- Term Life:
- Fixed premium in fixed period of time (e.g. 10, 20 years--hence the name "term");
- only pays if death happens within term, otherwise money is gone;
- pure death benefit;
- no cash value; - Permament Life:
- Whole Life:
- like Term Life except it's till death; - Variable Life
- fixed premium;
- premium includes insurance cost (basically a whole life policy, this part is fixed) and the 'subaccounts' for investment (this is the variable part)
- has garanteed minimum value, but can go above it;
- make mutual-fund-like investments within the policy; - Variable Universal Life
- variable premium (makes it 'universal'), with the possibility of reducing or even eliminating it, but can go the other way also; the idea here is to have a high investment portion so the gain from the investment will cover the insurance cost, which can be quite high when you're older;
- variable value;
- more flexible;
Friday, October 28, 2005
Life insurance in plain language
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The following sales pitch may sound familiar: "How would you like to invest money in mutual funds, pay no tax on the growth and use the money for retirement, tax-free? And, if you die prematurely, your beneficiary will get a big tax-free death benefit!"
Some deal, huh? It's called universal variable life insurance, a fancy name for a very complicated insurance product. Some of the elements of the sales pitch are true but misleading.
I've been around the financial-services business for 30 years, and I can tell you the primary purpose of any kind of insurance policy is not to make an investment -- it's to pay a death benefit to a beneficiary. Buying insurance solely for investment benefits is like paying a bridge toll for a 22-wheel truck when you're only riding a motorcycle.
This subject can easily make your eyes roll back into your head. Think of it as another one of those financial issues you must be aware of to make smart financial decisions. I will give you a quick summary of the key issues, but for those of you who want to get into more detail, check out The New Life Insurance Investment Advisor by Ben Baldwin (1994, Probus Publishing).
Before buying life insurance, ask yourself three questions:
* Do I need or want life insurance?
* If I die, will someone experience an economic loss?
* Do I care?
If your answer to these questions is no, tell the insurance agent to get lost. You simply don't need the insurance, so don't let anyone turn the discussion toward buying insurance as a way to invest.
Insurance Plus Investments
What is universal variable life insurance? It's a combination of universal life, which allows you to vary the premium and amount of death benefit while the policy is in force, and variable life, which allows you to make mutual fund-like investments within the insurance policy.
It's a unique insurance product in that it provides for a form of term insurance (a death benefit without any cash value) inside the policy while investing money beyond the cost of insurance premiums into "subaccounts" similar to mutual funds (the variable part). All of this is done in a tax-sheltered policy because any growth within an insurance policy is tax-free as long as you don't cancel the policy.
Let's assume you need some life insurance. To decide whether to buy a universal variable life policy, consider the following costs:
* The insurance agent typically is paid about 50% of the first year's premium for the term insurance portion and about 4% commission for the investments. If you decide to cancel the policy, there is often a penalty period. This could trap you into keeping a policy you don't want. Why pay any penalty if all you want to do is invest in something else?
* If you decide to add more money to the investments in the policy, there are state premium taxes that average about 2%. This is in addition to the 4% commission, bringing the total cost for investments to 6% for every new dollar you invest.
* There is a provision in the policy that allows you to borrow money. The insurance company sets aside the equivalent of whatever you are borrowing in a special account that serves as collateral for the loan. They credit an interest rate to the money in the special account and then charge you a different rate for the loan. For instance, it is common to credit you with 7% and charge you 8%, amounting to a 1% spread. That may work okay for a short-term loan, but for a long-term loan, it's expensive.
Supplement Your Pension
Universal variable life often is sold as a way to create a supplemental pension plan. The concept is that you build up the investment/variable part of the policy as much as possible to some age, say 65. At that point, a systematic monthly or annual loan is created. This will give you tax-free cash flow because, under current laws, money inside an insurance policy grows tax-free and a loan is not considered a taxable event. The loan is paid off when the insured dies unless there's a special option to forgive the loan.
The concept can work, but there are dangers:
* The government could change the law and make the buildup of cash inside a policy taxable. It probably won't happen because the insurance lobby is very powerful, but it's possible.
* Growth in excess of the original contributions into the policy will become taxable at ordinary income rates if the policy is canceled or lapses for any reason. This danger can be particularly acute in later years. Premiums for the pure term insurance inside the policy get very expensive over time, and the compounding effect of the interest on the loan that provides the income stream can become very high. If these two effects are not managed properly, the policy can implode from costs and be canceled. The policy has to be in effect until the day you die for this concept to work.
Tax-Free Premiums
This kind of policy can be a good idea if you use its tax benefits as a way to keep term insurance affordable as you grow older. If you use this policy primarily for the insurance benefit, consider adding enough investment dollars so the investment will generate enough profit to pay the premium. In effect, you would then be paying the premium with dollars that are not subject to income tax. It's all done inside the policy.
In order to justify using this policy for tax-free loans for education, IRAs, house down payments, etc., and ultimately as a supplemental pension, you need to do some very careful projections. Projections should include the following variables:
* The cost of term insurance. Examine the cost of using taxable dollars for regular term insurance vs. nontaxable dollars within the universal variable policy.
* The roughly 6% cost of putting money into the investment account. Is it worth it?
* The net cost of borrowing the money. Anything over 0.5% is excessive.
* Growth of the investments. I suggest using no more than 8% for these projections. Be sure you're comparing an 8% pre-tax return within the policy to an 8% after-tax return outside the policy. The tax on investments outside the policy held longer than 12 months is at the 20% capital-gains rate.
Have the agent figure how much cash must be left in the policy to keep the premiums paid. This is the cash you cannot use for anything else.
As you can see, making a decision about this kind of policy can be very complicated. It is certainly not as easy as the up-front sales pitch.
Universal variable life insurance may be something to consider if you're going to need life insurance for the rest of your life and you build up enough on the investment side to pay the premium inside the policy. Rates and the kinds of investments vary by company. If you do buy a policy, be sure to compare offerings from two or three companies.
[zz Universal Variable Life -- Make It Your Policy to Know the Details
By Vern Hayden
Special To TheStreet.com
11/11/98 12:17 PM ET]
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