Recently, my uncle managed to cause quite a reaction in our family chat group. He claimed that he was still making monthly life insurance premium payments. It was a shocker, since he’s well into his 60s and retired early about ten years ago. For someone who’s not looking to protect his income, what exactly is he trying to accomplish? Has he been wasting his money for the last decade? Naturally, we pressed him on the details. He revealed that he’s still paying for the policy because he bought variable life insurance many moons ago. He can still increase the death payout by continually paying into the system. So that begs the question — what exactly is a variable life insurance policy?
How Variable Life Insurance Policies Work
With standard life insurance policies, you pay a fixed monthly premium. Then your beneficiaries receive an agreed upon death benefit if you pass away while the policy is active. Variable life insurance policies are a bit different. Not only is there flexibility in how much of a premium you need to pay, but you also get to choose how some of your premium is invested for your benefit.
A variable life insurance policy really has two components — a death benefit and a cash value. The death benefit is fixed. This portion of the benefit works pretty much exactly the same as term life insurance. It’s the cash value portion of the policy where most of the action takes place. With variable life insurance, part of your premium is paid into a pot known as cash value. You then get to decide how it’s invested for your benefit. You’ll get a list of investment options with your policy. Then, you can move your money in and out of those funds as you please. It’s a lot like how a typical 401(k) plan works.
Here is the easiest way to think of how the two parts work together. First, imagine buying life insurance but also deciding to have an investment account. Then you limit the investment account to only be connected to life insurance premium payments and payouts. At the beginning, you pay into your life insurance and deposit funds into your investment account.
When the investment account does well, you can choose to use some of the proceeds to pay part of your life insurance premiums. Of course, you can also keep paying your life insurance separately too. That will let the investment account grow even more. If something happens to you and your beneficiaries make a claim on the policy, the investment account is also liquidated. What’s left in the account is paid to your heirs, along with the death benefit.
Pros of Variable Life Insurance
Since a variable life insurance policy is considered a permanent life insurance policy, it’s possible to pay for a short period of time, build up the cash value because of strong investment gains, and then use what you’ve accumulated to maintain a life insurance policy for the rest of your life. There are other benefits of this arrangement, including the following perks.
There’s flexibility in the monthly premium. Like we mentioned, it’s possible that you would pay for a fixed amount of time and then have a life insurance policy for the rest of your life without ever spending another dime. The flexibility can benefit you in other ways too. What if you get laid off and need to reduce spending? What if you want to remodel your kitchen and don’t want to dip too much into your savings or credit cards? Since the monthly payment to maintain a variable life insurance policy isn’t fixed, you can reduce your obligations as you see fit. You just need to ensure your cash value is built up to cover the shortfall.
You get tax-free growth. A major selling point of variable life insurance policies are that the cash value accumulates in the account tax free. That means that no matter how it grows or how much income the funds you invest in pays out each year, you won’t need to worry about tax consequences.
You Can Borrow From It
You can take out a tax-free loan from your policy. If you need to, you could withdraw the cash value portion of your policy as a loan to use at your discretion. You won’t be able to take out the entire balance though. However, the allowed amount could be up to 95% of the pot. So you use almost all of it. You will be charged interest on the loan, but it’s generally low.
Cons of Variable Life Insurance
Not everything about variable life insurance is amazing, though. For one, it can seem complicated to combine a death benefit with an investment component. In addition, here are some other things to think about before you buy a policy.
The costs of having this type of policy can be high. If you’re thinking of getting a variable life insurance policy, you need to carefully consider all the fees and costs associated with it. Right from the get go, there’s a sales and administrative fee that’s taken out of your policy’s benefit to pay for the agent’s commission. That’s why it’ll take time to begin accumulating anything in the cash value portion of your account. It’s essentially like started with a negative cash value balance from the beginning.
Then there are investment management fees. They work much like the expense ratios of mutual funds and ETFs. Your mileage will vary, but some of the options will cost more than equivalents available to investors in a standard brokerage account.
You also have to worry about surrender charges. It’s true that you can withdraw your cash value as a loan. However, you may be required to pay a surrender charge for up to 10-to-15 years of your policy. In fact, you will need to pay for the surrender charge even if you decide to give up your policy during the initial period.
There are other fees you will have to consider as well, but these are the major ones. Like we said, just remember to read your contract carefully. Ask your agent any questions you have until you fully understand what you are getting yourself into.
The Bottom Line
Many people don’t like variable life insurance policies. They arguably have good reasons. For most people, it’s generally just better to get a standard life insurance policy and keep their tax-free investments separate. In fact, with the high fees, it might even be better to invest any leftovers in a taxable account and just pay the yearly taxes from investment gains and income.
Still, investing through a variable life insurance policy can actually be beneficial. The investment menu for your cash value is usually limited to mutual funds. They won’t give you minute-to-minute price updates on the funds like they would in a do-it-yourself investment account. Furthermore, the insurance companies also won’t allow you to trade in and out of funds rapidly and continuously. Those restrictions might seem like a disadvantage, but they act as a guardrail for emotional trading — something that has proven time and time again to be detrimental to wealth building. There are plenty of people who time the market and strike it big. However, on the whole, most people are better off leaving their investments alone.
Some people, like my Uncle, have the discipline to stay the course through the thick of thin. Others need all the help they can get, even if they pay for the services. You are the only one who can determine which camp you belong in.