Most people shopping for life insurance are proposed two types: term life and permanent life. Term life insurance is pretty straightforward and easy to understand; permanent life insurance comes in various types, with each having a different way of accumulating savings over time.
One popular type of permanent life insurance is universal life. It’s a flexible life insurance policy that combines death protection with a cash value element. One of the most attractive features to those evaluating universal life is the flexibility of its payment structure — the policyholder can increase or decrease the amount they pay towards premiums. If you decide you want to have a lower premium, you have the difference withdrawn from your policy’s cash value.
Compared to term life insurance, universal life insurance is more expensive, but it’s a good fit for someone that values flexibility and is willing to pay more for it. Because of its higher cost, people with larger incomes gravitate towards it because it has a cash value component and is comparatively lower in price than another type of permanent insurance — whole life insurance.
Because of its complexity, many people select term insurance when comparing the two side-by-side.
Universal life insurance was prevalent in the 1980s when interest rates were high, and people wanted to take advantage of the tax-deferred growth of a life insurance policy’s cash value. Because of the feature allowing the policy’s cash value to pay the monthly premium, people bought policies with large face amounts and significant premiums because their cash value was growing fast enough to keep up with and pay for the large premiums.
But, history repeats itself, and the high-interest era came to a rather abrupt end when interest rates dropped, leaving those people that expected their cash value growth to pay their premiums in a precarious position — their cash value was dwindling, and they could no longer afford the high premiums. Because of this, many universal life policyholders had to let their policy lapse and ended up with no cash value, no death benefit for their heirs, and nothing to show for all of the premiums they had paid.
Consumers and life insurance agents learned a valuable lesson about universal life: use conservative interest rate projections when showing prospective buyers the potential growth of their cash value.
The cash value of universal life insurance grows tax-deferred, which is attractive to many people. As the portion of their life insurance premium that increases the cash value earns a small amount of variable interest, no income tax is due from the policyholder on that growth. While they’re alive, the cash value can be used to:
- Pay the policy premiums
- Withdraw cash, but with additional fees
- Take out a loan, which must be paid back with interest
Sold properly, universal life can be a good fit for some people. For those who have a fluctuating income but want the benefits of cash value accumulation, universal life works well because of its flexibility. For example, a commissioned salesperson that experiences a slowdown in business during the winter months would find universal life appealing because they could use the cash value to pay the premiums during those months.
However, for a universal life policy to build enough cash value to pay premiums, the policyholder will have to be patient. Because of the fees and commissions associated with universal life, it takes years for the accumulated cash value to be significant enough to pay the average premium.
Additionally, someone who used their cash value to pay their premiums might be forced to resume paying the premiums themselves if the policy’s investments underperform.
Another feature of universal life that is attractive is it comes with a choice of death benefit types when you apply for the policy.
Death benefit option A
Death benefit Option A pays a policy’s beneficiaries like term insurance and whole life insurance do. The face amount of the policy, less any outstanding policy loans, is what the policy’s beneficiaries will receive. Any cash value in the policy is forfeited to the insurance company.
Death benefit option B
Death benefit Option B pays the face amount of the policy, less any outstanding policy loans, and pays them the cash value of the policy. For this added advantage, the premiums for a policy with Option B are higher than those for one with Option A.
The interest earned on the cash value of a universal life policy is determined by the life insurance company and will fluctuate depending on market performance. The insurance company sets the interest rate and typically puts a floor on the rate for low-interest rate environments and puts a cap on gains during times of high-interest rates.
For many people, having their gains limited by being capped by the insurer means universal life isn’t the best option for saving money for the future. While they won’t lose any money due to the floor capped at 0%, they have potentially larger gains available to them through other types of investments, like an IRA or 401(k).
For example, an insurer may set the rate of return on a policy at 2%, while the rate of return on the IRA or 401(k) could be 7-10% if it matched historical stock market averages. For this reason, many financial advisors recommend that their clients buy term life insurance and invest the difference.
There are four types of policies that fall under the universal life umbrella.
Indexed universal life insurance
Indexed universal life insurance provides policyholders the opportunity for gains tied to a stock market index and is often added by people to their investment portfolio. There is a minimum guaranteed interest rate, which gives the policyholder the benefit of never losing money.
Learn More: Indexed Universal Life Insurance
Variable universal life insurance
Variable universal life insurance invests in mutual funds that can increase or decrease the cash value. There is a mix of conservative and aggressive mutual fund choices. People buy variable universal life insurance generally because of the potential gains the stock market can bring them.
Learn More: Variable Universal Life Insurance
Fixed universal life insurance
Fixed universal life insurance provides reliable cash value growth tied to a fixed interest rate. People looking for flexible premiums with guarantees gravitate towards this type of universal life policy.
Group universal life insurance
Group universal life insurance is offered to a group of people at a lower cost than what is typically offered to an individual and is commonly purchased by corporations as a benefit for their employees
Learn More: Group Life Insurance
Universal life insurance, like any type of insurance, has its fans and critics.
Pros of universal life
For high earners needing an additional means of tax-deferred savings because they’ve maxed out those available on their tax-qualified retirement accounts, universal life has some distinct advantages:
- It lasts the policyholder's entire life
- The accrued interest rate does not drop below 0%
- Cash value grows tax-deferred
- Premium payments can be decreased as needed
Cons of universal life
Many people find that the negatives of universal life outweigh the positives.
- It’s substantially more expensive than term life insurance
- The cash value is capped at a relatively low interest rate
- The cost of the life insurance portion of the premium increases over time
- Relying on cash value to pay premiums can result in a policy lapse
- The policy requires active management by the policyholder because of its fluctuations
Similar to universal life insurance, whole life insurance provides coverage that lasts a lifetime. The biggest difference between the two is cost. Whole life is usually the most expensive type of permanent life insurance policy because of the policy’s guarantees:
- Premiums are guaranteed not to change
- The death benefit is guaranteed
- The cash value has a minimum guaranteed rate of return
Whole life is the best choice for those who like predictability and are willing to pay the price.
Additionally, many whole life insurance policies pay dividends. They’re not guaranteed, and they can be used to pay premiums, added to the policy’s cash value, or taken by the policyholder.
Term life insurance offers a pure death benefit, and there is no cash value involved. Coming in terms lasting 5, 10, 15, 20, 25, or 30 years, it’s the least expensive life insurance available. You can outlive the policy, which is why it’s a good idea to match the term life policy with the length of time the coverage is needed, like when you purchase a home with a mortgage.
Considering the cost, most people find they benefit more by purchasing a term life policy and investing the difference in premium into an IRA, 401(k), or another type of traditional investment, like the stock market or real estate.
Universal life is a good value for individuals in higher tax brackets when used as a tool to pay estate taxes, grow savings tax-deferred, and provide financial security for loved ones.
A financial planner or life insurance agent can help you determine which type of life insurance policy is best for you and if a universal life insurance policy will fit into your financial plan. Each person’s situation will dictate which type of policy is right for them — one size doesn’t fit all when it comes to life insurance.
Having grown up in upstate New York, Bob Phillips spent over 15 years in the financial services world and has been making freelance writing contributions to blogs and websites since 2007. He resides in North Texas with his wife and Doberman puppy.
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