Second in a series.
Go permanent, or “buy term and invest the difference”? This question goes to the core of the term-vs.-permanent life insurance debate, and there is no easy answer. Whether a permanent policy is appropriate for you or not depends on many things, including your discretionary income, your tax bracket, your spending/saving habits, and your reasons for buying life insurance in the first place.
If you decide that a permanent policy is right for you, then you have another set of decisions on your hands. There are many types of permanent life insurance policies, and the differences between them can be significant.
What’s the same?
Before we get into the differences between policy types, let’s detail what is similar between all permanent types of life insurance. All permanent policies are designed (key term, remember that later) to last forever, they all accumulate at least some cash value which the policyholder can access, and they all are more expensive than an equivalent term policy. However, the similarities end there.
Until the late 1970s, the only alternative to term insurance was whole life. Everything about a whole life policy is 100% guaranteed to remain the same forever, assuming the policyholder continues to pay his or her premiums: death benefit, premium, interest rate, etc. The day you purchase a whole life policy, you can see the exact amount that the policy’s cash account will be worth at any point in the future, and the number is guaranteed to never change. On the flip side, your premiums are also inflexible, so if you miss a payment or two, be prepared for some threatening letters from your insurance company.
Whole life’s biggest advantage, its absolute guarantee, can also be its biggest disadvantage. In the late 1970s and early 1980s, as interest rates skyrocketed, whole-life-policyholders asked themselves, “Why should I continue paying premiums on this policy which is paying me 4% interest, when I can get 12% from a savings account?” The insurance industry responded with a new policy called “universal life” (UL). Like a whole life policy, ULs are designed to last as long as the policyholder lives. Unlike a whole life policy, however, a UL has a variable interest rate, which adjusts to market conditions.
Just like anything, ULs have some distinct advantages and disadvantages as well:
Pros: Variable interest rate will not lag the market; premiums are flexible (you can miss payments and not have to worry about your policy lapsing, especially if it’s been around for a while); interest rate will not drop below a certain contracted minimum.
Cons: If the policy is purchased while interest rates are high, the illustrated premium may not be enough to keep the policy in force if interest rates drop. Translation: the policy may not last as long as you live (which kind of defeats the purpose of a permanent policy to begin with) unless you pump extra money into the policy later. Any illustration you get with the policy is only an estimate, and your agent should make that fact very clear.
Variable Universal Life
In the mid-to-late 1980s, and interest rates came back to earth and the stock market took off, people began to abandon their (now) low-interest UL policies and dive into the stock market, where they saw the potential for big money. Insurance companies then developed a new product called “variable universal life” (VUL). The word “variable” in the title is a tip-off that this product is a registered security—it can only be sold by licensed financial advisors who have passed at least two securities exams in additions to their insurance license. In a VUL, the cash value portion of the policy is invested in “subaccounts”—basically a fancy name for mutual funds. The financial advisor helps the client put together a (hopefully) diversified portfolio of funds which are designed to generate a certain rate of return over time.
All of the pros and cons which apply to regular ULs apply to VULs. In addition, however, there is the additional caveat that goes into any kind of stock market investing. The market has unlimited potential for growth. However, the market also has unlimited potential for losses, and the last thing a person needs is for their life insurance policy to run out of money because 2008 happened again.
Indexed Universal Life
In response to the 2008 crash and its aftereffects, the non-variable UL (and even the whole life policy) has made a bit of a comeback, especially among seniors and baby boomers. However, there are still policyholders (and agents) who loved the potential of the VUL, even if they were not thrilled with the idea of stock market risk. For those clients, the industry has created “indexed universal life” (IUL).
IULs calculate the interest rate by measuring the performance of a preselected stock market index (or several indices), such as the S&P 500, the Dow Euro 30, the Hang Sang index, or others. If the index grows over the course of the year, then that rate of return (or a predetermined portion thereof) is credited to the account. If the index goes down, then no interest is credited to the account, but no value is lost. IULs have the advantage of regular ULs in that they will never lose their cash value because of a stock market crash, while still keeping some of the upside of VULs in good stock market years.
Life insurance as an investment
Is life insurance a good investment in general? Good question. Next time….