Variable life insurance became popular in the 1980s and 1990s as a result of strong stock market performance. Cash-value life insurance buyers and sellers wanted to “get a piece of that,” especially after comparing the relatively poor performance of their whole life insurance policies to mutual funds and other stock market-based investments. If Wall Street with its high fees and slimy ways is an ogre, and cash-value life insurance salesmen are trolls, variable life insurance is what you get when they mate-the worst of both worlds.
It's important to distinguish variable life insurance from variable annuities and variable universal life insurance. They're all a little bit different, although you're probably not going to be interested in any of them if you haven't been suckered into one already.
The basic idea behind variable life insurance is to improve the returns on a whole life policy. It is the ultimate combination of insurance and investing. The problem is that you end up with the worst of both worlds. Like with whole life, the insurance company sucks off a good portion of your premium for its profits and to pay the underlying insurance costs. In a whole life policy, the insurance company takes what's left and invests it into its own relatively conservative portfolio of stocks, bonds, and alternative investments (mostly bonds.) In a variable life policy, YOU get to manage the portion left over after insurance company profits and insurance costs are paid. You do this by picking amongst the mutual fund-like accounts offered by the policy and allocating your money as you deem appropriate.
You still get many of the benefits of a whole life policy including a tax-free death benefit, the ability to borrow money from the policy tax-free (but not necessarily fee-free), and the usual estate planning and asset protection benefits you expect from a cash-value life insurance policy. You also have the potential to outperform a whole life policy by choosing investments that outperform those that an insurance company would have chosen for you. Sounds great, right? So what's the problem? Let's take a closer look.
Problems With The Salesman
These products are sold by insurance salesmen. Variable life insurance, as a combination product, actually requires both insurance licenses and securities licenses to be held by its salesmen. As incentive to sell the product, these salesmen are offered high commissions, usually 50-100% of the premiums you pay the first year, with perhaps 6% of premiums going directly into the salesman's pocket after that. He'll tell you he's compensated by the insurance company, not you, but where do you suppose the insurance company gets the money?
Due to this ridiculously high commission, the salesman has a huge incentive to push you into these products even when they're not in your best interest. Worse, since most folks can't afford a big enough variable life insurance policy to actually cover their insurance needs, they tend to be underinsured. It really irks me to see someone own a life insurance policy that doesn't even cover their life insurance needs. Even if you decide you like variable life insurance, you still need to either purchase a separate term life policy or at least purchase a rider on the variable life policy that adds on some term insurance.
If a financial adviser suggests you buy one of these policies, I suggest you get a new adviser. Let's try to understand why.
Problems With The Insurance
Term insurance is sold as a commodity. You can go to term4sale.com (no financial relationship) and see dozens of companies offering essentially the same insurance and make your decision primarily on price. You can easily compare apples to apples. Not so with more complicated cash-value life insurance. You're lucky if you can compare apples to oranges. More likely you'll be comparing apples to a strange hybrid fruit that is 1/3 banana, 1/3 celery, and 1/3 gravel. There are so many moving parts with these policies, a typical buyer has no chance in being able to keep them all straight, much less comparing them to other policies. He is forced to rely on his adviser to do so. Complexity always favors the issuer (and his representative.) Every policy is different, and it borders on impossible to compare them all. Luckily, you can ignore all of them and still do just fine financially.
The insurance component of the policy is too expensive. Take a look at this prospectus from a Prudential policy sold back in the 80s and 90s. The first section is a mandated summary of expenses. The list of fees runs 3 pages. That can't be a good sign. The cost of insurance in the table varies from $0.06 to $83.34 per year per thousand dollars of insurance provided. It suggests a cost of $0.15 initially (it goes up) for a healthy 30 year old. Now I'm not the sharpest tool in the shed, but that seems like an awfully big range. Of course it is going to vary based on age, health, and dangerous hobbies, but a comparable 30 year level term policy for a healthy 30 year old runs $695 per year…for $1 Million, or about $0.70 per year per thousand dollars. That might seem expensive compared to $0.15 per thousand, but keep in mind Prudential will raise that each year.
