Variable vs. universal life insurance: What's the difference?

Variable vs. universal life insurance: What's the difference?

Updated on Jan. 9, 2018: Life insurance isn’t an investment ...except when it is.

More specifically, term life insurance isn’t an investment, but permanent life insurance often is. That’s because permanent life insurance has a cash value component – an investment aspect that can gain value.

Variable and universal life insurance are two types of permanent life insurance. Though they’re similar in their basic value, there are a few key differences. Despite the investment component, they may be the wrong option for people looking for life insurance protection. Read on to learn more.

Similarities between variable life insurance & universal life insurance

The most prominent shared aspects of variable and universal life insurance are the two they share by virtue of being permanent life insurance policies.

Permanent life insurance has that name for a reason: It lasts your whole life. A term life insurance policy lasts for a set period of time, after which it expires and you have to apply for a new policy or go uninsured. A permanent life insurance policy, on the other hand, stays in force for as long as you keep paying the premiums. This permanence can provide peace of mind for people who feel they still need coverage later on in their life after a term life insurance policy has expired.

The other shared component of all permanent life insurance policies is called the cash value. With permanent life policies, the death benefit (the payout triggered upon your death) is made up partly from savings contributed through your monthly premiums. The longer you keep the policy, the more the cash component increases until it eventually comprises all of your death benefit.

However, even though variable and universal life insurance have a cash value component, they aren’t used in the same way.

Differences between variable life insurance & universal life insurance

A unique feature of universal life insurance is it gives policyholders a surprising amount of flexibility with the premium payments and death benefit.
Your policy has a minimum premium you need to pay to keep it in force, but you can use any gains from the cash value component to pay the premium. You can put money toward the premium or even, if you have enough money in the cash value, "skip" premium payments entirely. There are typically some limitations to this, like only being able to do it after you’ve held the policy for a year or a requirement to have enough money in the cash value to keep the policy in force for two months. Still, it's a nice way to make the policy work for you.

You can also adjust the death benefit of your policy. Your individual policy outlines the exact requirements, and there are limits involved (further underwriting if you want to increase the death benefit or fees to decrease it), but it can keep you from over- or underinsuring yourself.

One downside to a universal life insurance policy is that the unpredictability of the interest rate of the cash value affects your flexibility. The policy outlines a minimum interest rate, but that can change based on the market. If your cash value is accumulating a lot of money, you can put that toward the premiums, but if the interest rate remains at the minimum, it can throw your payment plan out of whack, and you may find your premium increasing to make up for the lost value.

If universal life insurance and other permanent life insurance policies are like a savings account with gains coming from the interest rate, a variable life insurance policy is more similar to a typical investment with the potential for greater returns. A variable life insurance policy has a number of different investment options, ranging from stocks to mutual funds to bonds and more.

This series of sub-accounts are a better option for high growth for the same reason a mutual fund is a better option for growth than your bank savings account: Investment returns can do a lot more for you than a relatively small interest rate. But there’s also the potential for loss, and in order to get the most out of your investment, you need to be aware of what you’re actually investing in.

Overall, getting the most out of either of these policies is involved and confusing for many people. Universal life insurance is only really worth it if you’re going to take advantage of its flexibility, and a variable life insurance policy works best if you can take advantage of the investment options.

Variable universal life insurance

To make matters more complicated, there’s also a policy type that combines the two: variable universal life insurance.

Like universal life insurance, you can adjust the premium and death benefit of your policy. Like variable life insurance, there are sub-accounts in which you can invest. There’s a lot of potential with a variable universal life insurance policy, because it comes with the options and flexibility of its parent policies, but it also takes more effort to get the most value.

Think long & hard about permanent life insurance

One last thing that variable and universal life insurance have in common is a drawback that all permanent life insurance policies have: They aren’t necessary for most people.

Permanent life insurance policies sound like a dream come true — life insurance and an investment in one — but the high fees normally associated with permanent life insurance make these policies prohibitively expensive.

Whole life insurance, one of the simpler forms of permanent life insurance, can be four times more expensive than an equivalent term life insurance policy.

You also don’t have control over your investments when it comes to the cash value component of a permanent life insurance policy. If you invest on your own, you can choose between stocks, mutual funds and more to find the right mix that meets your needs and risk tolerance. A variable life insurance policy gives you control over your investments relative to other permanent life insurance policies, but you’re still limited by what’s offered with the policy.

What you end up with is life insurance that’s more complicated than what most people need, and an investment option that usually won’t get the returns you would by investing on your own. There’s a reason why "buy term and invest the rest" is a common refrain in personal finance circles.

Having said that, there are times when a permanent life insurance policy is a good option. Most notably:

  • You're a high-net worth individual looking to leave a tax-free inheritance to your family.
  • You have a special needs dependent who will need caring for when you're not around.

For a deeper dive into term vs. whole, go here.

As we said, term life insurance is enough for most people, but if you’re going to choose a permanent life insurance policy it’s important to know the differences between them. Just because they both have a cash value component doesn’t mean they’re the same, and the differences can have a big impact on your financial well-being.