Everything in life has its advantages and disadvantages. Life insurance policy types are no different. Unlike buying the wrong latest gadget out there, buying the wrong life insurance policy has more severe implications for you and your beneficiaries alike.
This is the reason I decided to write a post about the pros and cons of universal life insurance and clear some of the doubts by presenting the facts and letting you decide for yourself.
What Is Universal Life Insurance?
Universal life insurance (UL) is a permanent type of coverage that offers guaranteed death benefit, cash value accumulation, and the ultimate advantage of all: flexibility.
The flexibility to adjust your death benefit as the need arises (increase or decrease) and to change the premium amount or even skip payments, provided there is enough money in the policy’s cash value to cover the cost of insurance (COI).
Each time you pay the premium, a portion of that amount goes towards the COI, and the rest is going to earn interest in a crediting account which grows on a tax-deferred basis. Most carriers offer a few crediting accounts from which to choose, based on one’s risk tolerance and goals.
How Universal Life Differs from Whole Life
Both whole life and universal life are permanent policies. They last for the insured’s entire life as long as premiums are paid on time. Its purpose is to be in force and to pay the death benefit to the beneficiaries when the insured passes away, no matter when that may be.
The significant difference between the two is that whole life is set in stone while universal life offers flexibility to the policy owner. There are three main differences:
- Premium payments: Universal life allows you to adjust when to pay and how much premium to pay to fit your current life’s situation, while whole life has fixed premium payments that you must pay to keep the policy active.
- Death benefit: Universal life allows you to increase or decrease the death benefit as you see fit, while whole life death benefit can’t be modified.
- Cash value: With Whole life, if the owner wants to access the cash value, he must do it through a loan. A loan will have associated interest charges. With universal life, the owner can obtain the cash value through a withdrawal which has no interest. You want to make sure there is enough cash value to meet the policy’s expenses. It has a range between the minimum premium (to keep the policy in force) and the maximum amount of excess premium payments based on IRS life insurance guidelines.
Universal Life Insurance Advantages
Owning universal life insurance has a few advantages. Let’s take an in-depth look.
1. Flexible Premium Options
One of the most prominent advantages of universal life is the ability to choose when and how much to pay, provided, of course, there is enough cash value in the policy. You can pay more into the policy’s cash value in the early years so that, later in life, you may skip payments, pay your premiums from the cash value, or even surrender the policy.
The main takeaway is: you don’t want to pay only the minimum required payment. If cash accumulation is your main priority, pay as much as possible while you’re young so that the policy can build significant cash value.
2. Adjustable Death Benefit
The ability to increase or decrease your death benefit as life events unfold is a significant advantage to have. Let’s say you purchased a million-dollar life insurance policy in your thirties because you had two newborn babies and a mortgage. Now, you are in your sixties, your children are grown up and out of the house, and your mortgage is paid off. You can decrease the death benefit, and by doing so, you also reduce your premium payment.
The other example could be the opposite: You bought a policy ten years ago, and at the time, it was sufficient. However, you just purchased a new business and need a key person life insurance as collateral. You can do that by increasing your current death benefit. Keep in mind that you will need to go through the underwriting process again and be qualified.
3. Permanent Coverage
Universal life comes with a great promise: permanent protection. Protection for life gives the insured peace of mind that their beneficiaries will be taken care of no matter when they pass away. It’s an ideal solution for estate planning or funding a buy-sell agreement with life insurance.
4. Cash Value Accumulation
All permanent policies have a cash value element that is built into the coverage. The good news is that you are in full control of it and can access it at any time. The cash value in universal life is guaranteed to grow according to the insurer of choice and past performance. With most UL, it’s 2% per year. As you pay your premiums, the cash value in the account accumulates and can be used as follows:
- Surrender value: At any time, if you no longer need the policy, you can surrender it (withdraw), and the insurer will give your accumulated net value back. Some companies also allow a partial surrender after the first policy anniversary.
- Loans: You can borrow money from the insurance company up to the full amount of your cash value. Keep in mind that loan interest rates will apply.
- Premium payments: You can pay your policy’s premium from your cash value account. However, you will need to pay extra in the future, so the cash value won’t reach zero. At that point, the policy will lapse.
The cash value accumulation in universal life policy grows on a tax-deferred basis (which means you don’t pay tax until you withdraw money from the account). You can access this cash through a loan or a withdrawal.
