How variable universal life insurance (VUL) works

Variable universal life insurance (VUL) is a type of permanent life insurance policy, meaning that as long as you keep paying your premiums, your beneficiaries will receive a death benefit when you die. It also has a cash value component that grows with each premium payment and gains interest.

The cash value of VUL is invested into separate assets of your choosing, such as stocks and bonds. If the interest on the cash value is higher than the cost of insuring you as you get older, or the cost of insurance (COI), it can be used to defray some of the cost of your premiums.

If you’re wealthy and have exhausted your other investing options, VUL might be an appealing way to expand your investment portfolio while securing financial protection for your beneficiaries. Since you have more control over your investment options, there’s higher potential for cash value growth with VUL than a whole life policy. However, a variable universal life policy is significantly more expensive than a term life policy, and most people will see equal or greater investment gains in a traditional 401(k) or IRA separate from their life insurance.

How does variable universal life insurance work?

VUL combines features from two other types of permanent policies into one:

• Flexible premium pricing: Under a universal life policy, you gain interest at a predetermined rate, like a savings account at your bank, but your premiums can increase or decrease depending on whether the rate outperforms the market.

• Cash value investment options: Variable life insurance has consistent premiums and you can choose the assets into which your premiums feed, like an investment account. If the rate of return on your investments is too low to support the policy, the policy could lapse when your cash value reaches zero.

Variable universal life insurance combines these elements in a policy with fluctuating premiums and a choice of assets into which your premiums go.

If the assets perform better than the cost of your insurance, your premiums can decrease while your death benefit stays the same; you can also purchase additional death benefit coverage at the premium rate you’re currently paying. As the cash value increases, you can also put more of it toward premium payments for the death benefit and pay less out of pocket. You could even skip or stop paying premiums altogether and support the death benefit entirely with the cash value. You’ll be covered until the cash value runs out. If you need cash, you can borrow against the cash value (including interest) or withdraw all or part of the principal.

Naturally, if the assets don’t perform well, your premiums could increase to support the same death benefit coverage, or you could be forced to accept a lower death benefit for the premiums you’re currently paying. That’s because although you’re guaranteed at least a minimum death benefit, the cash value component effectively comprises the rest of the death benefit in VUL.

Pros of variable universal life insurance

A variable universal life insurance policy isn't meant for most people, but it may be a good choice if you’re set on buying a permanent policy or as a financial strategy if you’re wealthy. Here are a few scenarios in which VUL could be right for you:

• You’re wealthy but want to save more money. At a certain income level, you can no longer contribute to some retirement accounts, like the Roth IRA. You may have also already maxed out your yearly 401(k) contributions. In these cases, a variable universal life insurance policy can give you an additional tax-deferred savings.

• You want to create a tax-free inheritance for your beneficiaries. As with the above, this generally only applies if you’re already very wealthy. That’s because your inheritance is already tax-free if your total assets equal under $11.38 million. The death benefit can cover an estate or inheritance tax for those with assets above that amount.

• A variable universal life insurance policy could be cheaper than other permanent policies. If you’re set on buying permanent life insurance, you could pay less for VUL than you would for other permanent policies like whole life insurance if the cash value outperforms the market and the various administrative fees.

Cons of variable universal life insurance

Most people probably shouldn't purchase a variable universal life insurance policy and would benefit more from buying a traditional term life policy and investing separately. Here is why:

• It's expensive. Although VUL policies can sometimes be cheaper than whole life insurance, they’re always going to be more expensive than term life insurance. Term life is much easier for most people to fit into their budget.

• There are a lot of fees involved. You may have to pay a mortality and expense fee, fees to the mutual funds into which your premiums are invested, and insurance-related fees. All of these could eat into your cash value. And if you want to withdraw from or take a loan against your cash value, that could come with fees as well.

• Your premium payments toward the cash value are not a straightforward investment. Say you pay $500 per month in premiums. If $100 goes toward the minimum death benefit, the remaining $400 isn’t going directly toward the cash value. Instead, some of it may be paid as commission to the insurance agent and some into the amount it costs the provider to insure you. Whatever’s left after those deductions goes toward the cash value.

Alternatives to variable universal life insurance

The cost and unpredictable nature of VUL insurance may not be right for you. After all, the point of life insurance is to guarantee financial support to your beneficiaries when you’re gone. If you need an additional avenue for investing, whole life insurance comes with a cash value that grows at a smaller but more stable fixed rate. If your main concern is having the funds for the end of your life, a final expense policy might be right for you. But if you want the most straightforward and affordable life insurance, no investments included, a term life policy is the best type of life insurance for most people.

Whole life insurance

With whole life insurance, you’re covered from the moment you sign the policy until the moment you die, but you only have to pay premiums for a limited time. That means the premiums may be very high — 5 to 15 times more than term life insurance — and you won’t be able to use the cash value to pay them. However, that also means the final death benefit amount isn’t dependent on the cash value.

Term life insurance

Term life insurance is more affordable than variable universal life insurance. Unless you’re so wealthy that you’ve exhausted your traditional investing options, VUL’s cash value component is not cost-effective when you could be investing your money directly into a mutual fund yourself. With term insurance you’ll save not only on insurance premiums but also on your investments, and almost certainly enjoy a greater rate of return.

Is variable universal life insurance worth it?

Should you get a variable universal life insurance policy? Unless you're extremely wealthy and have maxed out all of your other investment accounts — probably not. Due to the policy's high costs and associated fees, you’ll likely see better gains and save more money over the life of your policy if you purchase a term life insurance policy and invest the difference in a traditional investment account.