Is variable life insurance worth it?

Is variable life insurance worth it?

There are a lot of different types of life insurance – something you’ve probably figured out if you’ve been shopping for a policy. Unfortunately, it’s not always easy to tell how these types of life insurance are different or if one is better than the other. In this post, we’ll explain variable life insurance – what it is, how it works, and whether or not it’s worth your time.

What exactly is variable life insurance?

Variable life insurance is a type of permanent life insurance where the cash value is invested in a number of sub-accounts that are similar to mutual funds.

Let's break that definition down a little bit.

All life insurance products are designed to provide financial protection for people or organizations you care about in the event of your death.

There are two main categories of life insurance: term and permanent. You’re probably most familiar with term. With term life insurance, you pay a monthly or annual premium, and, if you die, your beneficiaries will receive a death benefit. Term life insurance ends after a specified period of time.

The other type of life insurance is called permanent life insurance (also referred to as "cash value insurance). One of the big, obvious differences between permanent policies and term policies is that permanent policies last your entire life. They do this by offering an extra savings or investment component called the "cash value."

Variable life insurance is a type of permanent life insurance, along with whole life insurance and universal life insurance (and the confusingly named variable universal life insurance). The main difference between these types of permanent life insurance is how the cash value component works.

The cash value of variable life insurance is invested in a number of sub-accounts. These sub-accounts can be thought of as similar to mutual funds, except you can only invest them through the life insurance policy. That means that, unlike whole life insurance (which is just a savings account), there is no guaranteed growth rate, and your cash value can actually decrease.

How does the insurance part work?

Like all life insurance policies, variable life insurance policies have three important parts:

The death benefit is a tax-free chunk of cash paid out by the life insurance company in the event that you die. In permanent life insurance policies, the death benefit is made up of two components: a regular term life insurance policy and the cash value. We’ll discuss this in further detail in the next section.

A beneficiary is a person or organization that is set to receive the death benefit. Besides the obvious choices (your spouse, your children), almost anyone, any organization, or any kind of legal relationship (such as a trust) can be a beneficiary. There can be more than one beneficiary.
Your premiums are how you pay for your life insurance policy. You can usually pay either monthly or annually.

Variable life insurance lasts for your entire lifetime, assuming you continue to pay the premiums.

How does the cash value part work?

Every time you pay your premium, a certain percentage of it will go into the cash value of your policy. This cash value will then be invested into a number of sub-accounts that you choose. The easiest way to think about these sub-accounts is to imagine them as mutual funds. These sub-accounts are only available through the life insurance policy; you could not invest in them outside of the variable life insurance policy.

Like all investments, the cash value will fluctuate depending on how well each investment is doing. The stock market is in free fall? Your cash value probably is, too. Typically, however, your cash value will grow incrementally over the course of decades. Your investments are tax-deferred as well, which is why some refer to variable life insurance as a "super-IRA."

Remember when we talked about how cash value is one component of your death benefit? In all permanent life insurance policies, your death benefit is made up of a regular term life insurance policy and your cash value. Over time, as your cash value grows, your term life insurance policy will get smaller. Eventually, your cash value will cover the entirety of your death benefit, and your variable life insurance policy will no longer have a term component.

This can be confusing to people who think that, by buying a variable life insurance policy, they will receive both the accrued cash value and the term component’s death benefit when they die. Instead, the cash value slowly replaces the term policy until it represents the entirety of your death benefit.

There are various strategies you can use to withdraw the cash value from your variable life insurance policy before you die, though they are typically less flexible than whole life insurance policies. You can also surrender your policy to get the cash value. You can surrender at any time, however, most of the growth won’t happen for two or three decades. If you surrender your policy within the first twenty years, you’ll end up paying more in surrender fees than you will have made in profit.

What alternatives are there to variable life insurance?

  • Term life insurance. Term life insurance is a cheaper and simpler alternative to permanent life insurance policies like variable life insurance. Unlike permanent life insurance policies, term life ends after a specified number of years and does not feature any sort of savings or investment component. You can usually buy more coverage (a.k.a. a larger death benefit) for a smaller premium with term.

  • Other permanent (cash value) life insurance. Besides variable life insurance, there are three other types of permanent life insurance policies: whole life insurance, universal life insurance, and variable universal life insurance. How are they different? The key is the cash value – each one takes a different approach to growing it. Other details are largely the same.

Who sells variable life insurance?

You can get a variable life insurance quote from the insurance companies who offer permanent life insurance policies like variable life insurance, but we suggest speaking to an independent agent or broker instead. They can help you compare life insurance products from a variety of companies and help you decide which type of insurance or which policy you should purchase. In order to sell variable life insurance, a life insurance agent also needs to be licensed to sell securities.

What's good about variable life insurance?

Variable life insurance lasts for your entire lifetime. As long as you keep paying the premiums, your variable life insurance policy will stay in force and provide a death benefit to your survivors.

Growth is tax-deferred. Sometimes referred to as "super-IRA," variable life insurance policies grow tax-deferred, which means your annual growth doesn’t need to be reported to the IRS. If your cash value is distributed as a death benefit (as opposed to being withdrawn before your death), your beneficiaries will not have to pay taxes on it.

It typically has a higher rate of growth than whole life insurance. While a whole life policy’s cash value is typically guaranteed to grow a certain amount, it’s smaller than the potential growth of a variable life insurance policy.

What's bad about variable life insurance?

It is significantly more expensive than term life insurance. When you pay your premiums for a variable life insurance policy, not only are you paying for life insurance, but you’re paying to put money into the cash value as well.

Your premiums can rise if your cash value performs badly. If your investments aren’t doing well, your life insurance company may raise the premium in order to inject new capital into your sub-accounts. This became a huge issue for variable life insurance policyholders after the 2008 market crash.

High management fees. Each one of your sub-accounts has its own management fees, similar to the way a mutual fund has fees. However, fees on your sub-accounts are typically higher than the ones you’d find on a mutual fund.
Caps on growth. Some life insurance companies place caps on the growth of your sub-accounts. So even if your sub-accounts are doing really well, they may not be allowed to reach their full potential.

Is variable life insurance worth it?

For the majority of people, variable life insurance is neither a good life insurance product nor a good investment vehicle.

There are much better ways to invest than in a variable life insurance policy – ways that are cheaper, have a higher growth potential, and aren’t wrapped up in a complicated life insurance policy.

There is a small minority that may find variable life insurance useful due to its tax-deferred nature, but even in those cases, there are alternatives that may provide a better solution.

For the majority who won’t find variable life insurance useful, a much simpler and cheaper term life insurance policy is the way to go. In general, people should avoid combining insurance with an investment or savings component. If you’re trying to put together a long-term financial strategy that includes a variety of investments, you should speak to a financial advisor or tax expert.

Image: Thomas Hawk

Updated: Nov 13, 2017