By Grant Bledsoe, CFA, CFP® of Three Oaks Capital Management, Guest Writer
A fundamental concept of personal finance that Dr. Dahle and I share is that insurance and investing do not mix. Insurance companies are famous for creating products meant to be “all-in-one solutions” for your financial needs. Whether you’re seeking life insurance to reduce mortality risk, a tax-deferred savings vehicle, guaranteed income, or any number of other things, rest assured that there is a complex insurance product available to meet your needs.
The catch, of course, is that the more bells and whistles in an insurance contract, the more expensive it tends to be. And in the vast majority of circumstances, you’re better off purchasing the least costly insurance policy you can find to meet your risk management needs and keeping your investment portfolios completely separate. While there can be compelling tax advantages to insurance-based products, those benefits are usually negated by the costs.
As a case in point example, I have a physician client who was formerly working with a financial “advisor” at a national insurance-rooted financial firm. As you can probably guess, this person made most of their living selling investment and insurance products on a commission basis.
If you’re a devout (or even casual) reader of the site, you know that this type of compensation structure leads salespeople to come up with creative ways to sell insurance-based products. In this circumstance, the person they were working with recommended that they fund a variable universal life insurance policy (VUL) as a “personal deferred comp plan”. The rep positioned the idea as a way to provide a death benefit to cover mortality risk while offering a tax-free savings vehicle for retirement and their kids’ college tuition.
My client’s objectives are pretty typical for a mid-career parent: extinguish student loans in the least costly way, utilize income efficiently, max out tax-advantaged savings, put away some money for the kids’ college, etc.
Is a “personal deferred comp plan” via VUL a legitimate way to accomplish these objectives? It can work favorably given a very specific set of circumstances. But in my experience, those circumstances are quite rare, and in my client’s case, there were far better options. This post will explore why.
Is Variable Universal Life a Good Investment?
Taxation of VUL
With a VUL policy, your premium payments cover the cost of life insurance, the selling agent’s commissions, and the insurance company’s costs and margin. After those are accounted for, whatever is left goes toward a cash value. Being a “variable” policy, you can invest the cash value in a selection of mutual fund-like subaccounts.
The value of the policy will grow over time, as long as you continue making premium payments and have positive investment returns. This investment growth is tax-deferred until you take withdrawals from the policy. If you die prematurely, your beneficiaries are entitled to the death benefit. If you don’t, you can pull money out of the accumulated cash balance later, presumably in retirement. Hence the positioning as a personal deferred comp plan.
The taxation of VUL policies is their primary advantage. The IRS considers withdrawals to come out basis first. That means you can withdraw up to the total amount of your contributions to the policy tax-free. Once you’ve retrieved your basis in a policy, all that’s left is investment growth. Withdrawals from growth are added to your taxable income for the year.
This is where the “tax-free savings” claim comes into play. Rather than withdraw funds from a variable policy directly, a popular way to avoid taxation is to take them as loans against the accumulated cash balance. VUL policies allow you to borrow money from the insurance company, using the policy’s cash value as collateral. Policy loans accrue interest (usually at a reasonable rate) but are not taxable as income.
So, if structured properly, a VUL policy could be used as a tax-free deferred comp vehicle. You’d put money into the policy now and let it grow tax-free until retirement. When it comes time to take money out, withdrawals up to your basis come out tax-free. All others are technically loans, which are also tax-free. Plus, you’d have the death benefit in the meantime if you died prematurely.
Disadvantages of Variable Universal Life Insurance
VUL Policy Lapse
One problem with this strategy has to do with when and how the policy terminates. If you die while the policy is active, the insurance company takes the collateral you’ve pledged (the actual cash value) to close out your loans and pays any death benefit left over to your beneficiaries.
But if the policy lapses before you do, there can be significant tax implications. If your policy’s value exceeds your total contributions, you’d have a gain in the policy. This gain would be taxed as income, just as if you’d taken a direct withdrawal.
What’s worse, if a VUL policy lapses with outstanding loans, the total loan balance is immediately taxable as well. And if you’re using a VUL policy as a tax-free deferred comp vehicle, you’d likely have a significant loan balance over time. In my client’s case, the policy illustration showed a balance of $1.8M in the year they turned 80. That could be a massive tax bill if things don’t go well.
