Every once in a while, I receive financial questions from readers. I am not a financial adviser, so I usually suggest those needing significant assistance with their financial decisions to seek the advice of a professional. However, I don’t mind answering general questions that might be helpful for a wider audience. If you have any questions, contact me. If there’s anything I’d like to address but I’d like to learn more about myself, I have a strong network of colleagues who can add facts and expert opinions.
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Today’s question comes from a frequent participant in Consumerism Commentary’s discussions, and focuses on a topic I don’t usually cover, life insurance.
Flexo, I recently read a book called Tax Free Retirement by Patrick Kelly and the author was selling the idea of buying Universal Life Insurance as a way to build your retirement fund. I’ve been doing research on Universal Life Insurance (pros and cons). What are your thoughts on Universal Life Insurance, and is it something you recommend people to do?
What is universal life insurance?
It’s worthwhile to describe life insurance in general, although I will address the specific question about retirement funds later in the article.
The primary parties when it comes to insurance are the insured, the beneficiaries, and the insurer. Life insurance policies offered by the insurer protect the income of the insured, so that if the insured passes away, the beneficiaries, who relied on that income in order to survive, can continue receiving income or a lump sum payment. For example, the head of a household or all income earners in a family may buy life insurance to protect their children. Life insurance benefits could help pay for funeral costs, medical bills, and the normal expenses of everyday life for the beneficiaries.
Life insurance comes in several flavors. The most common and basic is term life insurance. This is a typical insurance policy that is based on a set number of years. During that period, the insured will pay premiums and be protected, but at the end of the term, the protection ends. The nature of insurance means that someone could pay into a policy for several decades, and if that insured individual continues to live and stay healthy, she’ll never have any benefit other than peace of mind. At the end of a term, insurers offer an option to renew the policy.
In an effort to reduce the risk of non benefiting from years of paying into a policy, insurers came up with different types of policies, usually including a savings or investment component to help insurers mitigate the risk because in these scenarios, the chance of paying out benefits is closer to 100 percent. These are often called permanent life insurance policies, and there are several different plans designed to suit customers’ needs. Universal life insurance is one form of permanent life insurance, like whole life insurance.
Universal life insurance
Universal life insurance provides some flexibility in the premium payments, the amount of money the insured pays to the insurer, usually on a monthly basis, to pay for the coverage as well as fund the savings component. The savings component is the cash value portion of the insurance policy; it’s basically a savings account. The insured can withdraw or borrow money from the cash value portion of an insurance policy. Because of this benefit, the premiums are much higher. Sometimes, the difference in premium is a factor of ten. Is the savings portion worth ten times more than an insurance policy on its own?
Because insurance companies usually offer low rates on the savings portion, and unlike money market funds there are no regulations that describe what the insurance company can do with your “deposits,” insurance companies often invest the money at a higher interest rate, making money on the spread between their investment returns and the low interest rate they offer their insurance customers.
When you withdraw or borrow money from a universal life insurance policy, it reduces the amount of benefit your heirs or beneficiaries will receive. This reason alone is enough to steer people away from this type of coverage.
An interesting benefit of universal life insurance, beyond the similar whole life insurance, is that the insured can use the interest earned on the savings component to help pay the monthly premiums. Also, there is a type of universal life insurance called variable universal life insurance. With this variable plan, the savings portion earns a variable interest rate. With whole and some universal life insurance policies, the rate of interest you earn is locked in for the remainder of the policy.
Variable universal life insurance is one of the most flexible products you can buy to protect your income stream, but it comes at an even higher cost than the type f unversal life insurance described above.
Compared to universal life insurance, variable or not, you may be able to generate your own returns in savings or investment that are better than the returns you’d receive by including a savings portion in your policy. If you’re a savvy saver and investor, you may want to leave your investments separate from your life insurance policy and opt for term life insurance. If you appreciate consolidating your savings with your insurance policy and are not concerned with a significantly higher cost, it might make sense to opt for this type of coverage.
Can a universal life insurance policy build your retirement fund?
The savings component can make this a tempting option. There are three major drawbacks to this approach, and because of these reasons, I would not use a life insurance policy of any type to increase my planned income during retirement.
- Any retirement income you need and withdraw reduces the value of the benefits your heirs will receive, as mentioned above.
- You can get better investment options by opening an IRA at a discount brokerage.
- You’ll be paying much more for less potential performance than other retirement options. Even a 401(k) could cost much less.
For readers: Do you have a universal life insurance policy and are you happy with the insurer so far? Have you had any experiences collecting benefits from a policy?
Updated October 21, 2015 and originally published August 22, 2011.