A 5 year level term policy for a 30 year old can be bought for $0.28 per thousand. How long do you think your insurance cost will be $0.15 per thousand? And don't forget the other insurance expenses in the policy- the mortality and expense risk fee (0.60% of the cash value), and the extra $2.50 plus $0.02 per thousand of insurance-for some bizarre reason charged monthly, not annually, presumably just to confuse you. That more than triples the $0.15 per thousand discussed above. Aside from the expense, there is another major problem with the insurance component of the policy. You should buy insurance for the guarantee. You want the company to guarantee to pay your heir a big chunk of money if you die. You want the company to guarantee the cost of your insurance so it doesn't become unaffordable. These policies don't guarantee either. If the investment portion of the policy does poorly, your death benefit can actually go down. They offer an option to keep that from happening, but it is going to cost you yet another fee. Likewise, the policies don't guarantee a level cost for the insurance. Here's a quote from the Prudential prospectus:
In several instances we will use the terms “maximum charge” and “current charge.” The “maximum charge,” in each instance, is the highest charge that we may make under the Contract. The “current charge,” in each instance, is the amount that we now charge, which may be lower than the maximum charge. If circumstances change, we reserve the right to increase each current charge, up to the maximum charge, without giving any advance notice.
Does that sound like a guarantee to you? What's their incentive to keep the charges low? Your only recourse is to surrender the policy, but you can be sure that will be a very costly option. How costly? Funny you should ask. Say you realized you screwed up buying this policy and want out after 5 years. It'll cost you 9%. 9% of what you say, the cash value? Oh no. 9% of the TOTAL PREMIUMS PAID over the last 5 years. Depending on investment performance, that could be the entire cash value. Worse than any mutual fund, this sucker's got a front load and a back load. Well, at least you can borrow your money tax-free from the cash value, right? Well, yes. But it isn't fee-free. On this particular policy, it costs you 1.5% to borrow your own money.
Problems With The Investment You've seen the fees associated with the insurance portion of the policy. What about the investment portion? This policy isn't too bad compared to most I've seen. It's expense ratios vary from 0.38% to 0.87%. That's not so bad, unless you compare them to something like Vanguard index funds with ERs around 0.07-0.20%. Of course, don't forget about the load. That's 5%, plus some bizarre 2.5% “for taxes” and another $2 per payment for “administrative expenses.” You'd think they could pay those out of the ER or the load, but no, they need another $2 per payment. So 7.5%+ of each payment you make just disappears before it even gets to the investment. So what are the investments?
This particular policy offers 14 different options, including a single index fund, although most options are actively managed. Let's take a look at their actively managed large cap blend fund called “Equity.” Very original. It boasts a return of 3.04% per year since its inception in 1984. That doesn't seem very good. Let's compare that to the Vanguard 500 Index Fund which has averaged 10.4% since 1976, and I assure you the lion's share of those returns didn't come in the late 70s and early 80s. Remember, those returns don't take into account the 0.6% “mortality charge” taken out of this pot every year, not to mention the loads and other fees.
Why are these funds so bad? They suffer from outrageous fees, but most importantly, there's no incentive to fire bad managers, hire good ones, or even close bad funds. The money is captive inside the policy. They don't have to compete with mutual funds, much less good, low-cost, index mutual funds. If you want an actively managed large cap fund, there's only one. Take it or leave it. And the managers know the people buying these policies aren't very smart to begin with. If you knew much about investing, you surely wouldn't be invested in this thing. So they just go to the local steakhouse for their three-martini lunch and make fun of you all the way to the bank.
Now, I picked this particular Prudential policy because the prospectus was easily found with a quick Google search. It is quite possible that there are better policies out there, with lower fees and probably better performing investments. But from the policies I've seen, this one is pretty typical. I was once sold a term policy that was convertible to a variable life policy that was far worse than this one, with ERs on the investments in the 2-3% range.
Some of us find it interesting to dive into these things, just to see how bad they are. If that's you, great. If it's not, here's the bottom line: Don't buy cash-value life insurance, ESPECIALLY variable life insurance. You will be well-served to not mix insurance and investing.