The most common reason a VUL policy would lapse is if there’s not enough cash value left to pay policy expenses. Remember, this cash value is subject to volatile market performance just like any other investment. So, if you took a significant amount of money out of a VUL policy before experiencing negative investment returns, it’s possible the policy could be at risk of lapse.
Realistically you’d have a couple of options to keep the policy in force if it were at risk of lapse. The easiest would probably be to reduce the death benefit, as doing so would also reduce the policy’s annual costs. Of course, you’d need to prove insurability again if you needed to increase the death benefit again in the future.
You could also make additional contributions and just cover the policy costs out of pocket. Personally, this option would be unappealing. I’d hate to be backed into a corner and forced to pay a rising annual VUL policy fee just to avoid a huge tax bill.
Investment Limitations
While tax-deferred growth is attractive in VUL policies, you’re limited to the investment options offered by the policy. My client’s policy offered 75 different choices, including risk-based portfolios, target-date options, and a few index funds. Unfortunately, the annual operating expense of the investment choices (including the index funds) ranged from 0.5% to 2.6% per year.
There are policies around now that offer decent investment lineups, including low-cost index funds and/or DFA options. This policy was not one of them. But even if you did have a stellar investment menu now, the selection could be limiting in the future. If some attractive new asset class is popularized 10 or 15 years down the road, the insurance company would need to formally add it as an option before you could invest. I don’t know any VUL policies today that list peer-to-peer lending or venture capital as investment options, for example.
Cost of Variable Universal Life Insurance
In my client’s case, the policy was structured for seven years of $50,000 annual premium payments, at which point the policy would be fully funded. Of the $50,000 year one premium, $6,866 went toward various administrative and insurance fees, leaving $43,134 in cash value before any account growth. This didn’t include the operating expenses of the investment options.
This particular policy offered a feature that recoups a portion of these initial costs if the policy was surrendered in the first 14 years. Even with this feature, the return in the first few years of the policy is very low. Assuming a 6.5% net return on the investment options, the policy illustration showed an ROI of:
- 3.91% after year 1
- 3.08% after year 2
- 2.60% after year 3
Low policy returns in the first few years of a contract is a common characteristic and huge drawback of VUL. In my client’s case, the illustrated returns were low throughout the contract. By year 30 the net return to the policyholder was only 4.98% per year, thanks to the annual increases in the cost of insurance. Even in the highest tax bracket, I’m confident a taxable account would perform better over the same time horizon if invested properly.
Compensation to Life Insurance Agent
Lastly, insurance agents make a killing when selling VUL policies. Depending on the company, VUL commissions payable to insurance agents generally range from 70% to 100% of total first-year premiums. And remember, in my client’s case they’d be contributing $50,000 per year for seven consecutive years. Do that math on that, and it’s not hard to see why these products are sometimes sold unscrupulously. And aside from the agent’s perspective, the fact that insurance companies are willing to pay up to 100% of year one revenue tells you how profitable (i.e. expensive) they are over the life of a policy.
Can VULs Work As a Deferred Comp Plan?
Sure, theoretically. But a lot of things would need to go right for a VUL policy to result in a better outcome than buying term insurance and investing the difference. You’d basically be betting that the good (the total tax benefits) offered by a VUL policy will outweigh the bad (the extra costs) over the rest of your life. For this to be true several different stars would need to align:
- You’d need to be in a high tax bracket. Or expect future tax rates to skyrocket, based on our national debt level or some other reason.
- You’d need to already be maxing out your contributions to all the tax-advantaged retirement account options available to you. The benefits of these accounts will trump the benefits of VUL policies any day of the week after costs.
- You’d need to find a policy that offers solid, inexpensive investment options. You’d probably be using them for a very long time.
In my experience, it’s quite rare to find a situation where variable universal life would be a good fit as a retirement account or personal deferred comp plan. For my client, surrendering the policy was a far better option. They weren’t maxing out contributions to their 401(k) or utilizing a 529 plan, yet they were able to obtain a term policy to replace the death benefit, and there were no surrender charges for ditching the VUL.
Is VUL Worth It?
Moral of the story? Proceed with caution when considering variable universal life. If you’re evaluating a policy as a retirement account or personal deferred comp plan, you’re probably better off separating your insurance and investing vehicles.
Have you been sold a VUL as a retirement account or personal deferred comp plan? Do you think doctors are starting to get wiser about not buying insurance that they don't need? Comment below!
[Editor's Note: Three Oaks Capital Management is a paid advertiser and a WCI Recommended Financial Advisor however, this is not a sponsored post. This article was submitted and approved according to our Guest Post Policy. I have written about variable universal life insurance policies many times in the past. While there are endless variations of cash value life insurance policies, the general principles are the same—an expensive life long insurance policy combined with some sort of cash value/investment feature that can be borrowed against or that provides cash (gains fully taxable at ordinary income tax rates) if the policy is surrendered. For a sampling of bad experiences with cash value policies, check out this thread on the forum. It would behoove anyone considering buying one to read that entire thing, especially if you are under the misconception that these are good investments. As always, if you really understand how these work and still want the policy, knock yourself out. But if you're like most readers, once you realize how they work you won't want one, even if you already own it.]
I sat down at lunch a month or two back and had a conversation with someone who made a living selling whole life insurance products like this. After poking holes in it for an hour, I asked this financial advisor two questions that I found enlightening when answered:
First, I asked, “How often do you think someone would outperform a whole life policy if they got term and invested the difference in a taxable account with diversified index funds?”
His honest answer, “Probably 100% of the time.” His argument, though, was that most doctors are not disciplined enough to do this… so, instead of educating them about financial discipline and the need to fill up tax-advantaged space and then filling up a taxable account….he thought selling them a forced WLI product was the better alternative.
Second, I asked, “What percentage of doctors do you think need a whole life insurance policy?”
He said, “100%. Every single person needs one.”
This one surprised me, because he genuinely believed it. It blew my mind given his honest answer to the first question.
Come to find out he liked to use WLI as his version of “fixed securities” that would be safe to withdraw from in retirement. He had zero percent of his portfolio (and it sounds like many of his client’s portfolios) in bond index funds or in municipal bonds, TIPS, or treasury bills . Or really any other more secure investment options. His WLI policy took the place of these.
They do a great job of making these products sound incredible. And anyone who is approached about one should do an equally impressive job vetting them before they turn them down.
TPP
I think that’s a lousy argument. If you aren’t disciplined enough to fund an IRA/401(k)/taxable account for decades why would you be disciplined enough to fund a whole life insurance policy and not borrow against it? Those are the people who cash out or surrender their policies (usually with a loss) early on. You’re not helping them. In fact, the low returns make it less likely that they’ll stick with the plan.
I also see WLI as not at all equivalent to bonds. For example, what is the expected return on bonds in their first 5 years? Well, it’s positive. What is the expected return on whole life insurance in the first 5 years? It’s negative. That’s not the same thing. They’re not equivalent. Sure, if you hold on to a well designed (and most aren’t) whole life insurance policy for 5 decades, you’ll end up with a bond-like return (usually 1-2% lower). But that seems like a silly reason to buy a policy when you could just buy bonds.
I’ve covered both of those arguments in my myth series, but I’m not surprised to see someone who sells these things actually believes them. As Upton Sinclair said, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”
https://www.whitecoatinvestor.com/debunking-the-myths-of-whole-life-insurance/
Haha. That’s a great quote (by Upton Sinclair). I’ve never heard that one before.
And, I agree. The arguments that were made simply didn’t hold water. That didn’t prevent him from believing it for the reasons that you alluded to in your response and your post.
TPP
Another good post showing the benefits of separation of insurance and investing.
Unrelated side note- Any idea why this post was not emailed out this morning?
Good question. I’ll look into it. It’ll likely go out tomorrow in addition to the podcast show notes published tomorrow morning.
At first I thought there was no post today but I happened to swing by to check the forum and saw it on the homepage. I remembered when all those issues happened with everything going to spam last fall. I thought it was something like that but nope not in spam.
Best of luck figuring it out. I look forward to my morning reading.
