Variable life insurance is a type of permanent life insurance policy, meaning coverage will remain in place for your lifetime so long as premiums are paid. Every variable life insurance policy has three primary components:
Death benefit
Cash value
Premium
Every time you make a premium payment, a portion of it goes towards the cost of insurance and insurer’s fees. This is the money that essentially pays to keep the death benefit in place. The remainder of the premium goes towards the policy’s cash value, which is similar in structure to a brokerage account. The cash value can be invested in certain securities (often called sub-accounts) which resemble mutual funds.
If the cash value performs well, it can be used to increase the death benefit, withdrawn as cash or used as collateral for a loan. The cash value is also the amount of money you would receive if you decided to give up your coverage to the insurer, or surrender it.
Cash Value of Variable Life Insurance
How a variable life insurance policy’s cash value works is what makes it particularly unique from a whole or indexed universal life insurance policy. Each policy comes with a prospectus detailing around 20 to 30 options for investing the cash value. The cash value investment options are similar to mutual funds in that there’s a particular set of securities that the money would be invested in, such as:
An index, such as the S&P 500
A portfolio of equities, such as an emerging markets fund
Bonds
A money market fund
In addition to these investment options, variable life insurance policies generally have a fixed interest investment option provided by the insurer. For each investment option, there are management fees, similar to expense ratios for mutual funds. These fees vary according to the securities being invested in and can be quite high if the money is being actively invested (meaning a portfolio manager is picking stocks).
Cash value investment management fees are sometimes listed as “basis points”, and one basis point equals 0.01%. So if an investment option is listed as having a 6% historical rate of return but comes with 125 basis points in management fees, you should keep in mind that returns will be reduced by 1.25%.
Since you’re able to choose from a variety of investment options, variable life insurance policies have higher upside potential than other cash value policies, such as whole life insurance. In addition, the growth of your policy’s cash value is tax-deferred, so you generally won’t pay taxes on gains so long as they remain in the account (which causes the cash value to grow faster).
However, variable life insurance policies may not have a guaranteed rate of return, or it may be quite low. In addition, your cash value investment options typically have a cap on the maximum rate of return. So, your cash value can actually decrease in value during bad years and may not perform as well as it could during good years.
Fees: A Key Downside to Variable Life Insurance
Every permanent life insurance policy comes with fees but the downside to variable life insurance is that it tends to have the highest. Variable life insurance policies will typically have the following costs:
Fee Description
Mortality and expense risk charges These are the costs to provide the actual death benefit.
Sales and administrative fees Costs to cover an agent’s commission, set up and maintain the policy, and the insurer’s ongoing expenses.
Investment management fees These vary depending on how you choose to invest the policy’s cash value.
Surrender charges Policies have a surrender period during which, if you withdraw part of the cash value or decide to give up your coverage, you will pay fees. The cash value of your policy typically isn’t equal to its actual surrender value for the first 10 to 15 years of coverage.
Withdrawal fees Each time you withdraw money from the policy’s cash value you can be charged a fee. This is often relatively small, around $25.
Policy loan interest If you take out a policy loan using the cash value as collateral, the insurer will charge interest on the loan.
Riders Riders are add-ons that can be used to alter the terms of the policy. Each needs to be evaluated as compared to its cost and your financial situation.
In particular, the administrative fees for a variable life insurance policy will be higher in part because these policies are SEC regulated investments. As the insurer passes these additional charges on to you, it should actually be consideration when you determine how to invest the policy’s cash value.
If you choose relatively conservative investments, you’re likely to have gains that are more similar to a whole life insurance policy’s cash value, but whole life insurance policies will have lower fees. Therefore, with the same cash value rate of return, you would actually perform worse with a variable life insurance policy.