There are so many choices out there for life insurance, and it’s SO EASY to get sucked into a life insurance policy that isn’t financially smart.
I have talked about term and whole life insurance in the past, but today I wanted to talk about universal life insurance and whether it's a useful tool for investing.
- How is universal life insurance different than whole or term?
- How does universal life insurance work?
- And, is universal life insurance a good investment?
But before we answer these questions, let’s talk about what life insurance IS and is NOT.
What is the Real Purpose of Life Insurance?
None of us wants to dwell on the idea that we might die younger than we should. Unfortunately, the unforeseen happens. And when it does, your life insurance benefit can make all the difference to your family’s future.
From universal to whole to term, there is a life insurance type for whatever you want it to be.
But, in my opinion, life insurance should really only be responsible for three things:
- Your burial expenses
- Maintaining your family’s standard of living
- Achieving financial goals for your family
In other words, the purpose of life insurance is to protect your loved ones financially after you are no longer here. Of course, the need for life insurance will vary with your age and life-stages.
From caskets and services to cemetery plots and headstones, burial costs are not affordable for many families, and yet, they are unavoidable.
Having the right kind and amount of insurance means that your family won’t have to deplete their savings – or worse, however – go into thousands of dollars of debt for the cost of your funeral expenses.
And burial expenses are only the beginning. Your loss not only leaves your family with emotional hardship but with a financial one as well. Whether you are a co-contributor, primary financial provider, or primary care provider, your loss will significantly impact your family‘s finances. Life insurance ensures the trauma of losing you will not be compounded by the loss of their home or standard of living.
Finally, life insurance can also be that “nest egg” to provide for your children’s education, pay off the mortgage, or other financial goals you had hoped to achieve for your loved ones.
Now, that being clear, let’s talk specifically about universal life insurance.
How is Universal Life Insurance Different?
Like whole life, universal insurance provides a lifetime death benefit coverage as long as you continue paying the premium. This means the full amount of your policy is payable to your beneficiaries upon your death, even if you live to 104. HOWEVER, there is a big catch here that has to do with the maturity date.
Term life is short-term insurance – usually 1- to 30 years – that provides a death benefit during the time in your life when your family needs it most.
What makes universal life unique is the built-in savings account that is part of your policy. Because of this investment feature, this type of insurance is also known as “cash value” or “adjustable” life insurance. A universal life policy accumulates cash value, earning interest at the current market rate.
In a universal life policy, you can have a flexible premium. You may choose the option of contributing extra to the savings portion of your policy each time you pay your premium (a “premium” is simply the amount of money you pay to keep your insurance policy activated.)
As the cash value of your policy increases, the savings portion can be used as:
- Premium payments
- Loan collateral
- Surrender value, if you terminate the policy.
This, of course, depends on how much you contribute and how well the investments perform. You will also have the option to withdraw from the savings like you would at a bank.
While this may sound like a great plan on the surface, let’s dig a little deeper so you can understand the downfalls as well.
How Does Universal Life Insurance Work?
Universal life gives you the option of dividing your payment into both insurance premiums and savings. The insurance company determines your minimum payment amount. It is based on the cost of your policy, the amount of your death benefit, and the administrative fees.
Once the premium cost is met, you have the option to pay more than this amount, which will go into the savings account. This is your “cash value.” The cash value will grow according to the annual interest rate set by the insurance company. There is also a maximum payment amount, which is determined by the IRS.
Premium Payments from Savings
Many people who choose universal life contribute the maximum allowed amount to build as much savings as possible. The common goal is to one day use the cash value to pay the insurance premiums.
However, if the cash value of the savings portion runs out, you may end up burdened in retirement with the increased cost of your premiums and with no surrender value left to the policy. Worse yet, when the balance goes to zero, your policy may lapse without your knowledge.
It is important to note that, while whole life has a fixed premium, universal life does not. It can continue to increase throughout the lifetime of the policy.
Using the Cash Value as Loan Collateral
The savings in your policy can be used as collateral if you choose to borrow money from the insurance company against the accumulated cash value without tax implications.
Be aware that you are not borrowing against the amount of insurance, but only against the cash value you have contributed. That savings portion is the maximum amount you will be allowed to borrow, and the insurer will set the interest rate.
Surrender Value of Universal Life Insurance
If you decide you want to surrender your insurance policy – meaning you no longer wish to make premium payments and your beneficiaries will no longer receive the death benefit – your insurer will return the cash value of the policy back to you.
So, with all these options, can this type of cash value life insurance be a good investment?
Is Universal Life Insurance a Smart Financial Investment?
The bottom line is: no. Unless, of course, you’re an insurance company.
If you are investing in universal life, you are paying a high premium for a lengthy period of time, possibly two to five times longer than you would with term life. Your premiums will increase substantially as you age. This means you could end up paying way more out of pocket than your death benefit is worth.
And don’t forget the attached fees. There are fees for the policy itself. There are also administrative fees and commissions. The reality of this is, even if you contribute the maximum, it will take you more than three years to start building any cash value.
The Big Secrets about Universal Life Insurance
Most people assume whole life and universal life policies are good as long as you live. But this definitely isn’t the case in many circumstances. Most of these policies have a “maturity date.” Simply put, the policy can end, and you could receive nothing from it, especially if you have reinvested all the cash value to pay the premiums.
“Universal life insurance policies have a maturity date which occurs when you turn a certain age (often between 85 to 121). When a policy reaches its maturity date, you generally receive a payment and coverage ends.” –ValuePenguin
Also, what happens to this cash value if you borrow it or, worse yet, if you pass away?
Well, if you withdraw any of the cash amount from the savings portion, that same amount will be deducted from your death benefit!
Worse yet, if you die, the cash value in your policy goes back to the insurance company. That’s right. Your family gets the death benefit from the insurance, but the company receives the amount you invested into savings.
What’s the Best Insurance Investment?
The best insurance investment is not to “invest” in insurance.
If you remember that the purpose of insurance is to replace your financial contribution to your family in the event of your death, it’s essential to have what your family will need to carry on, but insurance is not a financially savvy way for you to make money.
The smartest option is to buy term life insurance. You will pay a much lower premium than you would with whole or universal. Then take the money you saved on premiums and invest it in an IRA or mutual funds that are not connected to insurance. You will earn a much higher rate without the attached fees.
If you do this, by the time your term insurance policy matures, you will no longer need insurance. You should have enough in your investments to be “self-insured.” You and your family will benefit – not the insurance company.