I think the RSS feed was wonky this morning. I didn’t post to the RSS feed until 0400 and I think the email goes out with all new RSS content at 0200. I suspect you’ll all get two emails tomorrow morning. We’ll see.
I had a problem with my email not going out today, too. I had to set up a new email with the same RSS feed. Not sure why that happened. I use Mail Chimp. My posts go live at 0400 and the email is usually sent at 0500 EST.
Not sure if it is related.
I was sold one of these a few years back, soon after finishing training. (Despite my better half’s objections and concern about putting so much money away every month towards it, I decided to do it.)
About 4-5 years in, as I got more financially literate, I saw that it was a pretty crummy “investment” and started to do quite a bit of research into it and how to get out of it.
Where I ended up, however, was to just keep it for the time being. At that point, I had already put in >$200,000, and my surrender charge would be ~$50k. After I saw that, I couldn’t quite bite that bullet, so looked into it some more, ran some more numbers.
What I ended up doing instead was to optimize the policy that I had. I sold all of the high expense funds and consolidated into a handful of more diversified and cheaper funds. Also, I looked into how much a term policy would cost me at that point, and that yearly premium was a couple thousand for the same death benefit. By keeping the VUL, I was just getting those premium payments that I would have to make towards a term policy “waived”. I stopped making any further contributions to the VUL. I had them run some illustrations for me, with no further contributions, 4-5% predicted returns, other conservative parameters, etc. and found that the policy likely wouldn’t default for 20-30 years.
I had unknowingly overfunded the policy, but now, those funds had appreciated enough to cover the M&E charges and insurance charges. Sort of like building a nest egg and withdrawing 4%, the >$200k that I had put in was sufficient to cover the annual fees for long enough time (hopefully) for me to be financially independent. Then, at that point, I would no longer have a surrender charge and then would do a 1035 exchange. Fortunately, these last few years the market has kept up with expenses in the VUL. If the market takes a turn down, then the VUL cash balance would suffer, so I have to keep a periodic eye on the cash balance.
I wouldn’t get the VUL policy again, if I could go back in time. But, just as an example as someone who was sold one, and ended up keeping it instead of cashing out.
Sounds like you just kind of overpaid (and up front) for term life insurance. You’re still planning to dump it long before your expected life expectancy.
I don’t know if your decision to keep it was right or wrong, it just sucks to have to make that decision at all.
Not to mention the jerk who sold it to you that didn’t even get you into the best investments in it. I mean, that wouldn’t have even lowered his commission.
I am kind of like DFUN. I am 8 years into a VUL that my wife forced me to purchase against my objection. The market for the past 8 years has allowed our premium contributions to pay back the upfront expenses and the cash value is currently even with our contribution. In 2 more years, the surrender premium goes away, and at that time, it looks like keeping the policy would be cheaper than letting it self-fund and eventually lapse. Looking at term policies 10 years later doesn’t appear that we save too much money going forward.
I would not do it again, but here I am, and it may not be all bad once you get past the sunk costs.
Agreed. The decision to keep is different from the decision to buy. Good luck with it. Hope it works out well for you.
This exact thing happened to me. I am doing exactly what you are doing as well. I was too busy with my practice and did not think that an agent for my hospital group would steer me wrong. Lived and learned. In retrospect, I would have just got term life and invested in a taxable account after maxing 401k, 457b, 401a and backdoor roth.
After maximizing those tax deferred accounts, would investing in variable life insurance (pros: tax benefits, cons: premiums, agent costs, poorer growth) be similar to a taxable account (pros: better growth, cons: taxed)?
It certainly compares better than to a retirement account. But only you can decide if it is better for you. This article should help though:
https://www.whitecoatinvestor.com/variable-universal-life-insurance-as-a-retirement-account/
Would these policies permit one to pay a small premium in year one, when the commissions are extracted, and up the premium later? Or do they simply take out the same commission amount no matter when it is paid?
If the commission is simply based on whatever is paid in year 1, then one might be able to make the performance better through this approach.
Still hard to see this as worthwhile even for those who are maximizing their retirement plans and college savings. Hard to see the fees working even if one were able to find a, relatively, low expense ratio index fund.
