Variable universal life: The pitch, the pitfalls

Our expert explains the ins and outs of the insurance policy and why you should think twice.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: My wife and I are 28 years old and have both recently completed graduate degrees in medicine and law. We live well, but within our means and over the past year have been able to save 17 percent of our combined income.

An adviser we've been working with has recommended that we don't contribute to our 401(k) because we receive no employer match. Instead, our adviser suggested we buy a variable universal life policy through him, which is where we've been putting our savings.

Do you think this is a good move? And if not, is there a way to back out of the insurance policy? - David, Philadelphia, PA

Answer: Sounds to me like it was probably a very good move for your adviser. I'm sure he earned a nice commission on the sale. As far as you and your wife are concerned, though, I can't think of a good reason why you'd want to forego your 401(k) and instead buy a variable universal life (VUL) policy.

And your adviser's reasoning that your 401(k)'s lack of an employer match somehow argues for the VUL policy is, well, puzzling to say the least. I mean, it's not as if the insurer is going to kick in matching funds. And even if you're not getting a match in your 401(k) at least your contributions aren't taxed, which gives you a nice little immediate tax break. With a VUL, you're investing after-tax dollars.

The pitch for a VUL: Now, I suspect that part of the sales pitch for this VUL policy was the promise of tax-free returns down the road. With a VUL, part of the premium you pay goes to the insurance part of the policy, which pays the benefit, or face amount of the policy, to your beneficiary if you die. But you get to invest the rest of your premium in the policy's "subaccounts," which are essentially the equivalent of mutual funds.

The idea is that these subaccounts build value over time - this is known as the "cash value" portion of the policy - and you eventually tap that cash value when you need it for, say, a house down payment or child's education expenses or even for retirement.

And here's where the real sales hook comes in. Instead of just selling some of your investments and withdrawing money from the policy, you borrow (usually at a very attractive rate) against the policy's cash value. Since loan proceeds aren't taxable, you're effectively gotten a tax-free rate of return. Isn't VUL wonderful?

The pitfalls: Well, it seems that way until you understand the pitfalls. One major downside is that these policies are loaded with fees.

Fees for the insurance protection itself (which, by the way, is usually more expensive than what you would pay for a regular term insurance policy). Fees for marketing and sales commissions. Then there are the investment management fees that can run as high as 2 percent a year. And on top of that there's an annual fee that can run upwards of 0.90 percent that goes by the name of the "M&E," or mortality and expense charge. This is essentially a fee thrown in to assure the insurance company a profit even if all those other fees somehow don't.

As you can imagine, this fee-for-all arrangement can really drag down your returns.

But there's another risk you should be aware of-namely, those tax-free withdrawals can backfire. Once you start borrowing from one of these policies, you've pretty much got to keep it going the rest of your life.

Why? Well, if the policy lapses, all the investment earnings you've withdrawn immediately become taxable. If that happens at an inconvenient time - like when you're retired, have been drawing on the policy for income and may not have lots of extra cash on hand for the IRS - you could have quite a tax headache.

If you really want to delve into the nitty gritty of these policies and their pitfalls, I suggest you check out the life insurance section of the Consumer Federation of America site. James Hunt, a former Vermont insurance commissioner and variable life guru, plans to post a new paper on VUL policies there soon which will replace an paper from 2003 which was written before a change in the tax law lowered the rate on qualified dividends.

In any case, the bottom line is that I think you and your wife would be much better off contributing to your 401(k)s, match or no. Besides, you're both young. You'll probably change jobs a few times. When you do, try to find a new employer who also offers a nice match on your 401(k) contributions.

If you and your husband get to the point where you're maxing out on your 401(k)s, you're funding every other tax-advantaged vehicle the government offers - a traditional or Roth IRA, maybe a SEP for self-employment earnings - and you've got a nice emergency fund going as well as investments in taxable accounts, I suppose someone could make a case for throwing extra savings into a VUL.

But I wouldn't. I'd say move on to tax-managed mutual funds, index funds or maybe even ETFs. As long as you hold these for the long-term, most of your return will come in the form of long-term capital appreciation, which is taxed at the more favorable long-term capital gains tax rate, which now maxes out at 15 percent, compared with 25 percent for short-term gains and regular income. (For more on these alternatives, click here.)

As to your question of backing out, well, that brings it's own set of problems. Unless you've had the policy many years, simply surrendering the policy for cash would likely trigger surrender charges that could significantly reduce the amount of money you walk away with.

On the other hand, staying in could just mean throwing more bucks into a high-fee investment. These policies come with a "free look" provision that allow you to return them for a full refund within a certain time frame that varies by state, but we're talking a short time period, say, 10 to 30 days. If you've only owned the policy a short time, you might be able to squeeze in under the free-look deadline.

If you can't do that, you're dealing with a more complicated situation. If you feel you've been misled, you can go back to the adviser, demand your money back and, if he refuses (which is likely), ask to speak to the firm's compliance manager and make your case to him. If that doesn't resolve things, you can complain to the NASD, SEC and your state insurance department.

Quite frankly, unless you can show you were really duped, I'd be surprised if you get much satisfaction. (On the other hand, I think it's good for people in your situation to get their complaints on the record so regulators get a sense of how these policies are being peddled.)

You might also try talking to an adviser who can run some numbers that will help you weigh options like perhaps waiting until the surrender charges lapse or drop to a less painful level and then cashing out or converting the policy to another form of insurance or doing a tax-free transfer to a low-cost (yes, they do exist) annuity or maybe even holding onto the policy but funneling no new money into it.

You'll have to find someone who knows about and knows how to evaluate these and other options. You also want to deal with someone who isn't going to compound your problem by getting you out of the policy and moving you to another expensive insurance policy or annuity or other investment.

For that reason, I think you're probably better off talking to a fee-only financial planner or an adviser who will take on a project like this for an hourly fee. (The Garrett Planning Network has advisers who'll work on that basis.)

You might also try the Consumer Federation of America's Rate of Return analysis, which, for a very reasonable fee that starts at $65, will provide an analysis that can help you decide whether the policy is worth keeping.

Clearly, the moral here is that the best way to keep yourself in the unenviable position of trying to figure out what to do with a variable universal life policy you don't really want is not to buy one in the first place. That is no longer an option for you. But it is for everyone else who finds himself on the receiving end of a VUL pitch.


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