Universal Life Insurance: The Basics – Part 1
I describe permanent life insurance as a multipurpose jackknife that combines many useful tools into a single sleek package. Universal Life (“UL”) policies are the ultra-deluxe version that includes enough attachments to do anything from performing minor surgery or opening wine bottles. On the other hand, unless you are supremely confident in your surgical skills or don’t mind a little cork in your chardonnay, perhaps this mythical pocketknife isn’t always the best tool for the job.
Arguably, the same is true for UL insurance; although it is capable of many different uses, which is a wonderful thing, it isn’t always the ideal solution for every problem. All the same, since we don’t always know what to expect when wandering through the forest that is life, having something in our back pocket that can be useful in a variety of different scenarios is a very attractive option. On a similar note, UL may sometimes be a secondary tool you can use in conjunction with your preferred implement to improve your overall results. Of course, in other case, despite these cautions, maybe sometimes a UL policy is exactly what you need.
A Thumbnail Sketch of How UL Policies Works: The Face Value and the Accumulating Fund
i. The Face Value
UL policies are able to weave their magic by separating your life insurance policy into two separate parts: the face value and the accumulating fund. I’m going to about each separately, starting with the face value.
The face value is the amount of pure life insurance you own, against which you are charged an annual premium. The money you pay for that portion of the premium goes to the insurance company. This money is pooled and invested with that of other clients and used to fund the face value portion of your death claim. You have no control over how this money is invested and you don’t get any of it back if you cancel your policy.
To make thing more interesting (or at least more complicated), the face value of your policy can actually go up or down, depending on the details of your policy and your needs. You might want to a policy that allows you to increase the face value when appropriate even though this increases your premiums. At other times, you may want it and your related insurance costs to decrease. Although I’ll explain why the benefits of this flexibility shortly, let’s not focus on why this is so for now. Just remember that both the face value of your policy and your basic insurance costs can increase or decrease over the life of your policy if you select this option at the time of purchase.
If you are worried about providing a minimum benefit to your heirs but still want this flexibility, you can get the best of both worlds; in addition to selecting the ability to increase or decrease the face value, you can also restrict the maximum reduction. In other words, if you want to ensure that there is at least $500,000 left for the kids, you can limit the maximum reduction to the face value to this amount. You’ll still need to ensure that you can continue to pay the minimum insurance costs for this reduced amounts, either by continuing to pay into the policy each year or by using money inside the accumulating fund to pay the premium. I’ll explain how to use the accumulating fund to do this when I change directions in a few short paragraphs.
ii. The Accumulating Fund
The other piece to the UL policy is something called the accumulating fund. Once you understand how it works and how it is connected to the face value, you’ll understand why varying the face value can work to your advantage and how UL policies can be used for purposes other than just providing payouts at death.
To begin, the actual payout at death (the “death benefit”) may be higher than the face amount of your policy. This is where the accumulating fund comes in. Most UL Policies top up your death benefit by adding the balance of the accumulating fund at death to your face value. To put this in insurance-speak, your death benefit is often the total of the face (the face value of your policy) and the fund (the value of your accumulating fund at that time.)
How do you get this extra bump to your death benefit and how is it calculated? As you probably expect, it doesn’t come for free. The value of your accumulating fund is based on how much extra money you pay into your policy and its investment performance. In other words, the value of your accumulating fund is largely up to you; how much extra money do you to contribute and how much the investments inside the policy that you select grow over time. Although your choices are confined to the different options provided by your insurer, you generally have numerous choices with different levels of risk.
Expanding on this, the real benefit of the accumulating fund is that this investment growth inside the policy compounds tax-free and, on death, is paid out tax-free as well. If you put enough into your policy and the investment gods cooperate, you can eventually have a total death benefit that is many, many times the value of the original face value of the policy.
iii. Growing and Shrinking your Accumulating Fund
Unfortunately, the size of your accumulating fund is not a bottomless pit; the government has set rules on how much money you can have in the fund, including investment gains. The maximum size of your accumulating fund is linked to the face amount of your policy. As you might expect, the larger the face value, the more you can squirrel away for a rainy day.
