From the May 2007 issue of Boomer Market Advisor • Subscribe!

Variable universal life -- Are boomer benefits worth the risk?

Tax efficiency and the ability to gain from market upswings are just two of the benefits of variable universal life. But are there better alternatives, and does the product make sense for boomer clients?

It's a debate that seems to be as old as life insurance itself. Does variable universal life insurance make sense as a product, or is it better to buy a straight term policy and invest the premium difference? Unique to a VUL policy is the ability to choose how the premiums are invested. The risk is that the policy's cash value and death benefit can decrease, based on the performance of the underlying investments -- hence the variable tag.

Advisors equate variable universal life with buying life insurance and, at the same time, investing in a mutual fund. The VUL policy grows on a tax-deferred basis, and as long as the policy is maintained, it does not pass on capital gains and other tax obligations.

Often, VUL policies are used to assist with estate tax planning -- especially in cases where a sizeable non-liquid asset, such as a family business, is inherited.

"The basic tax benefits of variable universal life are the fact that the cash value is tax deferred and can be accessed tax free through loan provisions," explains Jeremy Portnoff, a NAPFA-registered advisor with Portnoff Financial in Piscataway, N.J. "This is a great feature because the loans can be used to supplement a retirement income as long as there is enough cash value. In a variable policy, the cash value can be invested in the market, which will hopefully produce higher returns than a standard universal life [policy] with a cash-equivalent return."

As far as estate planning is concerned, he says, if premiums are paid and the cash value supports the policy until death, there will be insurance proceeds to help with any necessary final expenses, which may include estate taxes. If it's included in an irrevocable life insurance trust, the policy also produces additional tax benefits. The proceeds will not be included in the decedent's gross estate -- assuming it is titled and structured properly -- thereby reducing potential estate taxes. In a second-to-die policy, says Portnoff, this becomes critical for reducing estate taxes. Assuming the estate was planned properly and the couple made use of the unified credit on the first spouse to die, the life insurance helps pay any taxes that might be due.

James Christie, principal with Freedom Wealth Management in Basking Ridge, N.J., adds that the key benefit for using second-to-die insurance is to use a client's annual exclusion to pay the premiums on the policy, once the policy is placed in an irrevocable life insurance trust. This places the death benefit outside of the grantors' taxable estate.

In certain circumstances, he says, using a variable product can boost the death benefit, which is true in cases where there is ample cash value in the policy and the underlying investments performed well.

But John Davis disagrees. A fee-only Certified Financial Planner in Elmhurst, Ill., Davis would rarely, if ever, recommend a VUL second-to-die life insurance policy for tax and estate planning purposes. He says there are simply too many uncertainties, chief among them:

  • What premiums will be required to keep the policy in force?
  • What are the commissions on the different policies?
  • What if the underlying sub-accounts perform poorly?
  • Are there conditions under which you may not be able to afford the premiums over the longterm?

There are a variety of alternatives, Davis says, and depending on an individual's unique situation, there may be a better solution.

"For example, if the client's goal is to pay an estate tax bill, a standard universal life insurance contract with a fixed investment component would eliminate most selling costs and result in premiums that are more predictable to keep the policy in force. The buyer should make sure that a reasonable 4 to 5 percent interest rate is assumed. The policy would have to be owned by a trust. Otherwise, if owned by the insured or the spouse, the death benefit would be included in the deceased's estate. A life insurance trust adds expense."

Also, says Davis, if the client's goal is to leave a legacy to his heirs, investments could be set aside, either in trust or not in trust, and pass tax free with a step-up in basis to the heirs upon death.

"I actually have a client who bought a second-to-die universal life insurance contract with a $500,000 death benefit. He wanted to leave $100,000 to each of his five children. The agent projected that the $12,000-per-year premiums would be paid for only eight years. It would then vanish when the cash value was large enough to pay the cost of insurance. Unfortunately, an 8 percent rate of return was projected, and the insurance company did not earn 8 percent in its general account. The client was forced to decide whether to pay premiums for eight more years or surrender the policy. He surrendered it."

Another option, according to Janice Forgays, vice president of individual insurance with Sun Life Financial is a universal life policy with a no-lapse guarantee. By paying a comparatively low premium, the policyholder is guaranteed a stated death benefit.

However, there is little value in the life insurance policy during the life of the insured.

By comparison, "with the variable policy, depending upon the underlying funds and their performance, there is the potential of having a fair amount of value in the policy during the policyholder's life, usually on a tax-advantage basis," she says. "However, the variable policies must be monitored and managed, unlike most other life insurance policies."

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