When we discuss life insurance policies, mostly we think of only two options available to us in general. These are term life and permanent (cash value) life insurance. Now, when we gather our attention on only permanent life insurance products, we are left with two major types:
Permanent life insurance is classified into two types:
1) Whole life insurance, and
2) Universal Life Insurance
Today, I will only be discussing universal life insurance and who should be looking at opting for this product.
The Concept Behind Universal Life Insurance Policy
The whole idea behind universal life insurance plan is to give the insured more flexibility in choosing the amount of premium which he wants to pay and when does he pay for it. Due to the flexibility it offers it is often referred as adjustable life insurance. As far as the expenses and pure insurance costs are met, the cost of insurance coverage can be changed and the cash value component keep on growing at a declared interest rate. Now before we get into the details of this specific product I would like to compare universal life insurance with other life insurance products. This will make your understanding a bit more clear. Refer the chart below
Comparison Table Of Different Types Of Life Insurance Plan
NOTE: Any guarantee offered by the insurer depends on its capacity to pay and also on the nationwide claims paying ability.
Proceeding further into our discussion and keeping the above mentioned chart in mind we single out the universal life insurance and elaborate the functionality of this insurance product. We will see how does a universal life insurance policy works?
Basic Structure
1) Once you choose a universal life insurance plan, you decide when and how much you are comfortable paying as your premium. The paying limits should abide federal tax laws. Minimum premium which you can pay depends on the cost of pure insurance component, expenses incurred by the insurer and insurance taxes.
2) During the course of your active policy as you keep paying your premium, the insurer deducts the company expenses and premium taxes.
3) The money which remains is credited to your cash value account. The insurer, each month, deducts its charges from this account with regards to the cost of pure insurance (risk cover) and other expenses.
4) The money which is being added to your cash value account earns interest at a variable rate which largely depends on the performance of the segregated investment portfolio. Having said that your insurance company will mention a minimum guaranteed interest rate in your documents.
5) In a case where the investment portfolio in the insurance company’s general account earns more than the minimum guaranteed interest then the extra money is credited to your cash value account.
6) At any given point in time, if the remaining cash value in your account is not sufficient to cover the expenses and pay for the risk cover (mortality cost) and you do not pay more premium the policy amount will be reduced or else your policy will lapse.
7) In universal life insurance plan you allowed to take out a loan not exceeding the cash surrender value minus the annual loan interest. The adverse effect is that repayment will reduce the cash value of your account. If the insured dies after the loan is disbursed then the any dues along with interest is deducted from the policy amount paid to your beneficiary.
Who Should Buy Universal Life Insurance And It’s Importance
Now, you should be clear about how does a universal life insurance works. I have seen many people selling this product as a good retirement planning tool which surely is far from true. A universal life insurance plan is best suited for individuals who seek expert financial advice for estate planning and asset protection. I have seen many financial advisors going to an extent where they say that universal life insurance is something which you should never buy. This again is not true. If you are looking at life insurance as an investment tool then surely no life insurance policy can meet your most conservative return requirements as it is NOT meant to be an investment product. Although I do not advocate the use of life insurance as an investment option, I also cannot negate the fact that universal life insurance product has its place and importance for someone looking to maximize his earnings. I will try to support my thought with one kind of approach.
“A good financial planner will always be able to identify if his client is the right fit for a universal life insurance policy. Anyone who is looking for a universal life product should understand the basics. You are indirectly looking at accumulating cash for future income. Hence, you should buy the lowest death benefit. This will help your cash value grow at a better rate while lowering pure insurance costs. So, basically, even though you have chosen a life insurance product, your main focus shifts from your life insurance needs towards cash accumulation. No, many still can counter this approach by the evergreen concept of investing in a cheap term plan and investing the difference in mutual funds for better returns. But, as I said there is no or right approach until you know an individual’s specific requirement. If a universal life plan is funded properly, all money can be taken out tax free which unfortunately is not the case with mutual funds. Also to make “invest the difference” approach really profitable you will have to earn more from your mutual fund investment to negate the tax effect.”
A Calculative Example To Understand Universal Life Insurance
An individual invests $5,000 in a mutual fund. Now, assuming 8% rate of return it will be equal to around $247,000 in 20 years of time. Now if you were to invest the same amount in a universal life insurance plan annually over a period of 20 years, it will grow up to $217,000 if we assume the same 8% return and if you have bought the lowest death benefit (roughly $200,000). Now, it may seem that the returns are low when compared to a mutual fund but we have not factored the after tax amount. So, a properly designed universal life insurance plan will outperform the concept of “Buy term and invest the difference”. Another point to note here is, if the insured passed away, he would have his death benefit and cash value. Assuming 8% return this would be more than $450,000 and that too, completely tax free. How long would it take to get that much tax free money by investing $5000 each year?
Where Does Universal Life Insurance Finds Its Use
- Final expenses – Like burial and help paying medical bills
- Estate Planning (Liquidity and Replacement)
- You buy a universal life policy when you are young and healthy. So, that later on its cash value is funded enough to pay for itself.
- You want your life insurance policy to have cash value as losing your premiums may not sound good for you. You may want to borrow money from the policy later on which will make this product more beneficial.
- In times of low financial liquidity you have the flexibility to alter your premium amounts. You can also increase or decrease the face value depending on your circumstances.
- Funded properly, it can be a good Roth IRA alternative
The only drawback a universal life insurance plan has is it is expensive and the returns which you get depend a lot on interest rates. Low interest rate would mean you end up paying high premiums to keep the cash value account growing. So as we see, it will depend on an individual’s financial situation to analyze if this plan is what you need.