For people who are decades into these policies and taking loans, they should be able to reduce the market risk by shifting the portfolio to short term bonds.
No, it doesn’t work that way.
With whole life you can maximize the use of Paid Up Additions (which have a lower % commission) to increase the returns and I suspect you can do something similar with VUL, but you’d have to talk to someone who sells them to see how easy that is to do. Obviously it isn’t to their benefit to do so (since it lowers commissions) so most policies don’t do that sort of thing.
Dear White Coat Investor:
You seem so hung up on and mad that an agent in this business makes commissions selling these products.
Your outlook about these products seem very bias and negative. If you don’t personally like them, that’s your choice and business. However, to paint everyone who presents these products to their clients in order to help solve a legitimate dilemma as illegitimate and thieves is not only grossly unprofessional, it’s also creepy and makes you out to be plain bitter bc someone else is taking a slice out of your business. Go educate yourself some more in stead of talking trash!
What’s the legitimate dilemma you think a VUL solves? And how would someone selling more VULs take money out of my business? What business do you think I’m in? If anything, it COSTS me money to not promote VULs because I could sell ads to VUL salespeople (like yourself?)
Just a little error. You say that $6,866 went towards insurance and administrative fees, and than you went on to say the insurance agent got 70-100% of the 50k premium. It sounds like a overfunded policy.
The agent in this case probably got paid comission only on the first 6800. On the other 43k the comission is like 2%.
If someone ‘wants’ permanent insurance and the tax benefits and it’s structured right with over funding, why isn’t it good?
Don’t compare it to term. Term is just that, for a term it doesn’t help you the day after the term.
https://www.whitecoatinvestor.com/variable-universal-life-insurance-as-a-retirement-account/
And here’s what usually happens with these: https://www.whitecoatinvestor.com/how-to-dump-your-whole-life-policy/comment-page-9/#comment-596929
I’ve had a VUL policy for a few years and I’ve watched the monthly charges and fees slowly increase. Currently about 40% of the monthly premium goes towards them. If the formulas in my spreadsheet are correct, the percentage will continue to get higher as the cash value increases. So far I’ve done well at selecting the investment choices, which has allowed the cash value to be much higher than a whole life policy. When I reviewed the 1st quarter statement, it looks like the insurance company is charging a higher M&E rate than listed in the prospectus. The amount deducted was slightly higher than the calculation shown in my spreadsheet. I’m in policy year 4 and I hate to lose 43% of the cash value to surrender charges so I may wait it out. I might get a term policy at a reasonable rate to avoid higher rates in 6 years and be double insured while both policy are in-force.
Thanks for sharing your experience. One of the worst parts of having one of these policies is the constant doubting and nagging as to whether you should have bought it in the first place and whether you should dump it now or not.
I have been dealing with my agent about this VUL finally I gave in and thinking about doing it. So my premium is only $56 monthly for the $250,000 insurance so by paying $200 monthly the difference will be cash value. And with investment growth at 8% the cash value could be up to $40,000 after 15 years. And this is my plan, withdraw a huge amount of money in 15 years from the cash value and then keep paying the premium and build again. Is this a good idea? Or should I just save money on a saving account? I am so stress out about if am making the right decision. At the end of the day all I want to do is save up a Enough money in 15 years to pay off my house. So my agent told me that I should put my saving into the VUL
That premium amount seems very low. If the minimum or even target premium for a $250,000 VUL policy is only $56 per month, I am guessing you are really young. The agent should have given you a prospectus along with the illustration that shows all the charges and fees, if not it may be available on the insurance company’s website. My VUL policy is through New York Life and they have charges and fees of premium expense (8% the monthly premium), cost of insurance per thousand, cost of insurance, contract fee, and mortality & expense fee (0.55% of the policy’s cash value). I’m paying $200 per month and only $122 is invested in various mutual funds. At least with NYL, paying more than the minimum increases the amount of fees instead of putting the difference in the investment options. Other insurance companies could have different fee structures.
If you want to use it as an investment vehicle to accumulate wealth in a 15-year time frame, then a regular brokerage account might be a better fit. Withdrawing funds from a VUL before the age of 59 1/2 will incur a 10% penalty plus applicable capital gains taxes. Loans can be taken against the policy’s cash value at generally low interest rate without tax consequences.
