Variable Universal Life: Flexibility at Its Best

"Buy term and invest the difference?"
"Buy term and invest the difference" is one of the most prevalent strategies consumers encounter when shopping for insurance. This approach involves purchasing lower cost term insurance (when compared to forms of permanent insurance) and investing the difference in growth-oriented products, such as stocks and mutual funds. For some, this makes sense, especially if the need for protection exists and you are on a tight budget.

Times have changed. Today, the insurance industry offers much more than just whole life and term insurance. One such product to arrive on the scene in recent years is variable universal life insurance (VUL). Variable universal life insurance combines permanent insurance protection with investment flexibility.

For the purpose of this discussion, we will examine VUL and see how it compares to the traditional "buy term and invest the difference" philosophy.

Permanent Protection and Much More
VUL offers permanent insurance protection, usually through age 95. Simply put, this means that as long as you meet the policy costs, you are guaranteed protection. Some term insurance products periodically require proof of insurability to continue coverage. While there are term products that can cover you for life without additional requirements, their rising costs can make them prohibitive.

Additionally, while all term insurance is purchased with after-tax dollars, VUL has the potential to satisfy its policy costs with pre-tax dollars (policy's cash value accumulates on a tax-deferred basis), further strengthening the VUL strategy.

At first look, term insurance may seem attractive because you can purchase large amounts of coverage at a relatively inexpensive price. But, the cost should not be the only consideration that goes into your decision making process. For instance, consider the impact of becoming uninsurable at the end of the term period due to a health condition. You may save a few dollars today, but the eventual cost of uninsurability may be the death benefit your beneficiaries will never receive.

Permanent protection also offers a host of policy riders that can further enhance the effectiveness of your policy. Term insurance provides a much more limited range of riders.

Cash Value Accumulation
You can also allocate a portion of each VUL premium to one or several investment divisions, or a fixed-rate general account option. These investment divisions typically include stock, bond, balanced, international, and money-market portfolios. Earnings within the investment divisions will vary with market conditions and your principal may be at risk. Premium payments plus investment earnings, less policy fees and charges, serve as your policy's cash value. Usually, you can allocate as little as 1% of the premium to any of the investment divisions in a VUL policy. It should be noted that a decrease in your policy's cash value may decrease the overall amount of insurance coverage.

Term insurance has no cash value. You do have the option of "investing the difference" in growth-oriented products, like mutual funds. The value of your mutual fund account will vary with market conditions. Your principal may be at risk and, in most instances, mutual fund earnings are taxable each year. This means that you have less money working towards achieving long term goals. Most mutual funds also require a minimum dollar amount to participate in a particular portfolio.

Investing in vehicles like mutual funds is still a solid strategy to follow. But you have to have the discipline to carry this out. If you neglect to put money aside for the future, the "buy term and invest the difference" strategy collapses. Without the 'invest' portion, you are left with a term policy that is incapable of accumulating funds for the future.

Meeting Today's Changing Needs
Should your insurance needs change over time, VUL usually provides the flexibility to increase or decrease your amount of coverage. ¹ You can also make a lump-sum payment to increase the policy's cash value. (The maximum lump-sum payment is subject to IRS limitations.) And, should an emergency arise and you are short on cash, you may be able to skip a scheduled payment and let the accumulated cash value cover the policy's expenses. Keep in mind that the cost of insurance and administrative expenses are still incurred.
1 To increase coverage, you may need to provide satisfaction evidence of insurability or meet other applicable underwriting requirements.

With term insurance, the cost for protection is lower. However, you cannot change the policy's face amount and must meet every scheduled premium payment or risk losing the insurance protection.

As your insurance needs change, it is quite probable so will your long-term investment goals and risk-tolerance levels. With VUL, you have flexibility to transfer funds between the investment divisions, tax free.² So, you have the freedom to make decisions based on your needs and not on the tax ramifications.
2 Many VUL policies restrict transfers from a fixed account to the investment divisions.

Tax Issues
Previously, it was noted that the earnings in VUL's investment divisions accumulate on a tax-deferred basis. By deferring current income taxes, your money benefits from the power of compounding. Most VUL policies permit policyowners to access almost all of the cash value via a policy loan provision. Usually, policy loans are tax free, but the overall amount of insurance coverage may decrease due to any outstanding loan balance.

Mutual funds are more liquid investments. There are no loan privileges and withdrawals of earnings may be subject to deferred sales and current income taxes. VUL policies may also charge a surrender charge for withdrawals. In addition, the tax treatment given to funds in a VUL policy is on a first-in, first-out (FIFO) basis. This is advantageous should you wish to create a stream of income at retirement. One potential option involves receiving withdrawals until reaching your cost basis, then changing the method of withdrawals to policy loans. Partial withdrawals are at net asset value, which may be more or less than the original price. Withdrawals may be taxable and, if under age 59 1/2, may be subject to a tax penalty. Assuming the policy has been in force for at least fifteen years and remains in force through death or maturity, this arrangement would avoid a taxable event on the funds withdrawn⁴. Remember that policy loans on withdrawals will reduce the policy's cash value and death benefit.³

3 Partial withdrawals are at net asset value, which may be more or less than the original price. Withdrawals may be taxable and, if under age 59 1/2, may be subject to a tax penalty.

4 Upon surrender, a taxable gain will be recognized, however, to the extent the outstanding loan basis exceeds the policy's basis.

The tax treatment given to dollars in a mutual fund is on a last-in, first-out (LIFO) basis. This places mutual fund owners at a distinct disadvantage when trying to access account values.

Death Benefit Proceeds
Protecting loved ones is one of the fundamental reasons for purchasing any type of insurance. Both VUL and term insurance policies offer a death benefit. And, both policies can be structured so your beneficiaries receive the proceeds estate and income tax free. Keep in mind that any portion of the 'invest' component not used in one's lifetime may be subject to both estate and income taxes. As a result, your beneficiaries may receive a lesser amount than originally anticipated.

Other Issues to Keep In Mind
In addition to the above comparisons, keep the following points in mind:

• You can use VUL's cash value as collateral when applying for a bank loan. This does not hold true for term insurance, as it does not have a cash value component.
• Generally, creditors cannot reach a permanent life insurance policy's cash value. This does not hold true for mutual funds.
• VUL's death benefit (which may include tax deferred accumulations) is free from probate. This does not hold true for mutual funds.

Make an Informed Decision
For some, the "buy term and invest the difference" philosophy is appropriate. For others, the flexibility and control of VUL may prove to be an attractive alternative. The key is to fully research both strategies and make a decision that best suits your needs.

VUL policies are sold by prospectus only. Investors are asked to consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. Both the product prospectus and the underlying fund prospectuses contain this and other information about the product and underlying investment options. You should read the prospectuses carefully before investing.

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