Benefits and Drawbacks of Variable Life Insurance

In a recent exchange within our family chat group, my uncle stirred up quite a reaction by disclosing that he continues to make monthly payments for his life insurance premiums. This revelation came as a surprise, considering he is well into his 60s and retired nearly a decade ago. Given that he no longer relies on a regular income, the question arises: what purpose does this ongoing investment serve? Has he been squandering his funds over the past ten years? Eager for clarification, we probed him for further information. It turns out that he maintains this policy because it is a variable life insurance plan that he purchased many years ago. By consistently contributing to the plan, he can potentially enhance the death benefit payout. This revelation prompts us to ponder: what exactly distinguishes a variable life insurance policy?

In contrast to standard life insurance policies, where a fixed monthly premium is paid and beneficiaries receive a predetermined death benefit if the policyholder passes away during its active term, variable life insurance policies offer greater flexibility. Not only can policyholders adjust the premium amount they pay, but they also have the opportunity to allocate a portion of their premium towards investments tailored to their preferences.

A variable life insurance policy comprises two main components: the death benefit and the cash value. While the death benefit remains fixed and operates similarly to term life insurance, the cash value component is where the policyholder can actively engage in investment decisions. A portion of the premium is allocated to a cash value account, providing the policyholder with the autonomy to choose from a range of investment options offered within the policy. Similar to managing funds in a 401(k) plan, policyholders can allocate and reallocate their investments according to their financial goals and risk tolerance.

As a type of permanent life insurance policy, a variable life insurance policy offers the flexibility to pay premiums for a limited duration, leveraging potential investment gains to accumulate cash value. This accumulated cash value can then be utilized to sustain the life insurance policy indefinitely. In addition to this primary advantage, there are other notable benefits associated with this arrangement.

The flexibility extends to the monthly premium, as previously mentioned. It’s conceivable that you could make payments for a set duration and then maintain a life insurance policy indefinitely without further financial commitment. This flexibility also offers additional advantages. For instance, if you encounter a period of reduced income due to unemployment, or if you have a major expense like remodeling your kitchen and wish to minimize reliance on savings or credit cards, you can adjust your premium payments accordingly. Since the monthly payment for maintaining a variable life insurance policy is not fixed, you have the freedom to tailor your obligations to suit your circumstances. However, it’s essential to ensure that your cash value is sufficiently accumulated to cover any reduction in premium payments.

One of the key attractions of variable life insurance policies is the tax-free growth of the cash value within the account. This means that regardless of the growth rate or the income generated by the invested funds each year, you can enjoy the benefits of tax-free accumulation.

You have the option to take out a tax-free loan from your policy, providing you with access to the cash value portion for your needs. While you may not be able to withdraw the entire balance, you could potentially access up to 95% of the accumulated amount, allowing for significant utilization. Although interest is charged on the loan, it typically remains at a relatively low rate.

Variable life insurance, despite its advantages, isn’t without its complexities. Combining a death benefit with an investment component can appear intricate, and there are several other factors worth considering before making a purchase.

The expenses associated with a variable life insurance policy can be considerable. Before opting for such a policy, it’s crucial to thoroughly evaluate all the associated fees and costs. From the outset, a portion of your policy’s benefit is deducted to cover sales and administrative fees, which go towards paying the agent’s commission. Consequently, it may take some time before any significant accumulation occurs in the cash value portion of your account, essentially starting with a negative cash value balance from the outset.

In addition, there are investment management fees to consider, akin to the expense ratios of mutual funds and ETFs. These fees can vary, but some options may cost more than equivalents available to investors in a standard brokerage account.

Another concern is surrender charges. While you can withdraw your cash value as a loan, you might be subject to surrender charges for up to 10 to 15 years of your policy. Even if you decide to relinquish your policy during this initial period, you’ll still be required to pay the surrender charge.

These are the major fees to take into account, but there may be other charges as well. It’s essential to carefully review your contract and ask your agent any questions you may have to ensure a thorough understanding of the terms and commitments involved.

Variable life insurance policies may not be favored by many, and there are valid arguments against them. For most individuals, opting for a standard life insurance policy and managing their tax-free investments separately might be a more prudent choice. Given the high fees associated with variable policies, it could even be more advantageous to invest any remaining funds in a taxable account and cover yearly taxes from investment gains and income.

However, there are potential benefits to investing through a variable life insurance policy. While the investment menu for your cash value is typically limited to mutual funds, this structure discourages frequent trading and emotional decision-making, which can be detrimental to long-term wealth accumulation. Although some individuals successfully time the market, the majority fare better by adopting a hands-off approach to their investments.

Ultimately, whether variable life insurance suits you depends on your financial discipline and investment preferences. While some may thrive with minimal intervention, others may benefit from the structure and guidance provided by such policies, even if it comes at a cost. Assessing your own financial temperament will help determine the most suitable approach for your circumstances.