Savings accounts earn little interest, which is why the agent recommended a product with investments to help achieve your financial goals. I don’t think Variable Universal Life policies are as great as I used to. As the policy’s cash value increases, so does the percentage of the premium going towards fees. When my policy reaches $40,000, the fees will represent 45% of my monthly premium compared to the current 39%. While New York Life has a decent selection of funds, it’s very limited compared to the broader selection available through a broker and it can be challenging to find fund prospectus to know its fund management expense rate.
Whole life and term are cheaper than VUL polices that would enable investing the difference. Whole life can provide a fixed premium for the rest of your life and term life a fixed rate for a specified length that can be converted to whole within a few years. You have multiple options to achieve your financial goals.
Thanks for the reply
I am 31
He told me my premium doesn’t increase.
Why do I care what fees I pay with my premium if at the end all I care about is the cash value
Permanent life insurance like VUL and whole do have premiums that don’t change, however, VUL allows flexible premiums between a minimum and maximum amount. Your illustration should show include the minimum and Modified Endowment Contract (MEC ) amounts that is the range of your proposed policy.
Fees matter if the goal is to maximize the amount invested. If the primary goal is to increase cash value, then invested in exchange traded or mutual funds directly are a better option than doing so inside an insurance product. Over time the cost of insurance and policy charges increase resulting in less of the premium being invested.
Thanks again,
But I was told that worst case scenario that let say I received 0 investment, He says that it is guarantee 90-95 % of the money I built up in the cash value.
The agent’s estimation of fees being 5-10% of the paid premium is extremely low.
The illustration should include a Cost Summary page(s) that project the amounts of the gross premium, cost of insurance, cost per $1,000, M&E, cost of riders, surrender charge, estimated cash value throughout the policy years. Dividing the sum of all the policy charges (exclude the surrender amount) by the premium will show the percentage of fees.
If the illustration the agent gave you doesn’t include these estimates then he or she is not providing the full picture of the policy. I would attach a copy of the Cost Summary page that was included with my NYL VUL policy proposal to show as an example, but I’m not sure how to do so on this blog.
10% penalty for withdrawing? I though that only happens with 403b
The VUL I was told you can withdraw your own money at any moment with cost
It might depend on how much of the cash value is withdrawn from the “policy basis.” I don’t remember which financial site I read about the penalty so a tax expert would know for certain. At a minimum, any capital gains from the investments should be subject to income tax if they are withdrawn verses taken a loan against the policy.
Probably not.
Get a second opinion from a fee-only financial advisor. I suspect 99 out of 100 will recommend against saving up $40K in a VUL.
So I’m a resident and my parents purchased a VUL $500k for me 13 years ago. The cash value currently stands around $35,000 and I’m not too sure of what to do with it. We did have a financial advisor (caveat: who sells life and disability insurance) who recommended that I convert it to a whole life insurance. Would like to hear y’alls input on what to do…
Well, I would start with a second opinion from someone who does not sell whole life insurance.
I would also read this:
https://forum.whitecoatinvestor.com/insurance/1728-inappropriate-whole-life-policy-of-the-week
Then I would read these and order an in-force illustration of my VUL:
https://www.whitecoatinvestor.com/variable-universal-life-insurance-as-a-retirement-account/
https://www.whitecoatinvestor.com/how-to-evaluate-your-own-whole-life-policy/
Then decide whether I had a better use for the cash value than leaving it in that policy, obviously getting a term policy in place if needed before cancelling if that seems the prudent course.
Hi ,
My financial advisor is recommending a VUL policy for me. 1mil. with 24 K per year invested for 15 years then is paid up. I qualified for preferred best. he said this is a good way to avoid taxes on what i invest. is this not true?
Thanks,
Rick
Well definitely get a second opinion on anything you’re going to spend $24,000 x 15 = $360,000 on. Chances are good your financial advisor is just an insurance salesman masquerading as one, but you can read more about VUL as a retirement account here:
https://www.whitecoatinvestor.com/variable-universal-life-insurance-as-a-retirement-account/