Understanding the disadvantages of universal life insurance helps consumers make the most educated decision. Here are the 10 major disadvantages that should be considered when considering universal life:
- The policyowner bears all investment risk. VUL policies provide no minimum schedule of cash values as with UL or traditional whole life policies. Instead, cash values are equal to the market value of the policy assets in the separate accounts.
- VL death benefits depend on the investment performance of the assets underlying the policy. If market values are down when the insured dies, the policy may pay a lower death benefit than anticipated. However, the death benefit cannot fall below the guaranteed minimum benefit.
- If the investment performance of a VUL policy is poor, to maintain the face amount of coverage the policy may require the policyowner to pay additional premiums.
- VUL policyowners must accept all responsibility for premium payments. The disadvantage here is that policyowners can too easily allow their policies to lapse. The policy has no forced savings feature, because it does not require the policyowner to make premium payments as long as the cash value is sufficient to carry the policy. To reduce the likelihood of lapse, most companies bill policyowners for a target premium set by the policyowner.
- VL and VUL policyowners bear some mortality and expense risk because these policies are “current assumption policies with respect to mortality and expenses. VL and VUL only guarantee that mortality charges and expense rates will not exceed certain maximums. In contrast, traditional participating whole life policies guarantee mortality and expense charges. Consequently, policyowners bear more of the risk of adverse trends in mortality or expenses than if they owned traditional whole life policies. However, if the trend of mortality costs and expenses improves, policyowners may participate in the improvement through lower charges.
- Lifetime distributions or withdrawals of cash values are subject to income tax to the extent attributable to gain in the policy.
- Realized capital gains on the underlying assets when taking withdrawals or surrendering the policy are taxed as ordinary income. In contrast, capital gains recognized on sales of similar mutual fund shares were treated as capital gains. In addition, under current tax law, taxpayers may use capital gains to offset other capital losses if the gains are from a mutual fund but not if they are from a life insurance policy. (In future years, ordinary and capital gains tax rates will probably change. However, that some kind of differential in the ordinary and capital gains tax rates will remain is highly likely. Also, the portions of distributions of cash values of life insurance that are attributable to capital appreciation of the underlying assets are highly likely to continue to be taxed at ordinary income tax rates, rather than lower capital gains tax rates.)
- Surrender of the policy within the first five to ten years may result in considerable loss because surrender values reflect the insurance company’s recovery of sales commissions and initial policy expenses. In addition, most VUL policies levy surrender charges rather than up-front fees or loads. These surrender charges generally decline each year the owner continues to hold the policy. Typically, insurers assess no explicit charges if the owner surrenders the policy after about seven to ten years.
- The flexibility with respect to premium payments and death benefits in VUL permits policyowners to change the policy in such a way that, inadvertently, it may become a modified endowment contract with adverse tax consequences.
- Expense loadings generally are greater than with other types of policies.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM