your investment in a series of payments from the insurer. With the latter, you can withdraw funds from the policy's cash value in installments, 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 be required to pay a fee if you withdraw before a certain age. Withdrawals from variable life insurance policies are only limited by the available cash value.
Variable life insurance vs. whole life insurance
Both variable and whole life insurance policies provide lifelong coverage, but whole life insurance policies provide both lower risk and higher reward.
Whole life insurance policies have:
- Level premiums - You pay a consistent amount in each premium payment.
- Death benefit level - The death benefit is guaranteed and will not fluctuate.
- Guaranteed returns - Your cash value grows steadily and is usually guaranteed to equal the death benefit when the policy matures (usually when you turn 100).
- Whole life insurance policies have lower premiums and are not regulated as securities.
- A downside to whole life insurance policies: fixed upside potential.
Variable life insurance policies' cash values can grow much faster and, in some cases, can be used to pay premiums. Variable universal life insurance policies have more flexible premiums than whole life insurance policies.
Variable life insurance vs. mutual funds and term life insurance
The phrase "buy term and invest the difference" is frequently used to discourage people from purchasing cash value life insurance policies, such as variable life insurance. If your financial obligations are likely to be fulfilled within the next 20 to 30 years, term life insurance is likely to be a better option because it is significantly less expensive than variable life insurance.
For example, if you're looking for life insurance to ensure your family can stay in your home if you die and you have a 15-year mortgage, term life insurance is a better option. Similarly, if you can save enough money over the next few decades to cover any future financial obligations, you should do so and only purchase term insurance as a backup. You pay more for variable life insurance to have a death benefit in place for the rest of your life. Alternatively, you could simply purchase guaranteed universal life insurance and invest the difference in mutual funds or exchange-traded funds (ETFs).
Continue adding to your retirement fund
Both options have advantages and disadvantages, but we would typically recommend maxing out contributions to retirement accounts before investing in variable life insurance.
Your money will grow tax-deferred in a 401(k) or IRA, and you will have a wider range of investment options with lower fees. The only disadvantage is that your money will be more difficult to access for a period of time, but even variable life insurance policies have surrender and withdrawal fees.
Assuming your retirement accounts are fully funded, the decision to invest in a brokerage account or a variable life insurance policy is based on how you believe the variable policy's investment options will perform. If your cash value performs well enough, tax-deferred growth can offset moderate management fees, but you must evaluate expected performance for yourself.