Moreover, the suits in Ottawa also limit how much you can increase the size of your face value from year to year to about 8%. Generally, the maximum yearly increase to the face value (unless you want to go through another round of medical tests) is about 8%. On a more practical level, insurance companies aren’t in favour of giving clients an unlimited right to increase the face value of their policies anyway; the insurance business would have failed a long time ago if clients were allowed to unilaterally tripling the face value of their policies the first time they felt chest pain!
Noting that there are rules governing both how much money you can have in the accumulating fund relative to the policy’s face value and how much this face value can grow year over year, it’s necessary to ensure you buy a big enough initial policy in order to shelter your planned contributions over the life of the policy and the expected investment growth. In such cases, clients make their life insurance decisions backwards from how it’s usually done: instead of calculating their initial and future life insurance needs, they work with their insurance advisors to determine the smallest death benefit necessary to shelter all the money they’d like contribute over the life of their policy. Of course, I am generally more comfortable with this type of strategy if you do need life insurance for its traditional purposes rather than solely for your own retirement or are one of the fortunate wealthy few who are financially set for life and are interested in some high level estate planning with some of the funds earmarked exclusively for your children, favourite charities and family pets.
If you are one of those clients whose initial face value is really higher than your basic life insurance need, you might be tickled pink to know that you can reduce your face value (and the related insurance costs) if don’t always need that large a face value to shelter your planned contributions, your policy investments tank or you can no longer afford to make your planned contributions. In fact, it is a common strategy to contribute the maximum amount allowed by law for a period of 10 years or less after the policy is issued and then, like a farmer waiting for a harvest that is far, far into the future, sit back and watch the accumulating fund grow. After you’ve made your last contribution, unless your policy investments soar into the stratosphere, you’ll likely no longer need as large a face value to shelter what you’ve already put into the accumulating fund and its’ subsequent growth. Moreover, some of your investment gains or original contributions will now go to pay the insurance premiums on the face value now that you’re not putting any new money into the policy.
How far into the future do you have to wait if you’re one of those patient investors planning on bumping up their retirement lifestyle? Generally, insurers suggest that you should plan on waiting about 20 years after your first payment into the (depending on how quickly you funded the policy, how much extra cash you contributed above the minimum and if your investment decisions have come up all roses.) Accordingly, if you don’t have the patience of Job or don’t have ample other resources to tide you over, this might not be the thing for you.
iv. Vanishing Face Value Policies
Although there are limits to how much you can increase the face value of your UL Policy from year to year, there aren’t any limits on how much or how fast you can shrink the face value of your policy. By cleverly (or aggressively, depending on who you ask) manipulating the current income tax rules that regulate the size of a UL Policy’s accumulating fund, it’s possible to actually reduce the size of the accumulating fund to next to $0 yet still protect a massive tax-sheltered and potentially creditor-protected accumulating fund. For clients that really just want the policy for these reasons, this might be the ideal solution. Some insurers even allow clients to make a single enormous initial contribution for an astronomically high face value that rapidly dwindles down to $25,000 or less (depending on your insurance company) over the ensuing years. Needless to say the government isn’t particularly ecstatic about this technique and the same opportunities won’t be available once the new tax rules for insurance policies come into place in 2016. On the other hand, since policies in place before that point will be “grandfathered” (i.e. allowed to operate under the old rules), many advisors and clients are looking at taking out such policies before the door slams shut. Even so, more conservative advisors don’t use this strategy.
As you have found out the hard way, even though they might not be as indecipherable as Participating Whole Life (“Par”) Policies, UL Policies are still not a walk in the park to understand. If you’ve made it this far, I promise to reward your suffering next time by providing you with more details of some of those extra uses I hinted about in my (hopefully) stirring introduction. I’ll also talk about some of the options available to you when selecting the appropriate UL Policy, especially premium choices and the range of investments available to you within the policy.
Until then, I welcome your questions and wish you the very best of RRSP season.