Loans trigger interest by the insurance carrier and withdrawals are subject to taxes. Note that you will be taxed if the withdrawal amount exceeds the total premiums paid into the policy. Policy loans aren’t subject to a taxable event.
6. Level or Increasing Death Benefit Options
In addition to the insured’s ability to increase or decrease the death benefit, universal life provides another unique opportunity for choosing between two death benefit options:
- Option A: Also called level death benefit, this is the original amount (face value) you bought when you first purchased the coverage. If you die, your heirs will collect the initial death benefit.
- Option B: Also called increasing death benefit, this includes your cash value accumulation plus the original death benefit. This option is more expensive, but it gives you the chance to increase the death benefit over time by increasing the cash value over time.
Universal Life Insurance Disadvantages
Universal life offers a wide range of flexibilities and a guaranteed death benefit. It also costs less than whole life and doesn’t cover you for a specific period of time as does term life insurance (up to 30 years). What’s not to like? Let’s review a few of the disadvantages of owning universal life.
1. Cost of Insurance
If your goal is to have coverage for a specific time or length and have no interest in building cash value, you’d be better off with term life insurance or guaranteed universal life. You would pay three to four times less and can invest the difference in premium savings in mutual funds or other investments.
For most, life insurance should be temporary protection. Its purpose is to protect your loved ones in the most critical duration in life, which is usually when you first get married, get a mortgage, or have children. Once that period is over, you may have saved enough, paid off the mortgage, and the children are grown up and do not depend on you anymore.
2. Cash Value Can Go to Zero
If you bought universal life insurance or saw an illustration, you would find two tables, side by side, which display the cash accumulation potential. One shows the guaranteed interest rate and the other the non-guaranteed (interest rate based on current market conditions).
Most choose to be optimistic and believe that their policy will outperform the current market conditions, and they forget to look at the guaranteed rate. Universal life insurance adjusts the cost of insurance (COI) each year. The older you become, the more expensive it is.
The idea behind this is that the cash value in universal life policies will grow at an elevated rate so the insurer can use that money to offset the costs. But have you asked yourself what happens if your policy doesn’t accumulate at that rate? (Did you check the guaranteed rate?) You guessed it. At that point, 20 years down the road, your cash value will slowly but surely decrease to zero, and you either replenish the account or cancel your policy.
This usually comes at a time when you are too old or have a condition that prevents you from qualifying for a new policy. Make sure you plan based on the guaranteed rates and not the current market condition interest
3. Surrender Fees
If you decide to cancel your universal life policy, you are allowed to take the NET CASH VALUE. The net cash value represents your total cash value minus the surrender charges. You will need to pay the surrender charges depending on how long you have had your policy.
With most companies, you need to have the policy for more than ten years so that you won’t pay surrender charges. If you cancel your policy in the first year, you may need to even pay out of pocket. The reason is that your money is parked in an investment, like stocks or mutual funds, and when they liquidate that money, they pay fees. They also try to discourage individuals from canceling too soon.
I have seen too many individuals who have no business owning a UL policy. The agent sold them on the “investment pitch” and only showed them the non-guaranteed rates. He told them that they can pay for their son’s college tuition while the policy still pays for itself in the future. They never really looked at the non-guaranteed rates and mostly just paid the minimum payment to keep the policy in force. I’ve heard too many of these stories through people calling my office to inquire about a policy, explaining to me that they just realized that their UL policy has just imploded, and they need to fund the cash value or surrender the policy.
Most can’t pay and don’t have coverage. If you haven’t maximized your 401k or SEP-IRA, and aren’t planning to pay more into the policy in the first ten years, you probably shouldn’t buy universal life. You will do just fine with term life or guaranteed universal life insurance which allow you to choose your coverage based on age rather than a term. Sure, there are a few who can benefit from buying universal life, but they are the exception, not the rule.
As a consumer, you need to work with a trustworthy broker so that you can rest assured he has your interest first and his second. Lastly, most people fall into one of two categories: the ones who buy life insurance but bought the wrong plan, and the one who wants to buy life insurance, but because of their age or health history, it’s either too expensive or impossible to buy now. Don’t be that person. We hate selling life insurance. It’s too boring and irritating. We prefer educating consumers by presenting all the options, so they can decide for themselves. This is a lot more rewarding.